You know that budgeting is an important part of managing your business, but most small business owners tell us that budgeting is a boring, and time consuming task with little benefit.
It’s true that traditional budgeting can be a waste of time. But when done correctly, it becomes a useful and even fun exercise.
That's because a good budget works for you: It delivers the insights you need to manage your business with confidence day-to-day, and make informed financial decisions to achieve your goals over time. But to get this type of budget you have to take your process a bit farther––do a few more steps.
How to create and use a better budget for your business
A basic budget should capture your annual expectation for sales, the costs required to deliver what you sell, and the expenses you need to run your business. Simply put, your budget is a look ahead at your profit. And if you include some extra information you can also prepare a look ahead at your cash and equity too, with a process called forecasting––more on forecasting later.
If you budget already, you probably do it one time each year to get a snapshot of your year ahead, and what you think your business will net in profit. But budgeting should be more than a one-time-each-year exercise. Budgets should be actively maintained and tracked, and even updated monthly.
If you use accounting software you might already be using a simple budget. That’s a fine place to start, but for a budget that will also work as your forecast and roadmap, you’ll need something more than your accounting software. You’ll want to add sales projections, and a forecast model, which can't be done in accounting.
We offer this free template to get started, and it comes with a free instructional video. We also offer services to build a more sophisticated budget and forecast model for you, track it each month, and guide you on business performance and cash management.
Do These 5 Things To Make Your Budget Work For You
Our team has many years of experience in forecasting and analysis for all types of businesses, and we've learned some things along the way. We want to share with you the five key things you should do in your budgeting process to make it work for you––to have it be your roadmap for running your business day to day, and making the right decisions to achieve your goals.
1. Create strategic income categories––get a bit granular
A dynamic budget will do more than manage expenses and reveal net profit. It will also help you see the differences in sales and profit between the various things you sell. But to do that you'll need to budget more income categories than just Sales.
You don’t need to list every item you sell. Use broad categories and think in terms of profitability and your sales process. Which items fit into categories together based on their cost structure to produce and/or the way they are sold?
For example, we sell business advisory services and financial forecasting. We work with clients in many different ways, but broadly we sell 4 different types of service products, and so we project sales each month in these categories.
Monthly strategy + forecasting
Monthly forecasting alone
Monthly financials review
A business analysis report
2. Consider Gross Margin––the engine of profit
The two metrics every small business owner wants to track are profit and cash. You want to know, are you profitable, and are you turning that profit into cash?
But before net profit, there is another metric you should know. And it’s a metric you can use as a leading indicator of your net profit and cash. The metric is gross margin. You can think of your gross margin as your engine of profit.
Your gross margin lives on your profit and loss statement. It’s the difference between revenue and cost of goods. Why does gross margin matter? Why not just track your net profit?
It’s critically important to know the profitability of your goods and services alone, without the other expenses you must incur to deliver those goods and services, like rent, utilities, administration, marketing and sales. If your goods and services aren’t profitable enough, you won’t have anything left over to run your business, or pay yourself.
To capture your gross margin all you need to do is be sure that all your costs directly related to building and delivering your goods and services are budgeted in the costs of goods sold category, and not as regular expenses.
Once you have your cost of goods captured correctly, you can subtract that number from sales (revenue) to get see your gross margin: the amount of profit margin on your goods and services. Different industries have different benchmarks for gross margin, but a good rule of thumb is 45%.
3. Track your budget each month by comparing to actual results
At the end of each month, after all your sales and expenses have been recorded, compare your budget to how you did. Anywhere you see a gap, ask yourself what happened to create that gap. This is called variance analysis.
A negative gap means you didn’t reach your goal. In this case you should consider the blockers that led to the gap.
A positive gap means you exceeded your goal. Good for you! However, if you have too many months of exceeded goals you might be setting your targets too low. In that case, consider a stretch goal––one that is about 15 - 20% higher than your average.
A stretch goal should feel just out of reach, but also still achievable. Setting stretch goals helps take your business to the next level because it forces you to consider what changes you need to make to achieve them.
4. Financial forecasting to look ahead at profit, cash and equity
Your 12 month budget will only take you so far. It will let you look ahead during the current fiscal year at your profit: the difference between revenue and expenses. But you want to look beyond the current year: 18 - 24 months into the future. And you also want to see projected cash and equity, which your accounting budget won't show.
If you want to really boost your ability to build your business with confidence, consider a full financial forecast. This is a multi year (we suggest 2 - 3) projected income (profit and loss), cash flow and balance sheet. With these you can see profit, cash on hand, and equity, for up to 3 years ahead, on a rolling basis. That means no matter the month, you will ALWAYS be able to see a forecast of your most important numbers.
And you can build what-if scenarios too. A what-if scenario is just that: a version of your forecast that considers, “what-if” I do a certain thing. For instance, what if you need capital equipment?
That’s a multi year consideration. You might want to plan for the purchase in the next 6 - 12 months, and you'll need to see what will happen to your business if you make that purchase. You’ll need a much longer look ahead than your one year budget. You'll need a multi year financial forecast.
Or maybe you want to consider growing your sales team, or your delivery team. You want to plan for additional hires this year and also know what will happen during the next 2 years if you make that change. What will your profits be? What will your available cash be each month, and at the end, what will your equity be?
A full financial forecast will tell you these things.
5. Update your budget (or forecast) as time passes and things change
Here’s where the rubber meets the road. This is the step that turns a boring, dead budget into a living tool that will help you run your business with clarity. And all it takes is just a bit of consideration, and some interesting conversations!
After you’ve compared your actual performance to your budgeted goal, and you’ve found your gaps, and determined what went wrong or right, it’s time to IMPLEMENT A CHANGE.
There are only two types of changes you have to consider: a change to your budget goal, or a change to your business process. In other words, either your goal is wrong, or your business operations need changing. That’s it––one of the two––simple. Here’s an example:
You missed a sales goal.
First step: consider your business operations: Did your sales team get the required leads? Or if you have no sales team, did you get the expected number of customers that month? Did you have product to sell? Were any employees sick that could have affected lower sales?
Second step: consider the goal you set for sales. Was it reasonable? Consider the season, the economy, the current appetite for your product or service, and even your marketing budget. If you think about it all again, did you set the right goal?
After considering all of those things, and determining your answers, implement the changes you need. You might have a mix of some operational changes as well as an edit to your goal. Maybe you need to boost marketing to bring in more customers, AND decrease your goal a bit because of seasonality. Or maybe you want to boost marketing by 20% to get more customers and keep your goal.
Whatever your decision it’s a combination of changing your budget and changing your business operations, and that is the action of you building your business better! You’ll feel confident that your decisions are informed and strategic because of your tracking, measuring and review process.
So, make those changes! Edit the numbers in your budget for future months, and collaborate with your team on the operational changes you considered. Ask your team for input and get buy-in. When employees feel part of the process they usually respond with dedication and enthusiasm.
Take it even farther by sharing your business goals with your staff. It will encourage them to be part of the solution. You might even want to read up on Objectives and Key Results––a tried and true management method.
Do you need help budgeting, forecasting and tracking?
If you want help with any of these things: budgeting, forecasting, analysis and decision making each month, and even implementing Key Performance Indicators and an OKR system, let us know. It’s what we do.
We help small business owners look ahead at their business with confidence, and we’d love to hear about your business goals!