Developing a Budget for Your Business

It's important that you use your budget as a control mechanism. At the end of each month, enter the actual figures for sales and expenses next to the figures that were forecast. If there are substantial differences, you need to consider what action to take. For instance, if your sales are too low, you may need to adjust your marketing strategies. If, on the other hand, sales are higher than planned, you may need to adjust staffing levels or raw material supplies, in order to cope with the rising demand. If expenditures are too high, you'll need to find ways to bring costs down.

To estimate sales, take into account the number of different products your business plans to sell, the number of units of each product that you plan to sell, the price that you plan to sell each unit for, and the location where you plan to sell them.

You'll need to split your expenditure budget into production costs or variable costs (such as materials, power, and subcontractors), overhead costs or fixed costs (such as rent and salaries), and capital costs (equipment).

If your business is new, forecasting sales will be particularly tricky, because you don't have actual sales on which to base your expectations. Instead, you'll need to base your budget on good market research and a realistic marketing plan. Don't just guess about sales figures—and don't just put in a figure that covers your expenditures.

Make the sales budget as detailed as you can, with a separate estimate for each product and each sales location. You need to make very clear what you plan to sell, and at what price, on a monthly or quarterly basis.

The expenditure budget can be split into production and overhead. Using your sales estimates, you can work out the direct costs of producing what you plan to sell. These direct costs will make up the production budget, and will vary with the level of production. The overhead costs will stay more or less constant.

The production budget is made up of items such as the materials and components that go into the product. If you have a sales team, you also need to include commission paid to salespersons (if they also receive a retainer, that is regarded as a fixed cost). Include the costs of any independent contractors you hire. If you give product discounts, those are usually shown in the budget as a direct cost.

Some expenses, such as depreciation, are usually treated as fixed overhead, but you can include them in your production budget for greater accuracy, particularly if you can associate them with specific products.

Overhead includes:

• Salaries for you and your staff, income tax withholding (both federal and state), Federal Insurance Contributions Act (FICA) tax (Social Security and Medicare), and pension contributions. Remember that you are taxed on the total profit (if you are self-employed), so allow for this too.
• Rent and company insurance, telephone, Internet, and e-mail account costs.
• Any interest on money that you have borrowed or money that you intend to draw out of the business. If your business is registered as a company, and you expect to take high dividends, make sure that you budget for this as well.

If your business is in manufacturing, it's likely that the above items will represent a relatively small proportion of the total costs. On the other hand, if you have a service sector business, it's likely that overhead will represent a very high proportion of the cost.

You may allocate overhead, to each product, or you may prefer to retain overhead as a single budget. Whichever path you choose, it's important that you ensure that the price for each product makes a reasonable contribution to the overhead.

The production budget and the overhead budget can be pulled together into a single production cost budget. If you offer more than one product or service, establish a production budget for each. To determine total production costs, add to production costs the variable overhead for each product and total fixed overhead.

If you expect to buy capital equipment, you'll need to decide how you'll pay for it (cash or loan), and make sure that you budget for these payments or loan repayments (including interest) in the relevant months.

The Internal Revenue Service doesn't consider an operating lease to be a purchase, but rather a tax-deductible overhead expense, so lease payments can be deducted from corporate income. If the business decides to lease equipment, make sure that you read all the small print of the lease agreement.

If you operate your business on a cash basis—taking in cash for your sales and paying cash for your purchases—then it's fairly easy to see if you're making a profit because you'll have cash left over at the end of the month. But very few businesses operate solely on cash. It's far more likely that you'll be selling goods or services in one month, and not receiving payment until the following month, or the month after that. Similarly, you may be buying raw materials one month, but not paying for them until the next month. To help you keep track of and manage your cash flow over time, your budgeting process should include:

• A cash flow forecast, setting out month by month all cash inflows and outflows from the business for the following 12 months
• Profit and loss forecast, to help you monitor profitability
• A balance sheet.

A budget based on unrealistic expectations cannot help you monitor how well the business is doing or enable you to spot problems in time to take action. Be realistic so your budget can serve as a real-world tool.

A cash flow forecast is as important as the budget itself. While the budget can tell you if your business is generally profitable, it might not alert you to cash flow problems.

Lalli, William R., ed. Handbook of Budgeting: 2006 Cumulative Supplement. Wiley, 5th ed., 2006.

Shim, Jae K. and Joel G. Siegel. Budgeting Basics and Beyond. Wiley, 2nd ed., 2005.

Entrepreneur.com: www.entrepreneur.com

U.S. Small Business Administration, "Budgeting for the Small Business": www.sba.gov/library/pubs/fm-8.pdf