One of the things that I help my clients understand is budgeting. Using a budget seems like something that should be easy. Unfortunately, many people have some misconceptions about budgets, and that makes using a budget harder than it needs to be. In this article, I will briefly explain some common types of budgets and address the budgeting myth that makes creating and using budgets difficult.
Let’s begin by answering the question, “What is a budget?” There are a lot of ways to answer this. The easiest answer is simply that a budget is a plan for resources. In a business setting, budgets are plans for income and expenses. However, budgets don’t have to be just about money. They can be a plan about any type of resource. A SCUBA diver, for example, will budget air for a dive by considering how much air is contained in a tank and how rapidly a diver uses the air. Farmers may develop water budgets that consider rainfall, humidity, how much moisture crops need, and how much water must be purchased for irrigation.
Many small business owners get along just fine without using budgets. Their businesses may be small enough or simple enough that they can keep track of everything without a budget. However, at some point, most businesses need to begin budgeting to be successful. Service businesses need to consider how many hours of service they can provide, and they need to manage their overhead. Manufacturing businesses need to track raw materials and job costs as well as sales so that they can be efficient. Businesses that resell goods need to be able to track inventory and sales. All businesses need to keep track of their cash, and growing businesses need to plan for capital purchases. If all of that seems complex, don’t worry. Once you understand budget basics, then the budget will make these things easier.
While it seems like there are many ways to create a budget, we will consider three simple types: 1.) Operating, 2.) Cash, and 3.) Capital. The next few paragraphs will summarize each type. I’ll provide more detail in later articles.
An operating budget is a plan for obtaining revenue. and managing expenses. The most difficult part of preparing an operating budget is making accurate estimates of sales. I’ll spend an entire article describing how to build an operating budget later. For now, simply recognize that your sales drives both your income and your expenses. Begin by estimating what you will sell. From that you should be able to develop an estimate for your gross sales. Then figure out what it costs you to produce the goods or services that you sold. That is your costs of goods sold. Subtracting your cost of goods sold from your gross sales will leave you with gross profit. Note that the sales and cost of sales figures are typically variable expenses. The next item in this type of budget is going to be your general and administrative expenses. This includes items such as rent, equipment, office supplies, and similar items. The key to successful budgeting is to put in the effort to make accurate estimates for each category of expense. Another important point about operating budgets is that they are typically used over a single operating cycle. It is possible to create an operating budget that covers several years, however the out years in a multi-year budget are frequently unreliable.
A cash budget is a close cousin to the operating budget. However, the intent of the budget is to help plan cash flow. Cash does not always track business activity in a firm. Business owners extend credit to good customers, and vendors often offer terms. Businesses also borrow and repay debt, and they purchase expensive capital items. Most business owners recognize that they need some sort of minimum amount of cash. The aim of a cash budget is to help manage cash flow so that the business can maintain the minimum desired amount of cash on hand. For each month in your budget, begin with your cash on hand. Then add your cash income. This is going to be equal to any cash sales. Remember that not all sales are cash sales. Some sales are credit sales. Add the current collections for credit sales to the cash sales number. Add any other cash from other sources. Next subtract all of your cash expenses. Remember that if you purchase goods or services on terms that you may not have paid cash. Use only cash expenses. Then subtract all your payments for previous expenses that are unpaid. The balance will be the cash available to your business.
Remember your minimum desired cash on hand? Compare your available cash to your desired minimum. If your available cash is less than your minimum, then you need to find a way to increase your cash. If the available cash is greater than your minimum, then you may want to pay down a line of credit or use your excess cash in some other productive manner.
Businesses frequently need to make large purchases that cannot be made from operating funds. It is one thing to purchase office supplies or inexpensive office equipment. It is something else to purchase expensive equipment, furnish an office, or replace a company-owned automobile. Sometimes businesses can save and purchase the types of things. Sometimes businesses must borrow. In either case, smart business owners plan these purchases. Remember that the operating budget typically covered a single year and included operating expenses. A capital budget covers many years and includes expensive items that would normally be capitalized and depreciated. For example, most computers have a working lifespan of three to five years. A smart business owner would develop a plan for replacing the computers periodically. A commercial property owner might also develop a plan for HVAC replacements and roofing.
The biggest myth about budgeting is that once the numbers are entered, the budget is fixed. Remember that a budget is based on estimates. As more information becomes available or as circumstances change, estimates can change too.
Another myth about budgeting is that variance or results different than what was planned is bad or reflects some sort of failure. That is not necessarily true. The problem with budget variances is when they cannot be explained. I’ll write more about this at a later time.
The most important things to know about budgets
A budget is a plan based on estimates. The most important reason for preparing a budget is that it forces you to think about your business and make assumptions about sales, revenues, and expenses. It also gives you a plan for the operating cycle.
A cash budget helps you keep track of your cash flow.
A capital budget is a tool that you can use to plan expensive purchases over a period of time in the future.
All budgets are based on estimates and information that was available at the time. Budgets can be dynamic and change as information becomes available and circumstances change.