One way to start the dreaded but necessary BUDGET discussion with my private business clients is by admitting that, “I hate budgets”. Most of them quickly agree and then add, “Budgets take too long; budgets do not generate income; budgets are too complicated; budgets are always wrong…”
A budget, however, is really just a plan or a blueprint for the future. So why do private business owners react negatively when budgets are mentioned?
The budget is usually NOT the problem. The problem is in building the budget. Instead of participants cooperating to build a reliable forecast, they become adversarial. Owners or managers demand a “best case” budget, and they push for unattainably high profits while the budget builders low-ball their estimates to try to guarantee that their later performance can beat the plan.
When the budgeting process is properly managed, it can produce a reliable plan that can be used to steer your business into the future.
There are different types of budgets: sales budgets may estimate the quantities and products that will be sold, payroll budgets might show how many employees a company will hire and the wages that will be paid, production budgets may forecast the quantities and costs of items to be produced, etc. The income budget, however, is an overall profitability plan for the company, and it combines revenue and expense information from across all departments.
The final result is an annual income statement forecast that shows revenue, expenses and net profits by month. Even if the budgeting process is difficult, time consuming and imperfect, all private companies should work to develop a realistic annual income budget.
Keys to building a successful income budget:
1. Take time to plan. Small and mid-size business owners and managers are often too busy running their business to stop and manage the business. Building a forecast requires company leaders to set aside time to think and plan for the future.
2. Look backwards. Historical performance can help predict the future. During the budgeting process there are opportunities to study past performance and talk about ways to improve. Time is spent trying to understand prior revenue and expenses, and this can lead to future changes and improvements.
3. Get participation from all departments. Your accounting staff might put the pieces together, but a successful budget requires participation from all departments. This allows opportunities for questions and suggestions across departments, and participants take some ownership because they help develop the plan.
4. Start with revenue. Your sales team should provide the sales estimate. Company leaders then need to agree upon a single revenue forecast that all other departments use to forecast their costs. If annual revenue is expected to double, then manufacturing and purchasing departments may need to increase expenses to hire more employees, buy more inventory, etc. If annual revenue is expected to drop by half, then departments need to focus on cost reductions. Deciding upon expected annual revenue helps every other department plan for the future.
5. Accept net profit levels. Once all the revenue and expense estimates are combined, the income budget shows anticipated profits. These are estimates, but company leaders should be willing to accept the calculated profits, if all goes as planned. If the estimated profits are negative or too low, then continue working to build a better, realistic and attainable plan.
6. Compare the budget to actuals. After you finalize the budget, actual company performance should be compared monthly to the plan during the following year. If actual performance is significantly different than the budget, research and address the problems. To be the most beneficial, your budget should be a working document that is continuously referenced and updated, if needed.
Developing an income budget gives owners and managers the opportunity to plan for their company’s future success. This process should include participation from key employees and cooperation across departments.
The final budget serves as a financial map that can be followed, and actual results can then be compared to the forecast each month in order to track company performance against the plan.
All private companies should take time to develop an income budget to help them be successful next year. They should then follow this plan to improve their chances of earning actual profits that closely match their forecast.