Small business budgets come in many formats, types and degrees of complexity. In most cases though they serve three purposes.
The first purpose of a budget is to establish performance targets over a specified period of time. Usually a budget plans for revenues and expenditures on a monthly, quarterly, annual and multi-year basis. Company managers and employees can then devise action plans to achieve the targets provided by the budget.
The second purpose of a budget is to measure performance. A budget serves as a benchmark to evaluate the performance of the company over a period of time. A company that increases sales by 50 percent during the year, for example, may in absolute terms be considered a success but if the budget called for a 100 percent increase in sales then the results are actually below expectations.
The third purpose is to determine compensation for employees. Measuring actual performance against a budget provides a tangible, quantitative basis for calculating raises, bonuses, commendations and promotions. Decisions made and actions taken by employees at any level will impact revenues, expenses or both. Without the benefit of a quantitative budget serving as a guide, the compensation determination process is left exposed to subjectivity, bias and other negative influences.
Business owners should follow these recommendations when developing a budget:
Use several benchmarks as a starting point
When developing an initial budget, the values will be based on estimates and educated guesses derived from the experience of managers. As the business grows, budgets should incorporate past performance and competitor results. A budget developed from these three sources – manager experience, past performance and competitor results provides the most realistic budget and ensures that the numbers are based on reality. Sometimes these three sources may provide very different results for a particular budget line item. In these cases it’s best to act conservatively and select the value (or a blend of value) that is least favorable to the company; this means either a lower revenue estimate or a higher cost estimate.
Provide a rationale for all assumptions
Budgets consist of projections. A detailed budget may consist of dozens or hundreds of individual projections. Each projection should have a logical explanation defending it. If a budget determines that replacement parts for a key piece of machinery will increase in cost by 10 percent, the person responsible for this projection must be able to justify it. Some projections are easy to justify because they are established by contract. Others are less predictable and may require more work to arrive at a justifiable number.
Avoid developing a budget in isolation
A proper budget requires input from employees located throughout the organization regardless of size. No business owner has perfect knowledge of every aspect of the business even if it’s very small. Producing a budget in isolation carries several significant risks. An unrealistic budget will provide unrealistic targets for the company and could unnecessarily hurt employee moral as they fail to achieve the targets. It also could cause the company to pursue a strategy that will ultimately fail because it is too aggressive.
Expect revisions and make them in a timely manner
A key budgeting challenge for many small business owners is knowing when to make a revision. Maintaining a strict “no changes” policy doesn’t provide sufficient flexibility to adapt to the realities of a changing environment. But operating at the other extreme – where changes are made continually – defeats the purpose of having a reliable benchmark against which to measure performance.
It’s helpful to have a policy in place – even its simple and drafted in an MS Word document – to determine when changes to a budget should be made.
The most challenging types of changes to make are those related to revenues, which can at times be very subjective. Sales people may recommend reductions in order to help them “beat the budget”. Cost centers within the company are also subject to the same pressures, at times exaggerating upward revisions to cost in order to come in under budget at the end of the year. A written policy which clearly states the parameters and conditions under which a budget will be changed can minimize these risks.
Map links between jobs and budget line items
In order to ensure that proper credit and responsibility are assigned to each department or employee, its important to create a map of which positions affect which budget line items and to what extend. The janitor, for example, has a direct impact on cleaning and maintenance costs. It may be a small percentage of the other all cost structure but performance can be measured. The same principal holds for key positions.
Budget – an effective tool for small business owners
A hidden benefit of using budgets is the education that takes place during the development phase. In order to produce a useable budget, owners need to delve into the details of their operations, engage employees, understand how different segments of the business interact and make educated guesses about sales. This process can reveal new ideas to enhance performance and improve the overall financial results of the business. If one isn’t forced to go through this process then it usually doesn’t happen. Developing a budget is a very effective way to become reacquainted with the details of your business.