You’ve heard it before, you know it’s a good idea, but you just can’t seem to get around to it. Perhaps you don’t believe that there could be benefits to budgeting! We hope to inspire you to start using this important business management tool.
Why are so many small business owners averse to creating and using budgets? Is it because it is a boring job? Is it because of a perceived imposed control on how you run your business? Is it because of an unwillingness to get real with your numbers? Is it daunting because you think it’s going to be really complicated and it’s beyond your understanding?
Whatever the reason for you, if you do not currently have and use a budget for your business, now is the time to get one in place for the new financial year!
Effectively using a budget means you need to understand your financial reports, but many business owners are not very interested in them; others are interested, but don’t understand the reports. Regularly reviewing your figures is essential to long-term success. Keep an eye out—we will be publishing a series of articles about understanding your financial reports in the coming months.
Why Budgets are a Great Idea
Okay, we think they are more than a good idea; they are essential to proactive business management. If you are serious about building your business, then budgets are a fundamental tool to help you examine your performance and reach your targets. Budgets will help you to:
- Forecast sales and expenses, taking into account seasonal patterns
- Evaluate performance of the business overall, but also specific departments within the business
- Obtain useful detail in assessing income streams, direct costs and business expenses, including changes or observable patterns
- Gain awareness and control over all business financial activity—where the money goes and where it comes from
- Prepare for and cope with unexpected costs; for example, accidental damage to business assets
- Forecast cashflow
- Recognise potential problems early and take action
- Analyse relevant data to assist in business decisions
- Clarify targets and goals; then maintain focus on the most important
Budgets and the Big Picture
Once the budget is embraced, it can motivate owners and managers to think long term and big picture, rather than simply focusing on managing day-to-day issues. Business success relies on far more than what is in the bank at the end of the week and whether you can pay all your bills on time. Unfortunately, many small business owners assess their business performance only on the bank balance, without an awareness of the total business landscape, and may be subject to all kinds of risks that they do not plan for.
Good management of business finances, assets and liabilities doesn’t guarantee success in the long term—but it certainly is a major factor in longevity of business. The more active you are in taking an interest in all aspects of the business, the less likely you are to be surprised by events and the more likely you are to be geared towards growth and accomplishment.
Creating a budget means you make certain assumptions about the future, which will be based on knowledge of your own business as well as competitors and the industry at large. Reassessing the budget on a regular basis also keeps you current with what’s going on in your business world and relevant industry trends.
What Period Should the Budget Cover?
If you are a small business and have not done budgets before, start with a budget for this financial year. If you’re keen, create a budget for the next two or three financial years as well.
Larger businesses may want to create budgets for five years or more to plan for larger or long-term projects.
Regardless of the overall period the budget is set for, you will need to set monthly budgets within the larger period.
How Do We Create the Budget?
Check your accounting software features to see what kind of budget tools exist. If you do not have budgets integrated into your software, you may need to create one in Excel, or consider using a dedicated solution for this purpose.
There are free templates available for this purpose if you are starting out, but if you are an established business we recommend that you either use the functions built into your existing software, or consider upgrading to an application such as Xero that does have integrated budget tools within it.
There are some essential elements to consider when creating your budget:
- Define all sources of income. For example, a freelance designer may bill everything to Fees, but in fact those fees may be broken down into one-off services, packaged design services, website design, logo design and corporate communications design.
- Identify direct costs. These types of costs relate to specific income-producing products, jobs or services. The freelance designer may pay certain contractors for particular jobs. If software is paid for on behalf of a client, this is also a direct cost. Any materials that are bought and used for a specific product, job or activity are direct costs. If casual staff were engaged for a particular job, this would be a direct cost. Most direct costs are variable, in that the expense amount changes in response to the overall cost or size of the job or income-producing activity.
- Identify fixed overheads. These expenses do not tend to change but are agreed to for a fixed contract, such as rent, mobile phones and internet. Regular employee labour, such as management or administration staff, may also be classified as part of overhead costs.
- Categorise general expenses. These can also be thought of as indirect costs, that is, the cost of running the business regardless of how much activity there is or the amount of income received. These types of expenses are things like advertising, administration, office supplies, staff amenities and insurance.
- Note any potential extraordinary income or expenses. For example, perhaps the freelance designer has a huge project on this year that is not going to be repeated in future. Or perhaps a company wants to spend extra money on celebrating and promoting a ten-year anniversary or other milestone. Another example might be that you have extra space in your office you would like to hire out for the next six months while you are building the business.
A basic budget will simply assess known income and expenditure. This may be useful initially, but as you begin to use the tool for business insights and planning, you will want to evolve it.
A more sophisticated budget will include other elements, such as additional employer costs (provisions for leave entitlements, professional development and so on), depreciation of assets, business investment, asset purchases, loans and debt repayments.
You don’t have to create and live by only one budget. It may be useful to create two or three budgets, such as the ‘We Can Live with It’ (or worst case scenario) budget, the ‘Carry on As Usual’ (or current figures continued, perhaps taking into account CPI changes) budget, and the ‘Wouldn’t It Be Fabulous’ (or sustainable growth) budget.
Okay, We’ve Created a Budget, What Do We Do With It Now?
Even if you have taken the plunge and created your own budget, it is a great idea to have an impartial set of eyes review the budget and ask pointed questions that you may not have thought of yourself. It can be constructive to involve your tax agent, BAS agent or business advisor in the process of creating the budget, or in an annual review process.
Once you have the budget, you need to keep it alive! Assess it every quarter at least, or monthly for larger businesses, to see if your estimates and predictions are still looking accurate. You can either edit the budget on a regular basis, or create multiple budgets.
Run your financial reports against the budget and look at the variance. Is your current reporting over, under or about the same as the predicted budget? This is where the decision-making power comes in, as it shows you the actual figures against the budget and therefore how the business is performing in reality.
Using the budget means having your accounts up to date. There is no point running your financial reports against the budget if the accounts are not fully allocated and reconciled for the month or quarter.
Even if you set the budget and don’t make adjustments to it, you should regularly run the reports against it (quarterly at least). You will find that doing this as part of your routine management process will, over time, inform your business decisions and potentially change the way you do things for the better, as you are generally more informed and aware of all aspects of your business.
Talk to us if you would like to dedicate some time to creating a useful Xero budget geared towards your business’s performance, development and success.