Building the Budget
FastTrac, Kauffman Foundation
After researching your business's financial prospects and building a preliminary budget, you are ready to build the final, detailed budget. With your preliminary forecast in hand, you are ready to start preparing the detailed budget. Before you begin, be sure to involve the right people in the budgeting process, not only key people within your company, but external advisers and mentors, as well.
Check the Numbers
“Just about every aspect of your business affects your budget—and cash flow,” says FMSI’s W. Michael Scott.
At FMSI, three people are actively involved in the budgeting process: Scott, his director of sales, and his chief financial officer who is also responsible for operations. “This team reflects our key divisions—sales, client services, and operations,” Scott says. “If we had more department heads, then we would probably have more people involved in the process.”
Each quarter, the three executives sit down and pore over the annual budget. Taking accounting reports from every area of the company, they review revenue and expenses—everything from capital expenditures to year-end bonuses and quarterly tax payments. Current numbers are compared to earlier forecasts, and they try to pinpoint the cause of any variances.
“Sometimes it’s timing that throws the budget off,” Scott says. “Perhaps a new client didn’t come through as expected. Or printing costs for marketing brochures may have hit in February instead of March. Learning when things are going to happen is important.”
Forecasting revenue accurately is a particular challenge for FMSI. “In our industry, a lot of mergers affect us. Some of our clients will be bought this year and we don’t know which ones,” Scott explains.
All financial results are shared with Scott’s partner who sits on FMSI’s executive committee. Each quarter, Scott has a “state-of-the-union” meeting with employees to give them a general report of the company’s health.
A formal budget is a powerful tool to manage growth and make decisions, Scott says: “It’s a roadmap we use and check ourselves against every month. It’s like being on a car rally and going through checkpoints. You may have gone too fast or too slow during some intervals and need to adjust on the next leg to get back on track and meet the end objective.”
The budgeting process gives participating managers a broader perspective. “The department heads have to think about their environment, what they want to accomplish, and how much that will cost,” Scott says. “They can see that the company doesn’t have unlimited funds, so choices of what to do are give and take.”
FMSI’s budget also serves as a call to action. “It gives us an idea of what we need to accomplish on the sales side to fund everything,” Scott explains. “That enables us to see the financial effects of not closing a sale and provides a greater sense of urgency to do so.”
Building the Budget Using Historical Data
As you build your detailed budget, your historical data will be the most helpful information. Resist the urge, however, to merely increase all amounts by a set percentage. Think about your goals and how these goals will affect the sales and expenses of the business.
Use the following steps as a guideline to build your budget:
Review your preliminary forecast. Confirm that your business’s vision and strategies have been integrated into this first budget attempt.
Review last year’s budget categories (revenue and expense), considering the changes necessary to reflect the current business strategy and financial goals.
Build monthly sales forecasts based on the annual amounts on the preliminary forecast. Consider past monthly sales figures, trends, economic, and competitive factors.
Enter the forecasts into a budget spreadsheet.
Review the budget for overall reasonableness. Is the budget attainable?
Building the Budget Using Ratios
Using ratios from historical or industry data can be very helpful in building the budget. You can use ratios as a basis for budgeting, to establish credibility in the budget, and to check the budget for reasonableness.
Your historical Income Statements will show that each expense can be presented as a percentage of sales. These percentages stay very similar from year to year as they are based on your strategy for business operations. You can use percentages in the budgeting process to estimate future dollars to be spent for each expense as it relates to sales. For example, a kitchen remodeling business could use its actual past advertising costs as an estimate for future budgets. It may make more sense, however, to use a percentage that relates to sales. Therefore, as sales increase, the advertising budget will increase as well. If the kitchen remodeling company has historically spent 7 percent of their sales on advertising, it is reasonable to assume that this same percentage would continue. This percentage may be increased if it follows a new strategy that includes increased marketing and advertising efforts.
Using ratios to establish credibility in the budget – Because ratios reflect a relationship between two or more account categories, they can be very helpful to establish credibility in the budget. For example, a budget for a health food store that has reported a Net Income Margin of 10 percent of sales for the last few years can generally assume that the Net Income Margin should stay about the same for the budget year. If one of the goals is to increase the Net Income Margin to 12 percent, the budget should reflect the strategies involved in creating this change.
Using ratios to check the budget for reasonableness – Ratios can also help to check the budget for reasonableness. If a mechanical auto repair shop, in efforts to improve its bottom line, budgeted a Gross Margin of 75 percent on labor and a Gross Margin on parts of 50 percent, there should be some justification as to why these budgets are realistic when other businesses in the industry average only 56 percent and 38 percent, respectively.
Building the Budget Without Historical Data
If you do not have reliable historical information, or your business is making dramatic changes to the overall business strategy, you may have to begin your budgeting process without the aid of historical data. Without detailed past history for guidance, you will need to rely on researched information. The best way to develop the new budget is to follow a consistent plan using these steps as a guide:
Review the company’s vision and business strategy, and identify specific financial strategies that should be visible in the budget, including sales forecasts.
Estimate direct costs associated with providing the quantity of products/services expected to be produced, delivered, and sold, including payroll, materials, and other direct costs.
Estimate other operating costs based upon the quantity of products/services, including indirect costs such as administration, marketing, and other expenses.
Develop a preliminary forecast to discuss with management and team members.
Finalize the detailed budget. Review the final budget for reasonableness. A budget that is a challenge to meet can be very motivating, if it is attainable.
© 2006 Ewing Marion Kauffman Foundation. All rights reserved.