The income statement starts with the $200,000 annual sales estimate and subtracts material and labor costs to compute gross profit. The costs subtracted from sales are defined as direct costs, or expenses that are directly related to tree service, landscaping, and other work.
Below gross profit, Joe subtracts operating expenses; such as the salary he pays his office manager. These costs, including depreciation, insurance, and office rent, are not directly related to the number of sales generated. Joe expects to generate a profit of $42,000 in 2019, and Twin Lakes is one of several businesses that Joe operates.
The Real Problem
Can Twin Lakes generate enough cash to operate during the winter months?
That’s the biggest problem, and Joe’s budget addresses that challenge. Here are the strategies that Joe uses to meet the cash flow requirement:
- Monthly projections: Joe creates an income statement budget for each month so that he can estimate the monthly costs. The busier spring, summer, and fall months require more spending and more cash inflows
- Cash flow planning: Twin Lakes also has a monthly cash flow plan, which includes a beginning balance in cash, expected cash outflows for expenses, and budgeted cash inflows from customer payments. If the firm generates a negative ending balance in the cash flow estimate, Joe must find other sources of cash, such as a line of credit from a bank.
- Collection process: Joe provides each customer with a job estimate, and he invoices clients by mail and by email when a job is completed. In order to speed up cash collections, Twin Lakes has a formal process to follow up on unpaid invoices. Joe emails customers if an invoice has not been paid after 30 days, and he calls clients who have not paid after 45 days. If a customer uses Twin Lakes but has a history of late payments, Joe will require a deposit before any new work is performed.
Many owners find it difficult to collect money from customers, but setting up a formal procedure is critically important. If you can’t collect cash fast enough, you may have to incur interest costs on a loan.
When a customer doesn’t pay you, your company is extending that customer credit. Don’t allow your business to become a “bank” for customers who don’t pay on time. Ask for the money- and don’t do business with clients who won’t comply with your collection requirements.
What are Sunk Costs?
Sunk costs, or past costs, are costs that you cannot change in the short term. Most of the operating expenses in the budgeted income statement, such as insurance premiums, must be paid, regardless of the sales generated in a particular month. Paying sunk costs during a business dry spell can be difficult.
Joe is careful to avoid taking on more sunk costs that he can finance. As an example, most of Joe’s workers are hired as independent contractors, and their hours are reduced during the winter months. Also, Joe’s suppliers know that Twin Lakes will reduce purchases of sod, mulch, and flowers during the winter.
This strategy makes it easier to finance company expenses during the winter dry spell.
Should I Diversify?
Some business owners diversify their product and service offerings so that they can generate sales when one area of business declines. Joe, for example, added snow removal services to drive more revenue during the winter, and many tree service and landscaping companies do the same thing.
However, taking on a new product or service will complicate your business operations. At Twin Lakes, Joe must purchase and maintain snow removal equipment, and train his staff to perform the work. Diversifying your product offerings requires proper planning or your overall business results will suffer.
Review and Consider
To get the most out of this budgeting process, you need to compare your actual business results to your budget and investigate any differences. This process, called variance analysis, will help you improve your budgeting process over time.
When Joe analyzes his actual results, he may find that his material costs for landscaping are higher than planned. If that’s the case, Twin Lakes may increase prices for landscaping to cover the higher costs.
Variance analysis helps you make adjustments to increase your level of profit.
Mindset
Most of all, creating a formal budget gives you the confidence that you can make it through a business dry spell. Managing a dry spell can be stressful, but your chances of success are much higher if you create a plan. Many companies pick up work when competitors stumble, and you may actually gain business if other firms don’t properly manage an industry dry spell.
So, start putting your plan together. You got this!
