As a business owner, getting the chance to work on a time-consuming task can be difficult. Often the act of running your business interferes with growing it. So the idea of allotting time to budgeting may seem impossible.
However, investing the time to create a comprehensive budget each year will yield many benefits. Building a budget helps you think about every aspect of your business, and you can compare your actual results to your budget and make better decisions.
Use this discussion to purchase accounting software, create a budget, and build a more successful business.
Why Create a Budget?
Successful businesses create budgets that are both comprehensive and realistic. Creating a budget has several key benefits:
- Analysis: Creating a budget forces you to think carefully about each component of your business, including your staff, production, marketing, sales, and customer support. When you create a budget for inventory, as an example, you must consider your suppliers, your expectations for sales, and your inventory costs.
- Profit levels: Building a budget helps you to determine if your profit margins are reasonable, given your assumptions about costs and sales. If you’re working on your inventory budget for sporting goods store, you may conclude that the total costs for an $80 baseball glove are $70- not the $65 you originally estimated. Your profit on each glove is $10, rather than $15. You can perform this analysis on all of your products.
- Cash needs: Perhaps most important, creating a budget allows you to determine your cash needs, and the sources of cash inflows for your business. The budgeting process includes a cash roll forward, which takes each month’s beginning balance, adds cash inflows and subtracts cash outflows. A sporting goods company, for example, will have cash inflows from sales and cash outflows to purchase inventory, pay employees, etc. The cash roll forward determines if you have sufficient cash to operate each month.
The process of creating a budget gives small business owners a greater understanding of their operation, and empowers them to make informed decisions.
How to Start
To create a budget, you need financial information to serve as a starting point. If you haven’t started your business yet, you need to make some assumptions about your financial statements.
Assume, for example, that Jenny owns Playground Sporting Goods, a retail sporting goods store. Playground just finished its first full year of operations, and Jenny has financial information posted in a spreadsheet.
Before starting the process of analyzing her financial data, Jenny’s first step should be to purchase accounting software. Using accounting software to operate her business has several advantages.
- Accuracy: Accounting software has automated checks to help ensure that the data you input is correct. For example, a software program will alert you, if you try to post a journal entry that doesn’t balance the total dollar amount of debits and credits. Using an excel document increases the risk of an input error, or the risk that a set of excel spreadsheets are not properly linked.
- Accessibility: You can give limited or full access to many people in your organization. Your warehouse manager, for example, may get access to the inventory area of your software, while the company controller has access to all accounts. Company staff can access accounting data on a laptop or mobile device.
- Security: Accounting software can be backed up on a company server and/or the cloud, and this feature increases the security of your data and minimizes the risk of lost accounting information.
Make the investment to purchase accounting software, even if you’re just starting your business.
Chart of Accounts
Once you purchase accounting software, use the software’s capability to create a chart of accounts. A chart of accounts is a list of, and number for, each account you need to operate your business.
Typically, balance sheet accounts (cash, accounts receivable) are numbered first, followed by income statement accounts (revenue, expenses).
Accounting software will provide a standard chart of accounts, which includes account titles that most businesses use (cash, accounts payable, accounts receivable).
You can add, delete, and change account names, based on the needs of your business. Playground Sporting Goods, for example, will need inventory accounts for baseball gloves, bats, and other products.
Opening Financial Balances
Next, input your account balances using the most recent month-end or year-end date. You can think about the budgeting process as a “before/after” one process, your opening account balances represent the “before” part of the process.
Assume that it’s early January of 2018, and Jenny has the company’s account balances as of December 31, 2017. Jenny will use the accounting data on her spreadsheets and post it into the accounting software. There are two key financial statements that a business must create for budgeting purposes:
- Balance sheet: The balance sheet is created using the formula: (assets – liabilities = equity). Assets are resources you use to produce sales and profits, and liabilities are amounts owed to creditors (accounts payable, long-term debt). The difference between assets and liabilities is equity, which is the true value of your business. The balance sheet is generated as of a specific date.
- Income statement: An income statement is produced using the formula: (revenue – expenses = net income). Most of a company’s revenue is driven by sales of products or services, but a company can also generate revenue from selling an asset for a gain. The income statement is produced for a period of time, such as a month of year.
Once the opening balances are posted in your accounting software, use the report feature to produce a balance sheet and an income statement.
Here is a basic version of the Playground Sporting Goods balance sheet and income statement as of December 31, 2017:
|Playground Sporting Goods Balance Sheet December 31, 2017|
|Playground Sporting Goods Income Statement Period Ending December 31, 2017|
|Gain on Sale of Equipment||10,000|
|Cost of Sales||200,000|
|Payroll Expense, Other Expenses||35,000|
To create a budget, you need to think about the activity you forecast for your business in the coming year. Ideally, a company budget for 2018 should be created before the end of 2017, but Jenny is new to the process and expects to complete her budget by January 15th of 2018.
Jenny meets with her entire staff to discuss the company’s financial projections for the upcoming year. After the discussion, Jenny makes the following assumptions:
- Sales, Cost of sales: Sales will increase by 20% ($50,000) to $300,000, and Playground’s cost of sales is projected to be 80% of sales, or $240,000. No other gains or losses on asset sales are expected in 2018.
- Payroll and other expenses: Jenny expects payroll and other expenses to increase 15%, or an increase from $35,000 to $40,250.
After inputting data into her accounting software, Jenny creates the following 2018 budgeted income statement:
|Playground Sporting Goods Budgeted Income Statement Period Ending December 31, 2018|
|Gain on Sale of Equipment||0|
|Cost of Sales||240,000|
|Payroll Expense, Other Expenses||40,250|
Jenny also makes assumptions about the balance sheet accounts, based on the conversation with her staff:
- Inventory: To support the increase in sales, inventory will increase by 30% to $39,000.Jenny also makes assumptions about the balance sheet accounts, based on the conversation with her staff:
- Accounts receivable: The majority of Jenny’s customers pay by credit or debit card, but some schools and university clients don’t pay immediately. Accounts receivable will increase by 10% to $22,000.
- Accounts payable: Playground does not pay for all of the firm’s inventory purchases immediately. Because inventory purchases are increasing, accounts payable is expected to increase by 25% to $50,000.
To analyze the change in the cash balance, Jenny puts together a cash flow roll forward for each month. Here is the roll forward for January of 2018:
|Playground Sporting Goods Cash Roll Forward Period Ending January 31, 2018|
|Beginning cash balance||10,000|
|Cash received on January sales ($300,000 annual sales)/ 12 X 90%||22,500|
|Other receivables collected||5,000|
|Cash paid for inventory ($240,000 cost of sales)/ 12 X 85%||(17,000)|
|Other payables paid in cash||(10,000)|
|Ending cash balance||10,500|
This roll forward assumes that:
- Receivables on sales: This analysis assumes that annual sales of $300,000 are evenly divided over 12 months, and that 90% of sales will be paid in cash during January.
- Payables for inventory purchased: The roll forward assumes that the $240,000 cost of sales will be incurred evenly over 12 months, and that 85% of required inventory purchases will be paid for during the month of sale.
- Note: the ending cash balance is higher than the beginning balance ($10,500 vs. $10,000).
Obviously, dividing a balance evenly over 12 months isn’t very precise, but it’s a starting point. Over time, you can be more specific on your budget expectation by month.
Jenny creates a cash roll forward for the entire year, and computes an ending cash balance of $18,000. She makes some other assumptions, and inputs data to create a projected balance sheet for 2018:
|Playground Sporting Goods Budgeted Balance Sheet December 31, 2018|
Jenny now has a budgeted income statement and balance sheet for the year, and her accounting software can present both projections by month, as well as by year.
Managing With a Budget
The payoff for creating a budget is the ability to make informed decisions to improve business results. Each month, Jenny should compare her actual results to the budgeted income statement and balance sheet for that month.
Her accounting software can produce a variance report, which reports the differences between actual and budgeted amounts. If inventory costs are higher than projected, for example, Jenny might consider negotiating a lower price for some items with her vendor. If, on the other hand, sales are lower than expected, Jenny might spend more marketing dollars to increase sales.
Make Better Decisions
Adding another task to your list may cause anxiety for you, but creating and using a budgeting process will make you a smarter business owner. Purchase accounting software, ask your staff for input, and create a budget that you can review each month. You’ll make better decisions and increase your profits.