How to Set an Annual Budget
It seems to be the least sexy part of running a business, but maintaining a realistic budget - and paying attention to it - can make or break your company.
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Sharon Eisenhauer never thought she would understand budgeting when she was preparing to launch Haiku, her Oakland, California, company making functional, feminine bags for the outdoor recreation market. But once Haiku was up and running, she says, "everything clicked."
"Our budget has been an incredibly useful tool, especially for a product-based business," says Eisenhauer, whose sales are at $1.4 million after six years. "I couldn't do this without it."
An annual budget may seem like the least sexy part of a business – far less interesting, say, than the signature recipes of a restaurant or the cutting-edge apps produced by a software venture. Yet creating a realistic budget and paying attention to it throughout the year can mean the difference between business success and failure.
"Having a budget stacks the odds in your favor dramatically," says Vicki Suiter, a business consultant with Suiter Financial Systems in Novato, California. "It helps you make happen what you want to have happen."
Businesses need two kinds of annual budgets: an operating budget focused on profitability, and a budget focused on cash flow.
Setting an Annual Budget: The Road Map to Profitability
An operating budget is a prediction of all expected revenues and expenses over a 12-month period. It projects your gross and net sales, along with your net profits or losses.
On the expense side, it includes both one-time expenditures such as equipment purchases and ongoing costs such as rent.
Some expenses commonly included in budgets are:
- Rent
- Insurance
- Personnel, including payroll taxes
- Costs of purchasing or producing your product
- Sales and marketing
- Phone, Internet, and utilities
- Repairs and maintenance
- Outside services (accounting, legal etc.)
- Fees and licenses
- Interest
- Depreciation
- Office supplies
- Company vehicles, travel
An operating budget allows you to try out different assumptions in advance for variables like pricing and staffing, so you can take your best shot at making a healthy profit.
"I tell my clients to create three scenarios – best case, worst case, and middle of the road," says Michelle Long, a CPA and business consultant with Long for Success in Kansas City, Missouri. "Their budget helps them identify potential problems that may hamper their chances for success. They can plan for them, or adjust their business model to make it work."
It's relatively easy to create a profit-and-loss budget with accounting software such as QuickBooks. There are also free budget templates available online from organizations like SCORE.
Dig Deeper: 12 Best Tools for Budgeting
Setting an Annual Budget: Cash Flow is King
Novice business owners sometimes neglect the second kind of budget: a cash-flow budget. But in fact, it is problems with cash flow rather than profitability that cause many new businesses to fail.
Positive cash flow means you have enough money on hand to pay your bills at any given point in the year. A business can be profitable but still have cash-flow problems if, for instance, it has to shell out money in advance for inventory but doesn't receive payment from buyers until months later.
"You can operate at a loss for a while – a lot of small businesses do when they start out – but you can't operate with a negative cash flow," Long says.
To create a cash-flow budget, start with the assumptions about income and expenses that you developed for your operating budget. Then figure out, month by month, when you can expect to receive payments and when you'll have to pay bills.
"You may bill clients this month but not collect from them for 60 or 90 days," says Suiter. "If you can see beforehand that you'll be short of cash, you can arrange to get a line of credit, or borrow money, or pay (bills) out of your personal reserve."
You can use a spreadsheet program like Excel to create a cash flow budget, or use a template like this one from the U.S. Small Business Administration.
Dig Deeper: How can I Create a Reliable Cash-flow Budget?
Setting an Annual Budget: The Start-up Budget Challenge
Ongoing businesses can use the prior year's financial data as a starting point in setting next year's budget. But start-ups don't have this advantage. They've got to come up with all their budget numbers from scratch. Some questions you should ask yourself include: How much should we charge for your product or service? How many units of it will we be able to sell in our first year? How much will we need to spend on inventory or production? How many employees will we need, and what will they cost when we add in payroll taxes, workers' comp insurance, and benefits?
Owners of start-up businesses should do detailed research on their industry, their competition and their target market to answer these kinds of questions.
Talk to owners of similar ventures that are not your direct competitors. Look at aggregate industry data: You can find free financial benchmarks for a number of industries at Biz Stats, or at some other sites mentioned by Long in her blog.
