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.

Get exact numbers in advance for as many of your costs as possible. "Talk to a broker to find out exactly what your insurance costs will be. If you're going to have a Web site, find out exactly how much it will cost to maintain," says Emily Gasner, a business coach with Working Solutions in San Francisco.  

Tailor your projections to your specific community and market - even to the point of counting the number of potential customers who walk by your storefront on a typical day. Consider seasonal changes in your kind of business.

And don't assume that sales will go from 0 to 60 miles per hour at once.

"People assume they're going to be making a lot of money as soon as they open their doors," says Gasner. "It takes longer than they expect to get up and running, and it's more expensive than they expect."

Dig Deeper: Budgets and Budgeting

Setting an Annual Budget: Don't Leave Your Budget in a Drawer

Once you're open for business, don't stick your budget in a drawer until the end of the year.

Review it often. Check, at least once a month, to see how it compares with your actual income and expenses. This allows you to adjust your expectations, so you can order more inventory than planned, pare back your marketing efforts, or hire that new employee at half-time rather than full-time if necessary.

Comparing actual monthly financial results with your budget can also allow you to catch hidden problems before they become crises.

"I had a client with a couple of sandwich shops whose gross margin was looking funny," says Long. "His costs were going up faster than his sales. For a couple of months, I kept telling him to look at it. It turned out that some of his employees were taking cases of meat out the back door."

This kind of critical review is something that is really up to the small business owner himself or herself. You may have a bookkeeper or accountant compiling your financial information, but they don't have your overall vision for the business.

Nor will they be looking at the numbers with an eye for potential business snafus or opportunities.

"Your bookkeeper can produce historical information and pull those reports for you, but the owner should take ownership of the budget," says Melinda Phillips Zumski, owner of Phillips Business Consulting in Castro Valley, California. "This is an opportunity for you to keep your finger on the pulse of the business."

Dig Deeper: How to Evaluate Your Company's Financial Position

Setting an Annual Budget: Budgeting to Weather a Recession

While a well thought-out budget is always necessary, it becomes even more important when businesses are trying to weather a recession.

Jorge Amorim, owner of Divine Catering in Madison, New Jersey, used to review his budget every quarter. But when the current recession started hitting his business, he began looking at his budget every month to find ways to trim costs.

"It let me see a pattern of planes that weren't ordering the same things as before," says Amorim, who provides catering services to corporate jets and also private parties. "They were scaling back $5 here or $20 there. It's stuff you wouldn't notice on a daily basis, but it adds up when you have thousands of orders a year. We saw that we had to beef up our house parties to make up for it."

Amorim now plans to dig even deeper and review his budget weekly - at least until the economy improves.

"A recession makes you look at every little thing - your marketing budget, supplies, containers," he says. "What times are good, what's the big deal about an extra case of something sitting downstairs? But in a recession, every dollar counts. We need to know: Do we really need to carry $20,000 worth of food rather than $15,000?"

Setting an Annual Budget: Look Forward to Next Year's Budget

When it's time to draw up next year's budget, accounting software like QuickBooks makes it easy to copy all of this year's financial results into a budget template. But it's what you do with that baseline information that will determine the accuracy and usefulness of your budget.

Traditional budgeting starts with historical data and modifies it as needed - for instance, increasing certain line-items to keep up with inflation. Zero-based budgeting, on the other hand, goes back to the starting gate and reevaluates every line item.

Vicki Suiter recommends a combination of both techniques to her clients. "Take it line by line and ask questions like, 'If we want to increase sales, what's the strategy for doing that?'" she says. "You may need to add sales bodies or increase your marketing budget. On the other hand, items like rent and utilities may be the same from year to year."

Michelle Long recommends keeping notes about one-time events such as a blizzard that kept customers away, or mass layoffs in a nearby factory that dampened your sales. "That way, when you're budgeting for the next year and say, 'Gosh, how come June was so bad?' you can remember that such-and-such a company laid off people then."

Sharon Eisenhauer, the owner of the Haiku bag company, uses the previous year's budget as the starting point for her next budget. Then she overlays her sales goals for the year.

"Say I want to increase sales from $1.7 million to $2 million," Eisenhauer says. "I increase my sales projections on a monthly basis to allow me to reach those goals. Then I add in the costs connected with that growth, such as a new trade show booth or an extra trip to (factories in) China."