Budget Planning

The core of good business planning is the budget – But as Matthew Gardiner explains, an effective budget is multifaceted, and each part is crucial to developing a business plan to manage day-to-day operations, risk and growth.

Developing a relevant and achievable budget is an effective way for a business to identify and plan to achieve objectives. Budgets should be prepared for each financial year and should include both revenue growth and control of expenditure.

A good budget can greatly enhance a business’s chance of success by helping managers to estimate future profits and needs, and plan for overall spending and cash requirements. It also allows problems to be identified before they occur, so plans can be amended to prevent them.

The first step, before preparing a budget, is to determine the overall direction of the business. A budget can then provide the financial details that underpin the achievement of objectives. Budgets therefore reflect the financial result of actions taken as part of an overall business planning process and approach. It is important that the budget addresses the overall plan for the business and contains an understanding of where business managers aim to be and how they plan to get there.

Budget Developing

Once a business manager has developed a vision for the business, he or she can address issues in relation to the financial consequences of those actions. Therefore, budgets should not be developed simply by adding a percentage to the previous year’s results, which is often seen as a simple way of determining the anticipated increase in performance.

If a budget bears no relation to the overall business plan it will either be over-estimated and unachievable, or will be underestimated and provide no ‘stretch target’ to increase overall profitability and growth.

Budgets can be developed for any aspect of performance, depending on the size of the business and its complexity. For example, a smaller business may have only a cash budget, while larger businesses may find it useful to have a profit budget as well as a related cash forecast. Asset acquisitions can also be budgeted to assist in the effective management of the business’s assets.

A profit budget includes sales, inventory, purchases and expenses, but doesn’t reflect the cash flow position because it also contains non-cash items such as depreciation. A cash flow forecast allows for items not included in the profit budget, such as loan repayments, asset acquisitions and tax payments. The cash flow forecast also reflects the impact of time delays in collection of debts and in paying creditors.

It’s a good idea to allow for these items in the cash budget so managers have an overall picture of the business’s ability to fund the purchase of additional assets, or pay taxes, as the need arises. Growing businesses are always cash hungry, and the cash flow forecast gives the manager a grasp of the timing of issues integral to the success of the business.

There is usually a link between a cash flow forecast and the profit and loss budget. However, it’s important to have both because the cash flow budget will highlight the timing differences in generation of revenue and collection of cash, and in the incurring of an expense and the payment of the outstanding creditor. Generally, a business manager can’t manage the business solely on one or the other.

Regular Budget Checks

The initial formulation of a financial budget will arise from the goals identified in the business planning process and to start with they may be untested. Analysis of historical trends is one source of budget formulation. Another is to obtain industry benchmark information, which is available from various sources. A combination of both may assist managers in developing a budget.

The actual results should then be monitored on a regular basis and, if significantly different from the budget, it can be amended. However, the actual budget should not be changed each month to reflect actual results. Variances in actual results to the forecasted budget should be analysed and the causes of any variances should be taken into account when re-formulating future budget figures.

Importantly, should the desired level of profitability not be achieved by the budget then the business has two choices: look into ways to improve revenue or ways to reduce expenditure. During the budgeting process the business manager needs to determine that the profit is achievable and how it will be achieved.

Budget Strands

As mentioned, a profit budget targets the desired profitability of the business for a given period. To arrive at profit, the business must determine sales revenue and related expenses.

Sales revenue is the cornerstone of the budget, and so it’s imperative for sales to be estimated as accurately as possible. Depending on the type of business, the determination of sales revenue will be based on the drivers that generate that revenue; for example, units sold times sale price, or budgeted billable hours times hourly rate.

The expenses incurred to generate profit must also be accurately estimated. Expenses are both fixed and variable and the budgeting process should include both. Estimating expenses can be difficult, as the budget must accurately reflect which expenses will change and by how much. For example, changes in unit prices may be driven by volume and market impacts. Variable expenses can be linked directly to the level of sales activity whereas fixed expenditure is not.

However, there are occasions when fixed expenditure may increase, for example increased warehouse space or additional sales force. This must be considered when setting the budget.

All profit budgets will also include income and expense items, and cash flow forecasts will include additional items not part of the profit budget. However, different types of businesses will have a differing emphasis on various components in each of their budgets.

Profit Budget
	Jul	Aug	Sept	Oct
Revenue	10,000	11,000	11,500	12,000
Cost of goods sold	5,500	6,050	6,325	6,600
Gross Profit	4,500	4,950	5,175	5,400
Expenditure
Interest	700	700	700	700
Advertising	0	0	0	0
Depreciation
Insurance	500	500	500	500
Legal Accounting
Repair Maintenance	50	50	50	50
Telephone Utilities	100	100	100	100
Rent	600	600	600	600
Office expenses	175	175	175	175
Salaries	1,050	1,050	1,050	1,050
Miscellaneous	200	200	200	200
Expenditure Total	3,375	3,375	3,375	3,375
Total	1,125	1,575	1,800	2,025
Cash Flow Forecast
	Jul	Aug	Sept	Oct
Opening Cash Balance	6,000	-3,915	855	-4,915
Cash In-Flow	6,000	8,600	11,100	11,700
Purchases	12,000	0	13,000	0
Overheads
Advertising	75	0	0	0
Depreciation
Insurance	500	500	500	500
Legal & Accounting
Repair Maintenance	50	0	0	150
Telephone Utilities	90	80	95	110
Rent	600	600	600	600
Office Expenses	150	200	225	175
Salaries	1,050	1,050	1,050	1,050
Loan Repayments	1,400	1,400	1,400	1,400
Tax Payments
Total Overheads	3,915	3,830	3,870	3,985
Cash Out-Flow	15,915	3,830	16,870	3,985
Closing Cash Balance	-3,915	855	-4,915	2,800

Small growing businesses tend to require cash flow to fund the growth of the business and by forecasting cash in line with anticipated growth in revenue and expenses the business manager can identify in advance potential need for additional working capital.

Businesses that rely on a high level of stock, such as retail businesses, will have a much greater emphasis on stock movement. The impact of lead times for the purchase of stock and the possibility of out of stock items will
require planning in relation to the timing of significant stock purchases.

Seasonal businesses that have very high fluctuation in business activity must consider the effect of this on cash flow both from a cash-in perspective from sales and the potential for timing differences for cash-out for purchasing of stock. The budget will assist the business manager to monitor the impact of seasonality on its goals.

Businesses in some industries will also need to consider the specific set-up of their business when setting their budgets. Any associated costs in generating income should be considered. For example, a plumbing business may estimate the number of chargeable hours for each plumber, multiplied by their charge rates per hour, but deduct an allowance for time spent in marketing, business administration and downtime.

Similarly, a massage therapist may calculate budgeted income on the basis of the average time for treatment, multiplied by the number of rooms and therapists employed in the business. The impact of additional therapists or space may therefore affect the bottom line. For example, employment of an additional employee may provide potential for greater revenue through additional hours and this can be balanced against the potential cost of engaging that employee.

By analysing the underlying revenue and cost drivers of each business, the manager can determine the ability of the business to meet a budget and therefore determine how reasonable the budget is.

Our four-month example of a cash budget linked to a profit and loss budget illustrates the importance of having both.

Business managers should consider getting expert advice when formulating budgets. Although the managers will have detailed information about their business and the industry they operate within, they may not have sufficient expertise to compile their knowledge into a workable budget.

A third party such as an accountant can provide an independent analysis of the budget. They can assist in formulating budgets, specifically the difference between profit budgets and cash flow forecasts, and provide an external sounding board to ensure the budget is realistic.

A good budget will be a vital tool in successful business planning.

* Matthew Gardiner is a partner with accountants and business and financial advisers HLB Mann Judd Sydney.