What is a budget?

The method of working out the finance of a small business begins by listing necessary purchases including tangible assets (equipment and inventory), services (power and insurance) and the costs of the people involved. (meta description)

Your budget must contain wording setting out how you worked out these amounts and a description of the expected financial results of your business activities. (meta description)

All businesses need to have a clear budget to support their plan that sets out what they are trying to achieve; what the ultimate goal of the business is. A budget is the financial plan for your business covering a specific period of time. It is a key element of your business plan as it details the financial performance that you expect your business to achieve. It ensures that you plan your finances to reduce uncertainty about the future and avoiding nasty surprises.

It also may demonstrate to you opportunities you might be missing!

One of the key considerations when starting a new business concerns the raising of finance to purchase equipment or fund your day-to-day expenses. Every business needs to have a clear idea for where it is going and what it is trying to achieve. Finding investment to start any business can often be time consuming, especially if you have no trading history, few savings, poor credit ratings, or no security.

All businesses will need finance at some stage in order for them to start up, grow in size, perhaps buy new machinery, or help with the day-to-day running of the business.

Why should you prepare a budget?

It is crucial for businesses to prepare detailed financial plans. Your budget sets out what you expect to spend your money on, and where the funds to finance that spending will come from. Not only does this make you sit down and consider the future but it also gives you something to refer back to regularly to assess whether actual performance varies against your planned budget.

Your budget serves a number of purposes in a business, including:

Providing a detailed financial plan on which business decisions will be made.
Providing financial figures against which actual performance can be compared.
Producing information to enable you to calculate the funding required by the business.
Controlling the allocation of resources.
Providing a framework to effectively manage finances.

How do you prepare your budget?

It is standard practice to prepare an annual budget which typically will cover the 12 months of your financial year, which may not be the same as the calendar year.

Preparing a budget for a start up business will be more difficult than for an established business because there will be no trading history. Assumptions will need to be made about how the business will develop and your budget will need to be justified against these assumptions. Your business plan will be an important starting point for preparing your budget, but you need to be aware that, as you develop your budget, you may identify changes that you need to make to the plan.

Your budget will quantify, in financial terms, the expected sales income and expenditure that will be incurred by your business. The main budget areas that you need to consider are:

Sales income.
Variable or production costs (which change in relation to your sales) such as raw materials bought for processing or goods bought for re-sale.
Fixed or overhead costs in relation to the running of the business (which are largely unaffected by changes in your sales) such as rent, rates, loans and salaries.
Capital costs, for example for the purchase of computers or other equipment.
Tax – you must remember that all businesses will have to account in some way for taxes.

Budgeting for sales

Your sales budget can be split into the number of different products or services that your business plans to sell. You will need to develop a sales budget for each product or service by considering the following issues:

The number of units of each product or service that you plan to sell.
The price that you plan to sell each unit for.
The different customer groups to which you plan to sell.

After considering all of these points, it will be clear what you are planning to sell, at which price and to whom. You will need to be realistic and cautious about how quickly your sales income will grow in the first few months. If you are too optimistic, your business may rapidly run out of cash if these sales targets are not achieved.

Budgeting for expenditure

Having prepared the sales budget, you now have the basic foundations for working out what your expenditure will be. There are three main types of expenditure for which you need to budget: variable costs, fixed costs and capital expenditure costs.

Variable cost budget

Knowing what sales you will make will allow you to calculate your variable costs, which will change in line with your sales. Some of the types of variable cost that you may need to consider are:

Materials and components that go into the products that you sell. For example a cabinet maker would have to budget for the cost of wood, screws, nails, glue, and handles.
Commissions to affiliates, sales agents or staff who earn commission as well as receiving fixed salaries.

Understanding the costs that you will incur for each product or service that you sell is a vital part of preparing an accurate budget. You should prepare budgets for the cost of producing each product or service. You can then review the costs associated with each product to ensure that your proposed selling price generates an acceptable gross profit (the selling price less the variable costs) for your business. This will also help you to identify which products are more profitable.

Fixed cost budget

Once you have prepared the variable cost budget, consider the other costs that your business will incur. These costs will stay more or less constant irrespective of changes in your sales or whether you make any sales at all. These are often referred to as the 'overhead' costs of your business and can include.

Marketing, promotional and travel costs.
Salaries for you and your staff, including employers' National Insurance (NI) and pension contributions.
Rent and business rates.
Telephone, Internet and utilities charges.
Building, contents and public liability insurance.
Professional fees for accountancy and legal advice.
Finance costs - bank charges, loan interest, leases, depreciation on equipment and tax.

You need to be aware that once your business is up and running, it is often hard to reduce many of these overhead costs quickly. This may be a problem if you do not achieve your expected levels of sales income, so you should look to keep these costs to the minimum necessary for your business to operate effectively. In particular, you should think carefully before committing to longer term costs such as leases for premises and equipment, which may additionally have to be backed up by personal guarantees.

Capital expenditure budget

You will need to buy capital equipment, such as computers or machinery, to use in your business. But what you actually buy will be determined by what you can afford, (the budget that you have available) and what finance you are able to raise to help pay for it.

You will need to decide how you will pay for your equipment, whether in cash, or with a loan or lease, calculate when you will need to buy it, and then budget for these payments in the relevant months.

This is essential information if an accurate cash flow forecast is to be prepared, particularly if your business may have to take out a loan or lease to finance the purchase and will have to meet a repayment schedule that includes interest.

Cash Flow Budget

A cash flow budget is a projection of your business's cash inflows and outflows over a certain period of time. A typical cash flow budget predicts the anticipated cash receipts and disbursements of a business on a month-to-month basis. However, a cash flow budget could predict the cash inflows and outflows on a weekly or daily basis. Because of the uncertainty involved in the cash flow budget, trying to project too far into the future may prove to be less than worthwhile. At the same time, a cash flow budget that doesn't look far enough into the future will not predict future events early enough for you to take corrective action in your cash flow.

A twelve-month cash flow budget minimizes the amount of uncertainty involved in the budget. It also predicts future events early enough for you to take corrective action. However, if you're applying for a loan, you may need to create a cash flow budget that extends for several years into the future, as part of the application process.

The primary purpose of using a cash flow budget is to predict your business's ability to take in more cash than it pays out. This will give you some indication of your business's ability to create the resources necessary for expansion, or its ability to support you, the business owner. The cash flow budget can also predict your business's cash flow gaps — periods when cash outflows exceed cash inflows when combined with your cash reserves. You can take cash flow management steps to ensure that the gaps are closed, or at least narrowed, when they are predicted early. These steps might include lowering your investment in accounts receivable or inventory, or looking to outside sources of cash, such as a short-term loan, to fill the cash flow gaps.

Preparing a cash flow budget involves four steps:

preparing a sales forecast
projecting your anticipated cash inflows
projecting your anticipated cash outflows
putting the projections together to come up with your cash flow bottom line

Using your budget

Use your budget as a control mechanism. You are setting targets that you expect to achieve and so at the end of each month, compare the actual figures for sales and expenses next to the figures that were budgeted. If there are significant differences between the budgeted figures and the actual figures, then you need to understand what caused these differences and take action to remedy it.

If sales are too low, you may need to reconsider your pricing strategy or identify if one of your products is underperforming against its target.
If sales are higher than planned, you may need to reconsider your cash flow forecast as your working capital requirements (the cash required to fund your day-to-day operations) may increase.
If certain expenditure is too high, you may need to reduce costs - this could involve finding a new supplier.

Your budget, like your business plan, should be an active tool. If you find that the original assumptions you used are not working in practice, then you need to be prepared to amend your forecasts looking forward, so that they reflect what you expect to happen. You should be prepared to review, and if necessary revise, your budget every three months during your first year of trading.

Budget Basics

Budgets are not easy. But budgets do not have to be the difficult nightmare they are often perceived to be. When developing your budget it might be helpful to consider the following:

Look at your business model and strategy first. Make certain your budget aligns with your strategy. If you have no model or strategy develop one before attempting a budget.
Make your budget fit your goals. Why should your budget reflect something else?
Think of your budget as a means or mechanism to achieve your goals.
Make certain you can track revenues and expenses accurately. Do this before preparing your budget.
Focus on revenues and expenses. Be especially aware of totals. Total revenues and expenses translate into the bottom line. Refer often to your business model.
Leave some margin in your budget for the unexpected. There are just too many factors in most businesses to predict with great certainty 'what will be'.
Keep to the real world. Budgets are guidelines and fantasy-based guidelines are worthless.
Look carefully at cash flow especially if you are in a seasonal or cyclical business.
Try to be as accurate as possible when looking at future revenues and expenses.
If you are a start-up, pay careful attention to what is possible and what your company is able to do. If you cannot do something, do not make that a premise in your budget.
If you are an existing business, use your past history as one of your guidelines.
If your numbers do not add up, look at your industry benchmarks to get an indication of what your ratios should be.
Track trends in your industry and your local marketplace. Do not forget to consider these trends in your budget.
Break out fixed and variable costs. If you do not understand the difference ask your accountant.
Check your budget against actual figures on a weekly or monthly basis. If conditions have changed reflect those changes in a revised budget.
Try to develop a worst-case and best-case scenario budgets. Usually reality falls somewhere in between.
The budget is a valuable business tool that can help your business thrive. Used correctly, a budget can help a business grow and maintain a healthy net profit.
Prepare your budget well before you plan to start up to allow plenty of time to assess potential financial requirements.
Look at the impact on your budget if your sales income is 10% or 25% below your expectations. In particular, look at the effect on your cash flow and consider what cost savings you could make.
If you consult your bank about start-up finance, discuss your budget with your bank manager or small business adviser. This will help you prepare the information in a way that suits their requirements and give you a better chance of success in raising the finance you need.
Remember that your cash flow forecast is as important as the budget itself as this will alert you to working capital shortfalls.

Choose your business to budget...

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