Budgeting Basics

There are several ways people have tried to budget with differing measures of success. One popular way is what I call the "Ego Method." This is where the company’s ownership reviews the income statement for the year just completed. They look at the earned revenue figure for that year, see it was $450,000, and, for no reason other than to placate their own ego, set a goal of $600,000 for the next year. Why $600,000? It just seems like the thing to do.

Another way to budget, which has a strong following, is the "Growth Method." In this case, ownership looks at the company’s trend over the past few years, sees it has grown an average of 25% per year, declares, "If it ain’t broke, don’t fix it," and sets a 25% growth target for next year. How much sense does that make?

Yet another method is the "Inflation Method." Here, ownership looks at local statistics measuring inflation and discovers inflation was 5% last year. Because they can think of no reason why, they increase all of their figures by the inflationary 5%. "Hey, inflation was 5% last year, so let’s increase all of last year’s numbers by 5% and that will be our budget for next year." Now, is that good thinking?

Last is the "Percentage Method." Here, ownership picks a sales figure with which they feel comfortable (typically driven by ego emotions) and then figures all of next year’s expenses based on the same percentages to sales as they were last year. We won’t kill any brain cells with this one, either.

All of these methods are what I call "Budgeting Faux Pas." They all focus on the top line, and if they seem a bit baseless to you, it’s probably because they are. Budgeting is not hard, but it’s not this easy either.

A legitimate working budget is a series of decisions — overt decisions by top management — which describe in numeric terms how the coming year will progress. It is a logical process, which begins with the basics. And, the most basic of all questions is "Why are you in business? Is it because of sales?" Of course not.

I submit that you are in business for two reasons: profit and fun. If you are making a profit, you are more than likely having your share of fun. However, if the profit is not there, business can be a real bummer.

Let’s think about this — if profit is one of the two primary reasons you are in business, doesn’t it make sense that profit is the first item you forecast? Of course it does.

If I wanted to prepare a budget based upon why I am in business, I would start with profit — at the bottom of the income statement — and work up. Or, if I wanted to, I could spin the income statement upside down, start with profit and work down.

STEP BY STEP. The budgeting process is actually a five-step procedure that begins with how much profit we need to make.

Step two forecasts the spending habits of the company’s overhead structure. The combination of the first two steps tells us how much gross margin we will need to generate.

Step three establishes how much of the gross margin is already sold.

Step four describes the revenue goals we will need to achieve to generate the remaining gross margin requirement.

Finally, step five takes our annual budget and spreads it over each of the 12 months of the year so that we can periodically compare how we are actually performing against our goals.

It’s important to note the choice of words used back at the beginning of the process — "How much profit we need to make." This is not about how much profit we need to make, but how much we need in order to operate our business.

To establish profit needs, you must remind yourself what profit is used for. Primarily, it is used to provide the cash for the company’s needs in five areas: the retirement of debt, the purchase of capital assets, the support of growth, the payment of bonuses or dividends and the payment of taxes.

If the business doesn’t generate the cash through the profits of the business, it risks not being able to pay for these items — and that is not good.

FIGURE IT OUT. Taken in order, you will first want to make a list of the debt you must retire in the coming year. Add up the principal portion only; interest will be budgeted as an expense item when we develop the overhead budget.

Second, make a list of the fixed assets you wish to purchase. Once you have made this list, itemize how much you will pay in principal against each item in the next 12 months.

Third, anticipate how much growth you expect for your company in the coming year. This may be an educated guess, since we have not determined earned revenue yet. Nevertheless, make an estimate of dollar volume growth for the coming year. Divide that volume increase by 10.

The number 10 is a banking rule of thumb for the industry that determines the amount of cash needed to support earned revenue in a healthy company.

Typically, I am not much on rules of thumb, but in this instance, 10 cents of cash to support $1 of revenue is fairly realistic for most of us.

Here’s an example: If I perform $450,000 in revenue this year and expect that next year’s performance will probably be around $500,000, I take the difference between the two revenue figures. Fifty thousand dollars is how much I expect to grow. Divide the $50,000 by a factor of 10 to determine how much cash I will need to support that growth. In this example, my cash need is $5,000.

Fourth, estimate what you would like to pay in employee bonuses or shareholder dividends given that you achieve your definition of success. This would be money paid after year-end profit is achieved and would not be anticipated in the overhead budget.

Lastly, add up the profit requirements established in the first four steps and estimate the state and federal income taxes that would normally be payable for this level of profit performance.

Add the five values together.

Now, subtract next year’s anticipated depreciation, as this is a non-cash expense item. You have just calculated the profit, or capital requirement, you must make next year to support your organization — not "want to make" or "should make," but must make if you are to meet all of your obligations for the next 12 months.

To illustrate, I am going to fill in the profit needs for the budget of our example company (see previous page). In your company, you will want to tabulate each of these profit requirements as they relate to you.

Therefore, $50,680 is the minimum profit requirement for next year. Certainly I can, and want to, make more, but this is what I must make if I expect to meet my obligations.

The author is a consultant with Ross-Payne Associates, Barrington, Ill. He can be reached at 847/381-8939.