Understanding the Importance of Budgeting
The start of a new year often brings with it the feeling of new opportunities. In some ways, it feels like we have a clean slate or an opportunity to make a brand new start. We often try to set goals and make resolutions for how we want to proceed going forward. In our personal lives, we may resolve to improve our diet, exercise more, or spend less time glued to our electronic devices. However, it is also a good idea to use the new year’s momentum to set a very important goal for your business: creating (and sticking) to a budget.
What is Budgeting
Entrepreneur Magazine defines budgeting as “establishing a planned level of expenditures, usually at a fairly detailed level.”
Budgeting is often viewed with some level of frustration, but it is one of the most valuable tools that a small business owner has at his disposal. Having a well laid out budget functions much like a roadmap for your business. Using this resource, you can track and manage business expenses relative to estimated income, as well as anticipate future cash flow and expansion needs. Budgets can also help identify holes or shortcomings in your business plan that need your attention.
Why is Budgeting Important
Creating and following a budget gives your business many advantages. Such advantages include helping you control your spending, track your expenses, and save more money. Further, by forecasting your spending, a reasonable budget allows you to ensure your business always has money for the things it needs and the things to help you grow and expand. Without a budget, your business runs the risk of being unprepared. A budget allows your business to factor in unexpected costs and investments, so that you are prepared and have financially planned to be able to adequately respond when such expenses inevitably come up.
If you successfully create an effective budget, your business’s total projected spending for a set period will be included in that budget. A strong, effective budget will not only account for all known expenses, but will also factor in things such as an emergency fund, increase in the cost of needed supplies/products, etc. By creating a budget that accounts for all possible expenses and then sticking to that budget, you can ensure your business sticks to a predetermined level of spending. In comparison, if you make purchasing decisions as they arise without the guidance of an effective budget, spending can often get out of hand without you noticing.
Another advantage of budgeting is the ability to easily track your expenses. Once you create and implement a budget, that budget’s usefulness does not end there. Every time you make a purchase, you record that in a document or spreadsheet associated with your budget. Then you should regularly compare those expenses to the budget you created. By doing this, your business gains valuable data on its day-to-day operations, such as the ability to see your actual spending and compare that actual spending to projected spending. Additionally, by accurately tracking your spending, your business gains data that will be extremely useful when it comes time to update your budget.
The use of an effective budget will also help your business save money! By accurately tracking your expenses and comparing that to your projected budget, you can easily identify areas where your business can save money. Whether that be identifying a category that you no longer need to spend as much on, a category where the spending is consistently greater than anticipated, or just being able to identify areas where potential cutback is possible more effectively and efficiently. The proper budget utilization can make a significant difference in your business’s bottom line!
Many businesses make the mistake of not constantly updating or reworking their budget. By periodically consulting and updating your budget throughout the year, you can stay on top of your finances and adjust for unexpected costs. Additionally, it is important to be realistic about your budget. You don’t want to set your budget too broad, which reduces many of the advantages of budgeting discussed above because the budget established is not a realistic reflection of the business’s expenses. However, it is important not to be overly narrow in establishing your budget because that may unnecessarily restrain your business’s spending flexibility. It is crucial to set a realistic budget and revisit and update it throughout the year. The following tips can be helpful when setting a realistic and effective budget.
It is recommended that you set up an annual budget, separated by month. Here are some key components to consider:
A good starting point is to revisit last year’s sales numbers and make a reasonable estimate for this year. It is best to be conservative and consider market trends as well as the trajectory of your brand and its reputation in the industry. In making your budget, it is important to remember that cash is king. Revenue numbers on their own may not be indicative of your business’s ability to satisfy its obligations. Businesses need cash to purchase inventory, pay staff and handle other expenses, such as leasing office space.
Believe it or not, there are companies that might generate significant profits – but are cash flow negative. At the end of the day, “profit” cannot satisfy a company’s current liabilities; only cash can. Negative cash flow often results when business owners have poor collections or excess amounts of inventory.
As a business owner, it is critical to keep your pulse on the balance sheet in order to have a true understanding of the full financial landscape of your business.
See our previous post on cash flow management for more details.
Plan for Day-to-Day Expenses
When estimating your day-to-day expenses, itemize all the costs associated with keeping your business operational. These may include the following:
- Production costs
- Employees’ salaries
- Debt repayment
- Tax payments
- Customer appreciation/marketing
- Vehicle maintenance
- Office supplies
You might also consider separating your expenses into fixed versus variable costs. Variable costs are tied to production levels and rise as your sales volumes increase e.g., hiring additional staff to handle an unusually large order. On the other hand, fixed costs, such as rent, remain constant regardless of output.
Another way to budget for expenses is to do so by the department. Examples include HR, IT, and Marketing. This process might help you keep better track of your spending levels and give your department heads more responsibility and accountability.
It is always best to overestimate each expense line item to give your business some wiggle room – especially in light of unexpected events, e.g., machine repairs.
Look for Ways to Save
Having a detailed budget may highlight areas in which you are overspending. You might even identify several functions that you can outsource to save time and money. For example, payroll processing is a critical business function that can not only take up time and resources, but often results in major headaches if carried out poorly. By outsourcing payroll, staff can focus on value-added, revenue-generating tasks that expand your business. For more information on the benefits of outsourcing payroll, see our previous post.
Budget for Big Capital Outlays
According to Investopedia, “The process of budgeting for capital expenditures is essential for a business to operate and grow from a sound financial position.” Because capital expenditures are typically much higher than operational (day-to-day expenses), they must be carefully planned for in advance. For example, you might need to replace your software system mid-year at an estimated cost of $10,000. You could then set aside $2,000 per month in anticipation of this expense to avoid a huge financial burden on the business.
Automate your Budget
Make use of free tools at your disposal that will help you keep track of and update your budget. As a start, this might be as simple as using Google Sheets which can be shared with your team members and easily updated. You could also consider this list of budgeting apps for small business owners.
Budget by Month and Review your Budget Often
It’s important not only to create a well laid out budget but also to stick to it throughout the year. However, you should also recognize that budgets may have to be revised when unexpected events arise.
Set up time for a brief monthly check-in to ensure that you’re meeting your monthly targets. If you’re not meeting your targets, then it’s time to redo the budget. It could be that one of your clients has scaled back a big order, and your expected income is less than projected. In this case, you might want to use your budget to quickly identify ways to save money — such as cutting back on non-essential expenses.
The old adage “what you measure improves” is especially true when it comes to budgeting. When you carefully track every dollar that comes into and goes out of the business, it provides clarity and helps you to manage your capital more effectively.
The RQB team wishes you a happy and prosperous 2022!
Please reach out to us if there is anything we can do to help you reach your financial goals.