Last month we looked at Business Planning, a well-run business will normally consider what it wants to achieve over the next several years and create plans, projects and set milestones with associated forecast costs needed in order to fulfil those aims.
The Business Plan is a good starting point for creating an annual budget as it provides a structure of what is required and from there the budget can start to be pulled together.
There are two different approaches to setting a budget for your business, if the business has been trading for one or more years a historical approach is the most common, but if you are setting up a new business what then? This is where a zero-based approach will need to be used as there is not historical data to base your budget on. Oftentimes budgets will contain elements of each approach especially setting a budget for a brand new project.
Historical Budget
In this method, we project future revenues and costs on the pattern of recent years’ trading, looking back and see the pattern of the revenues and costs by week or month and from there predict what might happen in the future. I appreciate this maybe a little tricky when looking at an extraordinary year like 2020.
The Zero-Based Budget
This method starts from a position of zero costs and zero revenues and each element of the budget is justified and challenged. Obviously the only option open to toys if you are starting a brand new business.
Both the Historical and Zero-Based budgets have their place, the zero-based option will be more time consuming although it can create the most well-founded financial budgets as everything is considered and challenged.
Key Budget Elements
When creating a financial budget for your business this can be an overall budget for the whole business or a smaller one for example for the marketing. Whatever budget you are creating there are some key financial considerations:
Revenues
Costs
Investments
Financing
Credit Management and Cash Flows
Let’s look at Revenues and Costs there are three types of monetary flow, which apply to both of these, Fixed, Variable and One-Off Costs, all of which need to be considered.
Fixed Flows
These are flows that are known with reasonable certainty for the budget period and are usually related to a fixed, contractual arrangement for example the premises rent, machinery lease costs, maintenance contracts. On the revenue side this would include any contract or retainers revenue or indeed rental income if the business has property. As these are well-known it is a good idea to use these as the first entries into your budget.
Variable Flows
These are flows that come generally as the result of normal business activity. Sales, not including those retainer and other fixed income costs which have already been discussed above. Costs of raw materials, related to the budget period, which generally scale with the volume of production, also fall under this category. Projection of these flows will normally be based on their equivalents from the previous financial period where products or services exist in both periods.
Variable flows will be based on expected activity that has been planned by the business for the budget period. While a Finance function may be able to do reasonable projection of these flows based on previous activity. The variable business functions will have to be monitored and amend based on knowledge of the current market situation and the assumptions that have gone into their business planning.
One-off flows
As the name suggests, these monetary flows are neither fixed nor variable, but come from expected transactions that, while the value and timing are known they are significant in scale and not likely to be repeated on a regular basis.
These would include the sale of Assets or the freehold or lease on a business premises, or the receipt of one off Grants. Conversely one off Out-Flows would include expenditure for new plant and machinery or other large asset. A significant change in value of stock of goods held could be either depending whether then stock is increasing or decreasing in value.
Creating the Budget
In order to create our financial budget, using the more common historical method we need to consider all costs and revenues that have occurred in recent years of trading.
It will be necessary to list all sources of cost and revenue from prior trading and determine its flow-type and its likely impact during our budget period.
Budgets need not be over complicated, however the greater the detail in a budget the more likely it will be that you’ll be able to identify elements are not staying inline with the budget, variances should be calculated and reported at least quarterly in order that action can be taken to correct the negative occurrences or exploit the positive ones which will show where extra money will be available.
If you are tasked to compile an overall budget for your company, it will make your life a lot easier if the information you receive from each department is in similar format and detail to this end it will be worth your while to create a template for each department to complete. This ensures that you have the right level of information to bring together and a consistent basis to track the progress of the organisation through the budget period.
All flows should be accounted for in the template that you provide to each contributor, as this will ensure that all items are captured, including those unexpected costs and revenues. If you are a Xero user they have a great budget facility in the software that you can use.
While creating a plan and such in-depth budgets is time consuming having a good understanding of the numbers in your business is crucial for the future health and indeed growth. Happy Budgeting!