A business may need a budget in order to model what its future results and cash flows will look like. Doing so gives management a reasonable idea of how much it can spend, and how much new revenue it should expect. This information can be used in the following ways:
- Management should only authorize that amount of expenditures for which there will be an offsetting amount of incoming cash flows.
- If actual results begin to diverge from the expectations outlined in the budget, management can take steps to alter expenditures to be in accordance with budgeted results.
How do you create a business budget? The following steps provide guidance in how the process works:
- Model structure. Initially construct the budget model to match the line items appearing in the existing income statement. By doing so, you can then take the budget information in the model and drop it into the accounting software to produce budget versus actual income statement reports.
- Revenue. As a starting point, enter in the budget model the amount of revenue that the company earned in the past year. Then consider the constraints of the business. Does it have sufficient cash to fund a higher level of sales? Is there a bottleneck in the business that will prevent sales from surpassing a certain amount? Is there a limit to the pace at which the company can create new products or open new stores? What is the comfort level of the owners in managing a larger business? Also, factor in the sales estimates of the sales staff, who are in the best position to understand likely future changes in sales levels. Based on this information, create a new budgeted revenue level.
- Compensation expense. Estimate the number of staff needed to operate at this new sales level. Include in this estimate the pay levels needed to attract and retain the correct level of experience in each position, as well as the cost of the benefits to be issued to the workforce. Include the amount of payroll taxes associated with the new pay rates. This becomes the compensation portion of the budget.
- Cost of goods sold. Determine the gross margin on sales in the past year. Should this amount remain the same? What factors could alter it? Will increased competition lead to reduced prices and lower margins? Will supply constrictions in the upcoming year lead to increases in material costs? Can cost increases be passed through to customers? Will freight costs change? Based on these issues, enter in the model a percentage for the cost of goods sold.
- Administration costs. Start with the administrative costs of the business in the past year, and estimate how they will change in the next year. Are there scheduled changes in the rent expense? If there will be more employees next year, how will that impact utility costs?
- Finance. Estimate any changes from last year in the areas of interest expense and interest income. Do you expect interest rates to change? Is it likely that the amount of debt will alter much from the current level? Is there an expectation to alter the company's investment policies?
- Reasonableness test. Review the resulting budget to see if the amounts appear reasonable. It is entirely possible that there are logic or spreadsheet errors that require correction.
The end result of these discussions is a rough-cut business budget. As the year progresses, it may be necessary to alter the budget assumptions, which will probably lead to alterations in the budget. These changes will be necessary, if you want to keep the budget model relevant as a basis of comparison to actual results.