It's essential to plan and tightly manage your business' financial performance. Creating a budgeting process is the most effective way to keep your business - and its finances - on track.
This guide outlines the importance of budgets and business planning, and explains how to go about this. It suggests action points to help you manage your business' financial position more effectively and ensure your plans are practical.
It also looks at using your budget to measure business performance.
Budgets and business planning
Your business plan is a roadmap for your future development. It describes your business, its objectives, financial forecasts and your market. It can help you secure external finance, measure success and grow the business. However, for internal management purposes, budgeting can be the most effective way to control your cashflow, allowing you to invest in new opportunities at the appropriate time.
If your business is growing, you may not always be able to be hands-on with every part of it. You may have to split your budget up between different areas such as sales, production, marketing, etc. You'll find that money starts to move in many different directions through your organisation - having a budget is vital to ensuring that you stay in control of expenditure.
What is a budget?
A budget is a plan to:
- control your finances
- ensure you can continue to fund your current commitments
- enable you to make confident financial decisions and meet your objectives
- ensure you have enough money for your future projects
It outlines what you will spend your money on and how that spending will be financed. However, it is not a forecast. A forecast is a prediction of the future whereas a budget is a planned outcome that your business wants to achieve.
Benefits of a business budget
There are a number of benefits of drawing up a business budget, including being better able to:
- manage your money effectively
- allocate appropriate resources to projects
- monitor performance
- meet your objectives
- improve decision-making
- identify problems before they occur - such as the need to raise finance or cashflow difficulties
- plan for the future
- increase staff motivation
Creating a budget for your business
Creating, monitoring and managing a budget is key to business success. It should help you allocate resources where they are needed, and should not be complicated. You simply need to work out what you are likely to earn and spend in the budget period.
Most businesses start preparing a budget around two to three months before the start of a new financial year.
Begin by asking these questions:
- What are the projected sales for the budget period? Be realistic - if you overestimate, it will cause you problems in the future.
- What are the direct costs of sales - ie costs of materials, components or subcontractors to make the product or supply the service?
- What are the fixed costs or overheads?
You should break down the fixed costs and overheads by type, eg:
- cost of premises, including rent or mortgage, business rates and service charges
- staff costs eg pay, benefits, National Insurance
- utilities eg heating, lighting, telephone or internet connection
- printing, postage and stationery
- vehicle expenses
- equipment costs
- advertising and promotion
- travel and subsistence expenses
- legal and professional costs, including insurance
Your business may have different types of expenses, and you may need to divide the budget by department. Don't forget to add in how much you need to pay yourself, and include an allowance for tax.
HM Revenue & Customs (HMRC) provides tax budgeting advice for the self-employed.
The budget should be in place before the start of the financial year. Your business plan should help in establishing projected sales, cost of sales, fixed costs and overheads, so it would be worthwhile preparing this first. See write a business plan: step-by-step.
Once you have figures for income and expenditure, you can work out how much money you're making. You can look at your costs and work out ways to reduce them. You should also be able to spot if you are likely to have cashflow problems - giving you time to do something about them.
You should stick to your budget as far as possible, but review and revise it as needed.
Creating a business budget: key steps
There are a number of key steps you should follow to make sure your budgets and plans are as realistic and useful as possible.
Make time for budgeting
If you invest some time in creating a comprehensive and realistic budget, it will be easier to manage and ultimately more effective.
Use last year's figures - but only as a guide
Collect historical information on sales and costs if they are available - these could give you a good indication of likely future sales and costs. It's also essential to consider what your sales plans are, how your sales resources will be used and any changes in your market or the competitive environment.
Create realistic budgets
Use historical information, your business plan and any changes in operations or priorities to budget for overheads and other fixed costs.
It's useful to work out the relationship between variable costs and sales and then use your sales forecast to project variable costs.
Make sure your budgets contain enough information for you to easily monitor the key drivers of your business such as sales, costs and working capital. Accounting software can help you manage your accounts. See accounting software.
Involve the right people
It's best to ask staff with financial responsibilities within the business to provide you with estimates of figures for your budget - for example, sales targets, production costs or specific project control. If you balance their estimates against your own, you will achieve a more realistic budget. This involvement will also give them greater commitment to meeting the budget.
You could also ask your accountant to review your budget figures or to put the final budget figures together.
What your business budget should cover
You should first decide how many budgets you really need. Many small businesses have one overall operating budget which sets out how much money is needed to run the business over the coming period - usually a year. As your business grows, your total operating budget is likely to be made up of several individual budgets such as your marketing or sales budgets.
What your budget will need to include
Projected cashflow - your cash budget projects your future cash position on a month-by-month basis. Budgeting in this way is vital for small businesses as it can pinpoint any difficulties you might be having. It should be reviewed at least monthly - see cashflow management.
Costs - typically, your business will have three kinds of costs:
- fixed costs - items such as rent, rates, salaries and financing costs
- variable costs - including raw materials, overtime and tax
- one-off capital costs - for example, purchases of computer equipment or premises
To forecast your costs, it can help to look at last year's records and contact your suppliers for quotes.
Revenues - sales or revenue forecasts are typically based on a combination of your sales history and how effective you expect your future efforts to be.
Using your sales and expenditure forecasts, you can prepare projected profits for the next 12 months. This will enable you to analyse your margins and other key ratios such as your return on investment - see plan and forecast sales.
If you want to improve your financial skills and knowledge, learndirect provide an online course on business finance.
Using your budget to measure business performance
Your budget can be a financial action plan. This can be useful, particularly if you review your budgets regularly as part of your annual planning cycle - see prepare a business plan for growth.
Your budget can serve as:
- an indicator of the costs and revenues linked to each of your activities
- a way of providing information and supporting management decisions throughout the year
- a means of monitoring and controlling your business, particularly if you analyse the differences between your actual and budgeted income
Comparing your budget year on year can be an excellent way of benchmarking your business' performance - for example, you can compare your projected figures with previous years to measure your performance. See plan and forecast sales.
You can also compare your figures for projected margins and growth with those of other businesses in the same sector, or across different parts of your business.
Key performance indicators (KPIs)
To boost your business' performance you need to understand and monitor the key 'drivers' of your business - a driver is something that has a major impact on your business. There are many factors affecting every business' performance, so it is vital to focus on a handful of these and monitor them carefully.
The three key drivers for most businesses are:
- working capital
Any trends towards cashflow problems or falling profitability will show up in these figures when measured against your budgets and forecasts. They can help you spot problems early on if they are calculated on a consistent basis. See deciding which key performance indicators to measure.
Reviewing your business budget regularly
To use your budgets effectively, you will need to review and revise them frequently. This is particularly true if your business is growing and you are planning to move into new areas.
Using up-to-date budgets will help you manage your cashflow effectively and identify what needs to be achieved in the next budgeting period.
Income and expenditure
There are two main areas to consider when reviewing your budget - income and expenditure.
Your actual income - each month, you should compare your actual income with your sales budget.
To do this, you should:
analyse the reasons for any shortfall - for example, lower sales volumes, flat markets and underperforming products
consider the reasons for a particularly high turnover - for example, whether your targets were too low
- compare the timing of your income with your projections and check that they fit
Analysing these variations will help you to set future budgets more accurately and also allow you to take action where needed.
Your actual expenditure - regularly review your actual expenditure against your budget. This will help you to predict future costs with greater reliability.
- look at how your fixed costs differed from your budget
- check that your variable costs were in line with your budget - normally variable costs adjust in line with your sales volume
- analyse any reasons for changes in the relationship between costs and turnover
- analyse any differences in the timing of your expenditure - for example, by checking suppliers' payment terms