Like most good accountants, I believe every business should prepare an annual budget. A budget is like having a road map to guide your journey. As in travel, in business there are different kinds of journeys, such as traveling to a very specific location, or a journey where you’re simply traveling in a general direction. Just because your location isn’t specific doesn’t mean you shouldn’t use a map; it just means you will use the map differently. The same is true for budgeting.

Most people seem to think that a business budget should be like a personal family budget, where every inflow and outflow of cash is known. For a business though, there are often costs or revenues that are unknown. Costs are typically more readily determinable in a business, making it easier to budget. I often hear from my clients who don’t have a budget that “if I can’t plan my income, why should I prepare a budget?”

This reveals a fundamental misunderstanding that a budget is only intended to provide a perfectly accurate calculation of the net income for the budget period. However, a budget is a financial management tool that provides control and direction for a business. There needs to be sufficient specificity to enable planning for the year (or a longer period), but that doesn’t mean you have to know every outcome.

A well-constructed budget consists of various elements. A complete budget will include a balance sheet, income statement, and cash flow statement by month for the company’s next fiscal year. For my smaller clients who feel intimidated by this, I suggest they at least prepare the income statement. The inputs for the budget can be subdivided into the following worksheets:

  • Payroll budget
  • Operating Expense Budget (OPEX)
  • Capital Expense Budget (CAPEX)
  • Revenue and Cost of Sales Budget

Payroll Budget

  • Populate the annual compensation for each employee
  • Estimate the annual equivalent for each hourly employee
  • Estimate hiring and firing for the year, and document the effective dates
  • Add employer’s costs for each employee (e.g. CPP, group benefits)
  • Estimate profit sharing or bonus payments for each employee

Operating Expense Budget

  • Use the prior year’s actual results to challenge your budget assumptions
  • For each major expense line incurred in the past, estimate the cost for the next fiscal year (e.g. insurance, advertising, rent)
  • Fixed costs are easier to estimate, but variable costs should also be estimated
  • Estimate the monthly allocation of operating expenses

Capital Expense Budget

  • Estimate fixed asset repairs required, the cost, and when it will be incurred
  • Estimate any fixed assets purchases (replacement or new), including the cost, and when it will be purchased
  • Estimate any fixed assets you will be disposing of, the proceeds to be received, and when the sale will occur
  • Then calculate the depreciation expense based on the updated fixed asset register

Now that you’ve estimated your costs, you can work on the revenue budget. Even if you believe your revenues are too indefinite, you can estimate your revenues with a little effort, and yes, some assumptions. The key is to document your assumptions and to critically evaluate these to ensure you believe they are reasonable. Here are some steps to estimate your revenues:

Revenue Budget

  • Run a revenue by customer report for the current and prior fiscal year
  • Using this report, segregate your customers into regular recurring customers, new customers, departing customers, and non-recurring customers (e.g. cash sales)
  • Now, estimate your revenue expectations from each group of customers. This will be influenced by:
    • your current order book
    •  recurring revenues from agreements (e.g. a maintenance contract)
    •  revenues known or expected to recur based on knowledge of the customer’s operations
  • Now, you may estimate additional unknown or unspecified revenue after comparing the total from the previous steps to the revenue generated in prior years
  • Lastly, you should estimate your cost of sales to calculate the gross profit

These elements can now all be put together the create your income statement budget for the next fiscal year. Remember, even if it is difficult to prepare a budget, it doesn’t mean you shouldn’t prepare one. In a future post, I will address how you can use your budget as a management control system. And remember, once your budget is on paper, it will be wrong. It will either be wrong on the high side, or wrong on the low side. So, don’t aim for perfection, as that is an exercise in futility.

In the coming months, our Oikonomos accounting experts will be designing a budget template that will be available for download.

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