The first step to creating a budget is the creation of the sales forecast. The forecast is an estimate of future sales and other types of income. Although the budget is not a prediction of the future, it uses future estimated income as a means of dispersing expenditures. Budgeting financial expenditures allows the business to maximize profitability by controlling expenses.
What is a Small Business Budget?
The budget is basically a tool that allocates expenses overtime. It acts like an alarm to alert the entrepreneur if expenses are exceeding their limits. There are generally two categories of expenses, fixed and operating expenses. When creating a budget, there is usually more emphasis put on operating expenses, because they tend to fluctuate with operating activities.
Fixed Expenses and Small Business Budgeting
Fixed expenses generally don’t fluctuate overtime. Since they remain somewhat constant, incorporating them into the budget is relatively easy. Often times fixed expenses may not even be incorporated into the budget since they don’t fluctuate with operating activities. Some examples of fixed expenses are:
Operating Expenses and Small Business Budgeting
Operating expenses, sometimes known as variable expenses, usually fluctuate with operating activities. In a manufacturing environment, they tend to increase as production increases. In a business sales environment they tend to increase as sales activities increase. Operating expenditures are usually the main types of expenses that are incorporated into a budget because they have better probability of increasing if not controlled. Some examples of operating expenses are:
- Sales Commission
- Hourly Wages
- Equipment Maintenance
Creating a Budget – The Income Statement and Forecast
Besides the forecast, the other analytical tool that’s used to create the budget is the income statement. Since operating expenses play a more important role in small business budgeting, let’s look at creating a budget using operating expenses. The following are the steps for creating a budget.
- Gather the three previous years’ income statements
- Average the three previous years’ gross profit
- Average the three previous years’ operating expenses by category
- Calculate operating expense percentage to gross profit by dividing the average gross profit into the average operating expense by category
- Multiply the operating expense percentage to gross profit for each expense category by the monthly forecasted gross profit
As an example, let’s assume that the average yearly gross profit from the past three years income statements equals $1,000,000. The following examples equal the yearly average amount for each expense category.
- Sales Commission $70,000 or 7.0%
- Hourly Wages $55,000 or 5.5%
- Supplies $11,000 or .1.1%
- Freight $13,000 or 1.3%
- Equipment Maintenance $12,000 or 1.2%
- Advertising $35,000 or 3.5%
These percentages are then applied to the monthly sales forecast gross profit amounts. The calculated amounts from the sales forecast are then used for the monthly budgets. The historical percentages used don’t have to be set in stone. If the entrepreneur feels that the expenses can be reduced without affecting operating activities, the reduction should be applied to the budget.
If actual expenses exceed the budgeted amounts, appropriate action should be taken to either curtail the over expenditures or adjust the budget accordingly. Small business budgeting is essential for financial planning. Besides maximizing profitability, adhering to a budget is essential for proper cash flow management.