Why is it so important to take the time to set a budget for your SME? Here are the main reasons why I advocate setting a budget is vital if you would like your business to thrive:
A budget provides the financial context behind a business’s goals and objectives and considers the risks and opportunities the business faces.
It helps you understand where you are spending your money and how that might change over the coming year.
A budget helps identify areas where cost savings can be made.
It enables planning for different scenarios such as an increase in sales or the impact of losing your largest client.
It helps determine if you can afford to make investments such as expanding your premises, purchasing equipment, or growing your team.
If you are trying to obtain investors or funding, then a budget is vital to share with potential investors and lenders.
A budget can be used as an incentive tool for staff and is frequently used to set the sales department’s targets.
How to build a budget?
Bring together stakeholdersFirstly, I suggest bringing all the relevant people in the business together. Budgets can become battlegrounds so it’s essential to determine and agree on the business’s goals and objectives which will underpin the budget. If sales, production, management, and finance agree on the principles, then the next steps should be easier!
Estimate sales To estimate future sales, it’s best to start with past information. Looking at your financial history enables you to make accurate predictions which makes the budget a more useful tool. The finance sales ledger system should have details of past sales including who, what, when, and how (i.e. which sales channel). The person in charge of sales needs to agree on the budgeted sales levels for both existing customers and any potential new customers. Timing of sales is important, so ensure you consider any discounts or promotions that you plan to run, for example, a January sale or a Black Friday deal. If you are a startup business, you won’t have the benefit of past information, so instead you should look at the size of the market, your potential share, and any available competitor information. Ensure any estimates are grounded in reality, and it is important to sense-check your predictions. For example, if you are predicting sales to increase then it is very likely that costs will need to increase too e.g. stock, staff, or advertising, and if you need to hire new people, then factor in the time it takes for them to learn the ropes.
Estimate Cost of sales Once you know what the sales function hopes to sell, it should be possible to work with the operations and production team to estimate the cost of buying the materials/ services needed to produce the products or services. The cost of sales is generally by nature variable, as it changes with the number of goods you are producing (e.g. raw materials, packaging, shipping, etc.) The purchase ledger system can provide the most up-to-date costs from suppliers. Talk to your production team who should be able to determine the cost of producing the estimated sales. The method of calculation will be specific to the business and industry, for example, a manufacturing business would calculate the cost of materials, labour, packaging, and shipping costs. A service-based business would consider labour costs. Make sure to include any recent pay increases and to factor in inflation with your purchase costs. For more information on costings, click here for an article I wrote on the steps to take to understand the true cost of production for your business.
Estimate Overheads Overheads are typically fixed costs that are consistent and don’t change with the number of sales you make, for example, rent, utilities, insurance, etc. Again, start with the profit and loss, for details of historical actuals and the purchase ledger for details of up-to-date costs. Whilst overheads are relatively stable, they may change, for example, if you’re anticipating business growth and require a larger site, or an energy contract is due to end and tariffs have increased so these costs need to be sense checked in light of sales forecasts.
Profit Using sales, cost of sales, and overheads you can now build the profit and loss budget.
Capital Expenditure It is important to identify any major investments or capital expenditures you plan to make during the budget period, for example, purchasing any new equipment. This will impact the cash outflows in the budget. Capital expenditure shouldn’t hit the profit and loss account directly. Instead, it is released into the profit and loss account as depreciation over the life of that asset.
Cash Whilst the profit and loss budget is essential, it is not the full picture and it’s important to know how cash will flow in and out of the business over the budget period too. Profitable businesses often cease to operate if they run out of cash and whilst periods of growth and investment are exciting, the working capital (i.e. the funds required for day-to-day operations) needs to be funded. For advice on managing your cash flow, please click here. The profit and loss budget and capital expenditure plans can be used to forecast cash however, make sure to consider timings. For example, assuming staff are paid on the last working day of each month, wage costs will turn into cash outflow within the month whereas, sales and material purchase costs might be paid on 30 days credit.
Reviewing your budget
Each month the management information produced by the finance function should include a comparison of actual results to those predicted in the budget. This is a useful way to review the performance of the business and helps you stay on track and make informed decisions. Regularly reviewing the budget ensures it is valid and up to date and in an ideal world, I would recommend the management team review the budget as follows -
At the end of Q1, take time to review the actual versus budgeted and you may need to tweak the budget. I normally find that if the budget process is robust, this should be a relatively light touch.
Halfway through the year, review the budget again in more depth, and by this point, more information will have come to light so it can be more accurate.
The end of Q3 is an ideal time to create an outturn for the full year. This update should be the starting point for the next year’s budget as you should aim to start working on the budget for the coming year around 3 months before your year-end.
Reviewing your budget is an annual cycle and one that needs time allocated to it as without comparing the actual results to those you forecast, you won’t be able to tell if you’re achieving your business’s goals.
Budget disputes
When setting a budget, there will inevitably be internal conflict, for example between the CEO and Sales Director as they may have different goals and agendas. For example, the CEO may be focusing on achieving 10% growth to keep investors happy whereas the Sales Director may be unsure how this growth will be achieved without expanding their team.
The purpose of the budget can also vary – for the finance function it is to establish where the company is going and to monitor performance whereas for the sales team, it will likely be used to track their performance and earn any bonuses. Therefore, it is important to ensure there are the right incentives in place and that everyone is working towards the same goal for the business.
Final thoughts
There is little point in creating a budget if your bookkeeping is inaccurate as the bookkeeping can be likened to the foundations of the financial house.
The truth is nobody can predict the future, however, with experience and knowledge of the business and industry it does become slightly easier and budgets can become more accurate over time.
If you need any help putting together a budget or bookkeeping for your SME, then please contact me and we will be happy to help. We love to deliver financial order, efficiency, and understanding by providing flexible, part-time finance director expertise and bookkeeping services.
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