Preparing a budget does not have to be laborious. I hated wasted time; I also hate spending a lot of time on budgets. That view might strike some of you as strange given that it comes from a CFO (Chief Financial Officer).
But the truth is that budgets do not have to take a long time. One client and I did a budget in five hours.
In this blog post, I explain step by step how to create a budget using an efficient process that you can repeat each year.
If you haven’t read my blog post about whether your company really needs a budget, you may want to start there.
A Budget in 15 Simple Steps
Do not be overwhelmed by the number of steps. To make the process easy, I have broken the budget process into very small steps.
1. Start with revenue. Revenue pays the bills and produces the profit. Revenue growth is a sign of health — growing demand, customer satisfaction, a growing market share. Many companies have long term revenue goals. Consider past revenue growth and long term goals to identify the desired revenue for the budget year.
2. Determine whether you will offer any new products or services that will influence revenue growth.
3. Decide whether you will change pricing on existing products and services.
4. Determine the actions that produce revenue. For example, if you have a business with salespeople, they need leads. Start with your lead generation activities. Quantify them in the monthly budget. Then, quantify the lead converting actions performed by your sales people — hosting demonstrations, preparing proposals, negotiating contracts. In your budget, make sure that you have enough lead generation to keep the sales people productive and enough sales people to produce the revenue target. You will have to budget the size of your average order. Your budgeted conversion rates for leads to proposals and proposals to revenue as well as average order values should be based on history and any improvements that you foresee in the coming year. If your business has repeat customers, you will want to segment your budget between revenue from existing customers and revenue from new customers.
5. To ensure accountability, assign a person to each revenue producing activity. Review the budgeted actions with them to get their feedback. Find out if they believe they can win.
6. Review cost of goods sold (COGS) or cost of services (COS) as a percentage of revenue for the past few years. Has the percentage changed? Will the percentage change this year? Budget each line item and identify the person responsible for each expense in cost of goods sold.
7. Budget sales and marketing costs based on the activities planned in step 4 above. Some of the expenses in this category may be fixed like attending trade shows and some may change as revenue changes, like commissions. You will want to think about each expense category and what causes it to change.
8. Budget research and development (R&D) expenses, if applicable. For product companies, R&D expenses are required to keep the company’s products competitive or to achieve greater dominance in the market. For service companies, think of R&D in the sense of conducting experiments. Healthy companies will experiment with new product and service offerings. Be sure to set expectations about experiments with your employees — letting them know that not all experiments will be successful.
9. Budget general and administrative expenses (i.e. overhead). In budgeting each one of these expenses, you want to determine what causes that expense to change. Some of these expenses will be the same as the actual expenses in the current year, like rent. Other expenses may grow with revenue or with the addition of new employees. Be sure to consider any planned changes to salaries and benefits like health insurance.
High Level Review
10. Evaluate your employee compensation. Are you rewarding your key employees for the value that they are creating so that they have every reason to stay?
11. For businesses in most industries, I like to take the income statement for each of the last three years and express the key expense categories (COGS, sales and marketing, research and development, and general and administrative) as percentages of revenue. Then I do the same for the budget year. In many growing businesses, especially service businesses, these percentages should stay the same from year to year. In other businesses, like a software business, these expenses should decrease as a percentage of revenue as the business grows.
12. Identify the person responsible for monitoring budget to actual performance for each overhead cost line item in steps 7, 8 and 9.
Long Term Thinking
13. Now, it is time to move away from the income statement and think longer term. What capital expenditures (assets to be purchased that will last longer than one year) do you need to make next year? I think of four types of capital expenditures:
- Replacements of existing buildings, furniture and equipment. The amount of this type of capital expenditure should approximate this year’s depreciation expense.
- Required upgrades for legal, safety or security reasons. For this type of capital expenditure, there is little discretion; you just have to purchase these items.
- Expansion of current capacity. Your company is growing; in order to support the growth, you must purchase these items.
- Efficiency improvements. These capital expenditures will allow your company’s employees to be more productive which means other expenses should go down (or increase less quickly than revenue).
You will need to budget additional depreciation expense to cover the addition of these items.
14. As you think about the company’s long term goals, consider what expense items you may need to increase in order to achieve those goals. For example, if you are expecting to grow sales much more rapidly you may need to invest in marketing or hire a sales executive to lead the expansion of the sales team. Unlike capital expenditures which can be expensed (depreciated) over multiple years, these investments must be recorded as expense when they are incurred.
The Last (and Most Important) Review
15. Finally, review your budgeted net income before taxes. How does it compare with prior years? Does it represent an adequate return on the owners’ investment in the company? How does net income before taxes as a percentage of revenue compare with prior years and industry averages? (Please do not be content with being average in your industry; you work too hard to settle for average. If your company is run well, it should be well above average.) If you are unsatisfied with the answers to your questions, go back and review some of the budget assumptions and amounts. Determine where improvements need to be made over the long term.
Implementing the Process
The process outlined above will work whether your goal is to prepare the budget yourself to guide your decision making or you want to involve others in the budget process to spread accountability for beating the budget.
If you involve others, I recommend weekly meetings over four to six weeks to prepare the budget.
I also like to organize a series of spreadsheets that can be shared with team members. Typically, I have a tab for revenue drivers, a tab for revenue and direct expenses and a separate tab or tabs for overhead expenses. Each tab contains detailed line items corresponding with the accounts listed on your detailed income statement with a column for each month of the year. I also have a tab for capital expenditures which describes each significant capital expense. If you do not share all of the revenue and expense information with everyone involved, then separate the tabs into separate spreadsheets.
Once these spreadsheets are complete, then the budget can be entered into your accounting software like QuickBooks to produce budget to actual reports. Alternatively, these budget spreadsheets can drive a separate spreadsheet that when combined with actual results will show the comparison between budgeted and actual results. I will discuss reporting results and ensuring accountability in the next blog post.