Some entrepreneurs consider a budget to be a rigid, dictatorial document that robs them of power and stifles their creativity. Others believe that budgets are only important to government agencies or large corporations. However, a formal budget is just as important for a one-person startup as it is for a large, well-established company. Budgets are financial maps that those responsible for operational decisions can use to compare actual production costs, operating expenses and sales goals to earlier projections. Among other things, a budget can help you determine the right time to increase your inventory or hire additional employees. Many entrepreneurs who fail to create a formal budget find themselves enduring a personal financial hardship, including increasing their investment in the business or forgoing a paycheck, that might have been averted with an effective financial plan that included a budget. Here are nine things that you may not know about budgets.
1. The budgets for virtually all commercial enterprises use the projected revenue for the budget period as a starting point. This is a logical place to begin. Whether you purchase items to resell or manufacture your own, you need to maintain an inventory that is sufficient to cover the orders you receive. Therefore, sales have a direct impact on your inventory costs, and they can also affect your shipping costs, staffing needs, tax liabilities and other expenses. This is why it is critical to pay special attention to your sales goals when creating a budget. Sales estimates that are unduly optimistic can result in overspending in numerous categories, but if the sales projections are overly conservative, you might find that you have not allocated enough money to support the costs related to the additional orders.
2. A formal budget can help with your long-term planning. As a small business, it can be important to keep your costs as low as possible. A sound budget can help you identify situations in which a contract spanning multiple years might be advantageous. For example, if a particular material that is an essential component of an item you produce is subject to frequent price increases, signing a contract that will allow you to purchase the material for the next two years at its current price could be beneficial. Unless you have a budget and review it frequently, you might not fully realize the impact that the price of the material has on your bottom line.
3. There are two types of budgets that are commonly used. The first is a static budget. Static budgets establish a fixed dollar amount for almost every revenue, overhead and expense account. Unless you manually reallocate funds from one account to another, the budget never changes. Flexible budgets include a factor that will adjust the amount budgeted for the affected accounts whenever sales goals vary from the projections. For example, suppose it costs you $20 in raw materials to produce an item that you sell for $100. You expect to sell 2,000 of these items in the coming year. With a static budget, you would allocate $40,000 for the raw materials. However, by the end of the second quarter, you have already sold 2,000 items, leaving you with no funds budgeted for the rest of the year. With a flexible budget, every additional item sold would automatically allocate $20 to the appropriate raw materials account. Furthermore, other affected accounts would be increased by a predetermined factor to recognize the costs associated with the additional sales. If sales fall short of your projections, the budget for related expenses can be reduced accordingly to prevent unnecessary spending.
4. Budgets can cover a variety of intervals. Most businesses establish an annual budget that is converted into quarterly and/or monthly amounts. However, you can create a budget that covers a shorter or longer period of time. For example, if you are creating an initial budget for your startup, you could start with a budget that will cover the period between your first day of business and the end of the calendar year. On the other hand, if you are planning to make substantial capital expenditures, you could create a budget that spans several years.
5. One mistake that is commonly made by those creating their first budgets is to forget to include encumbrances. Encumbrances are funds that are already earmarked for a future legal or contractual expense. As an example, suppose you have signed a three-year contract to cover repairs on the equipment in your plant. Under the terms of the contract, you pay $200 per month. After careful consideration, you estimate that the annual maintenance costs for your equipment will be $2,000, so you budget that amount without considering the existing contract. Even if you do not spend another penny on maintenance, at the end of the year, you will have exceeded your budget by $400. Other types of encumbrances can include leases, purchase contracts and mortgages.
6. You should review your budget periodically to see whether you need to make any course corrections. However, it is important to remember that budget variances are only part of your company’s financial picture. It is important to understand the underlying cause of every substantial variance so that you can evaluate the context. For example, a significant increase in overtime payments might lead you to assume that you need to increase staffing. However, if you know that the additional overtime was necessary to meet the deadline for a large, one-time order, you might choose to delay the hiring process. If you know that a substantial percentage of your annual utility costs are the result of heating your facility during the winter, you will not falsely assume that you can reallocate funds from that account just because your budget appears drastically overstated in the summer.
7. Establishing a formal budget can help you ensure that you will have adequate cash to meet your obligations. Virtually all businesses have periods in which sales are lower or higher than average. Depending on the services and goods you offer, your peak season may be just before Christmas, the start of the school year, the months covering summer vacations, the weeks after New Year’s Day, early spring or some other time of the year. Your lulls could encompass all of the winter months, the weeks surrounding major holidays or other periods in which your customers have little interest in your offerings. A budget can help you make sure that you do not make unnecessary expenditures or commitments during peak times that could compromise your ability to meet your financial obligations during slow periods.
8. A budget can help you identify potential bottlenecks or constraints. For instance, if your budget calls for the purchase of a specific volume of an item or material, will your current vendor be able to supply you with all that you need? If not, you may need to locate a secondary supplier. The process of finding an additional source and negotiating a contract can take time. An effective budget can provide with the warning you need to complete the process in a way that is beneficial to your business.
9. Budgets can help you manage your staff and train them for leadership. Instead of having to seek your approval for every small purchase, your managers or employees can refer to the budget to see whether a purchase can be made immediately or needs to be delayed until a later date. If the budget shows that there are no remaining funds, the person requesting the expenditure will likely know that the purchase needs to be justified. By the time that the individual presents the requisition to you, he or she can be prepared to present logical reasons as to why the purchase cannot wait.
A carefully prepared budget can help you plan all of your business activities, and it can also be a valuable tool for communicating your goals to your employees. The important thing to remember is that budgets are tools that are intended to make your business operate more efficiently. However, like all tools, the effectiveness of a budget depends on how well you use it. It is worth your time to learn how to use your budget wisely so that you receive the best results possible.
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