How to Budget for Profit in Small Business

Budgeting is an activity which is undertaken by most people in their private lives, and yet one constantly meets arguments from small businessmen that it is not relevant to the manage­ment of their companies. This resistance is difficult to under­stand. If the technique is relevant to the management of a household, it must surely have even greater significance in the operation of a business. The family budget is easier to plan, as in most cases income is fairly fixed, as are many of the items of expenditure. In a business, many of the overhead costs are fixed (some will vary with sales volume), but income (ie sales revenue) cannot generally be quantified as easily. It is the area °f sales forecasting that appears to cause the most difficulty to businessmen and may to some extent explain their reluctance to use budgetary techniques.

The analogy with family budgeting is too simplistic, but the budgetary techniques used in the management of a small busi­ness need not be unduly complicated. A budget is in essence a projected profit and loss account for say the next six or twelve months’ trading activity. It is based on certain assumptions, but reflects the plans of the management for the future of the busi­ness following the identification of their objectives, which have been determined after an analysis of the available resources and the constraints which operate.

Profit  Small Business

In most small businesses the budgetary control system would include the following:

1. An operating budget. This budget quantifies the planned trad­ing activity in terms of sales, cost of sales, overheads and thus profit (or loss).

2. A capital expenditure budget. This is basically a list of the pro­posed capital expenditure in the budgetary period. Expendi­ture in this area is financed from profits in the short or medium term and thus is not included in the operating budget. However, acquisition of capital items has an impor­tant effect on cash flow and expenditure on capital should be included in the cash budget.

3. A cash budget. The cash budget or cash flow forecast attempts to identify the implications of the operating and capital ex­penditure budgets upon the available cash resources of the business.

4. Management information. It is obviously vital to the fulfilment of any plans that the company’s performance is regularly measured and compared with the original budget. For ex­ample, variances that occur may necessitate a change in policy or activity if the plans are to be fulfilled.

There are many advantages of introducing this type of approach into the management of a business. Although it will not guarantee the success of the business, it should make failure less likely! Budgetary control aids decision-making and facili­tates the control of expenditure. It acts as a motivator to mem­bers of the management team, as they see the budget figures as targets to achieve or indeed to exceed. Moreover, budgeting can be used as an important delegatory tool in the armoury of the small businessman. Responsibility can be given to middle management for specific areas of the business activity using the budgetary control system to measure his performance. Finally, the budgetary process gives the businessman the bonus of Rowing where he is going as well as where he has been.

We may now outline briefly the way in which operating bud-can be prepared. An operating budget is made up of several interrelated budgets and we shall assume that we are dealing with a small manufacturing operation. The various budgets which have to be prepared are now considered.

The sales budget

It would normally be appropriate to forecast sales for, say, six or twelve months ahead on a month-by-month basis. Ideally, the forecast should be made in unit terms and converted into monetary terms at a later stage. However, this is not always pos­sible. Sales forecasting is considered by some businessmen to be a difficult area, but the following can provide a useful base for projections:

1. Analysis of past trends. Historic performance is a useful guide as to the future. An analysis of the individual sales perform­ance of various products may reflect important trends which may affect future sales levels. The seasonality of sales should also be borne in mind.

2. Trends in the market place. Is the market expanding or contract­ing? Is competition increasing? What effect will price in­creases have upon demand, if any? These are important questions, the answers to which will have an important bear­ing on the future of the business.

3. The forward order book. This can give important information about anticipated sales levels in the short term.

4. Reports from the sales force. Salesmen spend their time dealing with customers and should be in a position to make a useful contribution as to future sales levels.

5. Reports from major customers. An inquiry to major customers as to their likely future requirements can be rewarding. Indeed, it may facilitate relatively accurate forecasting for the major part of the sales budget.

Cost of sales budget

To establish the monthly cost of materials necessary to support budgeted sales, the number of units to be sold each month should be multiplied by the unit cost. If this is impracticable it would not seem unreasonable to base material costs on the his­toric material usage relationship allowing for any factors which may cause this relationship to change. Budgeting in this area should take into account such factors as changes in stock levels manufacturing lead times, etc.

Wages costs pertaining to the manufacturing process should be included in this budget. The projection should take into account planned increases in the wage rate, employers’ National Insurance contribution, and productivity factors. In some cases it is appropriate to include certain manufacturing overheads in the compilation of the cost of sales budget.

Profit  Small Business

Overhead budget

Preparation of this budget is generally relatively straight­forward. Historic information derived from previous financial accounts can give a useful guide to trends. However, the budget for the next six or twelve months should take into account any known changes in the overhead structure as well as cost escalation resultant from inflation.

Armed with these budgets the small businessman will be able to calculate the level of profit which may be derived in the trad­ing period, ie sales minus cost of sales plus overheads. It should be remembered, however, that certain components of these budgets are based on assumptions, and thus monitoring of per­formance is paramount if financial control of the business is to be maintained.

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About the Author: Marie Mayle is a contributor to the MegaHowTo team, writer, and entrepreneur based in California USA. She holds a degree in Business Administration. She loves to write about business and finance issues and how to tackle them.

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