A Budget is a Powerful Tool
One of the key ingredients in building a successful business is financial control. As we work with clients, we often find that they are managing their business through their checkbook. If there’s cash in their checking account at the end of the week, they can make their payroll and pay their bills. That’s the extent of their control. Real financial control comes when the manager knows that the operation is profitable and can build it successfully. The first step in increasing this level of financial control is the development of a budget associated with one business plan and reviewed on a regular basis. Let’s consider three areas of budgeting; building the budget, reviewing the budget, and cash versus accrual accounting.
Building a Budget
A budget should be built upon two elements, history and the business plan. A budget is a reflection of what has happened in the past and the plans for the future.
Your financial data from previous years is the basis upon which a budget is constructed. What has been your sales history? Has there been a historic sales growth rate? What costs have you previously experienced that will continue into the coming year? Which of those costs are variable and will increase with sales growth, such as labor? Which of the costs are fixed and will not increase with an increase in sales? What new fixed costs will need to be added in the coming year such as new equipment or overhead staff?
A plan for the coming year may be composed as part of a Strategic or Business Plan. A budget is an intricate part of that plan. You cannot construct the budget and then write the plan or vice versa. How would you know if your plan is achievable if you cannot finance it? It might have been a great plan, but cost of execution was too high. If the plan is not feasible because of the financial results generated by the budget, adjust the plan to suit.
Reviewing the Budget
At some point during each month, the practice should be to review the financial performance from the previous month against the budget. Here you may find that the assumptions made during the preparation of the budget were in error. Don’t get discouraged! Learn by doing. We find that each year a budget is developed, the accuracy increases. It’s very rare that one gets it 100% accurate the first time.
When the actual income or expense for the month differs from the budget, what is known as a variance occurs. The two goals here are to control income and expense so that they exceed the budget on the income side and are less than the budget on the expense side. More importantly is to understand why the variance occurred and to take corrective action as required. For example, if sales are below budget a special promotional program may be required. If expenses are greater than budget, reductions may be necessary. It’s ideal if income exceeds the budget but when expenses exceed the budget, it points to potential problems. The most important objective here is to be able to read into the financial statement the reason for the variances, either positive or negative. That reasoning and logic will lead to action plans of corrective action
During each month of the previous month’s performance, one should look at the following standard reports:
- Previous month’s Profit and Loss Statement versus Budget
- Year to Date Profit and Loss Statement versus Budget. This is an important report because a monthly report only covers a limited period of time, while Year to Date reports show the overall trend. For example, expense such as insurance payment in a month may cause that account to incur a variance in that month, but the Year to Date reports shows that over the year that expense is in balance.
- The Balance Sheet at the closing of the month. Look here for growth in liabilities or receivables
Cash versus Accrual Accounting
Our purpose in the monthly financial review is to understand the profitability of the business both during the previous month and on a Year to Date basis. Here is the departure from the previous method of looking at the checkbook balance. The checkbook balance represents a point in time but does not show the current, past and future state of profitability. One may be able to cover expenses this week, but how about next month. There are two common types of accounting systems used by business today; Accrual and Cash.
Accrual accounting is used by most large companies because it accurately reflects the profitability of a given month. This system:
- Recognizes product and service as they are sold, not when payment is received.
- Recognizes expenses when they are incurred, not when they are paid.
- It includes an Inventory Account which is relieved when items are associated with a sale and increased when an item is purchased. These transactions impact Cost of Sales.
Unfortunately this system becomes complex when dealing with small companies. Most accountants do not recommend this system for small companies, especially when they are a service provider not a manufacturer. There also is a tax benefit in that the tax liability is only occurred when the cash is received, not when the invoice is sent.
Cash Accounting is commonly used in smaller companies because of its simplicity and tax advantages. This system:
- Recognizes products and services sold only when the payment is received.
- Recognizes expenses when they are paid.
- Doesn’t need an inventory system because purchases are recognized when they are paid, not when the goods are received.
This system makes understanding the profitability of a month more difficult and in many ways makes the Year to Date reports more important. There are some ways to better understand monthly profitability in a cash system:
- If a large amount of inventory is purchased and paid for during a given month, expenses will increase and profitability lower. Note that in the period following the month of purchase, profitability will increase because the goods being sold have already been paid.
- If receivables increase during a month, it indicates that costs were incurred in making a sale, but the funds offsetting that sale were not received.
These two factors make it more important to look at changes in the balance sheet. Many business managers and owners become disheartened when see what they think on unprofitable month and don’t consider the changes in the balance sheet.