Budgeting and Performance Evaluation
Although it’s impossible to accurately forecast all of your business expenses and earnings, it’s still useful to make plans and predictions and then evaluate your numbers to make better forecasts in the future. The process of budgeting and performance evaluation is an ongoing cycle of planning and adjusting. It involves educated guesswork about business activities and retrospective analysis once you see how circumstances actually unfold.
Budgeting and performance evaluation are forecasting tools that can prepare your business for upcoming events such as infrastructure upgrades and new product introductions.
The Budgeting and Performance Evaluation Process
Creating a budget: To create a budget, consider all of your company’s revenue streams, such as wholesale sales, retail sales and rental income and all of your types of expenditures, such as rent, payroll, taxes, utilities and materials. If your business has some operational history, use past numbers to make future predictions, adjusting for known upcoming events such as materials shortages or new product launches. If you’re starting a new business, do some research and make the most realistic forecasts you can.
Using a budget: Your budget should provide guidelines on how you will spend your money and targets for receiving your earnings. Refer to your budget as you plan operations but don’t follow it strictly if there are opportunities to leverage or emergency expenditures to make. Rather, make cautious adjustments as needed.
Evaluating a budget: It is exceedingly rare for business activities to precisely correlate with financial activities laid out in a budget. Sometimes these discrepancies can be traced to circumstances that could not have been foreseen, and sometimes they are the result of faulty forecasting. The budget evaluation process measures the degree of discrepancy and tries to identify inaccurate assumptions so you can forecast more accurately in the future.
Benefits of Budget Forecasting and Evaluation
Creating a budget helps you to anticipate cash-flow shortfalls and plan for major expenditures. If you can foresee when your business is likely to be short of cash, you can seek financing in advance, and if you can identify the time of year when you’ll likely be flush, you can plan capital improvements to coincide.
The process of budget forecasting is also an opportunity to set aside time to focus on understanding how your business works financially. If your payroll figures add up to a consistent percentage of your revenue over time, you can use that percentage with confidence for making forecasts. If your payroll percentage swings wildly from one end of the spectrum to the other, the budget forecasting process is an opportunity to research and identify the variables behind these divergences and then make changes to achieve greater consistency.
The budget evaluation process forces you to take a close look at your assumptions and to consider whether you’ve simply encountered unforeseen circumstances that led to unforeseen outcomes or whether your understanding of the financial variables in your business was incomplete. If you made flawed assumptions, the evaluation process creates a space and process for revising your thinking.
Disadvantages of Budget Forecasting and Evaluation
The process of budget forecasting can give you a false sense of security if you compile your numbers and everything seems to be on track. This complacency can be dangerous if it causes you to let your guard down and stop regularly looking for threats and opportunities.
Budget forecasting and evaluation can also be time consuming and expensive. You may end up spending too much time looking for trends and problematic assumptions and not enough time getting your day-to-day work done. In addition, the evaluation process may identify variables that were part of the current business cycle that don’t have much relevance beyond the present circumstances.
It’s impossible to gaze into the future and see all of the variables that could make your company earn or lose money. However, it is possible to use past information to make tentative forecasts and then adjust your information as real-world circumstances unfold. Budgetary control is an important tool and a useful process, but it should be approached with caution because of its limitations, and predictions should be always be treated as scenarios rather than facts.
Budgetary control systems involve laying out financial forecasts for earning and spending and then reviewing these numbers relative to actual accounting numbers.
The Benefits of Budgetary Control
- Setting goals. Budgetary control can be indispensable for short- and long-term planning, helping you to sync day-to-day expectations with big-picture projects. Your numbers should reflect your priorities, such as allocating significant resources for marketing a particular product or investing in worker benefits to improve employee retention.
- Clarifying strategy. By setting a clear budget and working out spending priorities, you position your company to coordinate the activities of different departments to run smoothly in tandem. A budget that allocates funds for researching and developing a new product line charts a path forward and provides clear reference points for spending and staffing. A budget based on tight cash flow forces you to clearly define spending priorities and avoid unnecessary expenditures.
- Reference points. The budgetary control process forces you to review actual outcomes relative to theoretical projections, providing concrete reference points for evaluating success. Measuring your company’s performance and its deviation from the budget you set forces you to reflect on the numbers themselves and the situations they reflect. This evaluation process also provides feedback on your forecasting capabilities, showing their accuracy or shortcomings.
Disadvantages of Budgetary Control
Unpredictability. The significance of budgetary control can be undermined by the fact that there really is no way to anticipate certain outcomes, such as shifts in customer demand that affect sales numbers and shortages that affect the cost of critical materials. Inflation can also influence both revenue and expenditure levels. Budgetary control may create a false sense of certainty and control in situations where it may be more advantageous to accept the difficulty of predicting outcomes and instead maintain maximum flexibility.
Accounting costs. To practice budget control conscientiously, your company will need to allocate resources and personnel. If you have a dedicated accounting department, this may not be an issue, but if you have a small staff that shares responsibilities, you may have to divert employees and payroll hours from activities such as production that are more likely to directly produce income.
False sense of security. The budgetary control process may create the illusion that you know what you can expect from future business activities. For example, you may forecast that a new product you introduce will increase revenue by 20 percent and then purchase inventory and equipment based on this projection. If these anticipated sales fail to materialize, you may find yourself in the position of spending funds you cannot recoup.
The Purpose of Budgetary Control
Budgetary control isn’t intended to reflect solid, final numbers but rather to provide a useful road map for management decisions. The part of the process that compares actual numbers to projected figures serves as a form of reconciliation, bringing together real circumstances with the vision you have articulated and spelled out in numerical form. This reconciliation process can be both humbling and indispensable, allowing you to reflect on past assumptions while rethinking your forecasts and plans for the future.
The success of your budgetary control process depends on your ability to anticipate the future based on past performance. Although there are some outcomes that you will never be able to predict, the better you learn to recognize correlations and patterns, the more accurate your projections will be.
A cash budget is a projection of how your business will earn and spend money during an upcoming period. Preparing a cash budget is important because the process forces you to think about your expectations and plan for the future. It is important to follow your cash budget–unless unforeseen circumstances arise–because adherence to a plan can discipline your spending.
The process of creating a cash budget is important in and of itself because it forces you to ask important questions that can guide you as you plan future business activities. As you prepare your cash budget, you must determine how much it will cost you to run your company during the period it covers, how much you expect your business to take in, and how you will make up for any shortfall. Developing answers to these questions helps you to stay a step ahead of potential difficulties.
It is essential to make assumptions when creating your cash budget, but it is also important to be aware of the assumptions you are making, and adjust them as you go along, if necessary. When creating a cash budget you must project the availability of working capital, which depends on sales volume as well as outside funding. You must also project your upcoming expenses, which include fixed expenses such as rent and business licenses, variable expenses such as utilities and materials, and occasional, often unanticipated expenses such as equipment repairs.
Your cash budget is a tool to gauge your ability to meet expectations and live up to predictions. But it is virtually inevitable that your day-to-day financial activities will not precisely conform to your cash budget simply because it is impossible to predict the future. The process of comparing your actual income and expenses with the numbers that you project in your cash budget provides you with a fertile opportunity to evaluate your expectations and take a close look at your assumptions.
As you compare your actual business activities with the predictions you made in your cash budget, you glean information that will be useful in preparing future cash budgets and planning future business activities. For example, it is natural to assume that your business will grow as a result of making investments such as upgrading the appearance of your product or expanding to new markets. But it is impossible to know exactly what kind of effect these changes will actually have on your sales volume. Comparing your cash budget with your actual business activities provides you with information about the impact of this kind of change that will help with future planning.
There’s no way to look into a crystal ball and see exactly how much your business will earn and spend during the upcoming year, but you can use a budget as a tool to lay out a realistic scenario. A budget is a financial projection based on current information that compares expected revenue and expenses. Although actual circumstances will almost certainly differ from your budget, this document can serve as a road map, helping you to chart a path and anticipate shortfalls and opportunities.
Earning a Budget Surplus
If your business is functioning as it should, it earns more than it spends, generating a profit or budget surplus. A business that earns a surplus has sustainable operating costs relative to its gross revenue or receipts. In addition to generating sufficient income in sales, a business with a budget surplus also has healthy cash flow – it receives payment for goods and services quickly enough to cover the expenses it incurs. A business may also have a budget surplus by using financing strategies such as loans and credit cards for working capital. However, if you rely on financing to make ends meet, it is just a matter of time before you run into a budget deficit because you’ll need to start paying back the money you borrow.
Incurring a Budget Deficit
If your business spends more than it earns, you eventually confront a budget deficit or revenue shortfall. Your operating costs may exceed your earnings if your business model is faulty or if you’re not charging enough for your products and services to cover your costs. Alternately, you may run into a cash flow shortfall because of short-term difficulties or bad breaks, such as inclement weather, broken equipment or a surge in competition. Review your budget proactively even if your business suffers from circumstances that seem temporary. A short-term problem can become a long-term nightmare, and it may be difficult to determine with certainty whether any situation will be long- or short-lived. Your business may also encounter a budget deficit if you invest heavily in the future by buying equipment or ramping up production.
Using Your Business Budget
Your business budget can tell you if you’re likely to encounter cash flow difficulties or if your revenue during upcoming months won’t be sufficient to cover the costs you’ll likely incur. The information in your budget can help you to react to this anticipated shortfall by seeking financing before you run out of money or adjusting your plans, so you don’t spend as aggressively on expansion. If your budget shows a significant surplus, use the opportunity to save for the future or invest in infrastructure that benefits your business in the long term.
With today’s rising prices, it is becoming more and more important to prepare a budget and stick to it. If you want to get the most out of your hard earned dollar, take some time to evaluate your financial situation and prepare a budget.
Evaluate your current expenditures. Take one month and jot down all of your expenditures. To truly prepare an accurate budget, you must track everything from purchasing the daily newspaper to the lunchtime candy bar from the vending machine.
Track all of your income. Usually this is the easiest part of the budget. Most people know how much money they make each month.
List all of the expenditures. After a month of tracking your expenditures, prepare a list of expenditures. It’s best to categorize them into fixed and modifiable expenditures. Your rent or mortgage payments would fit under the fixed expenditure category, while dining out and weekly manicures fall under the modifiable category.
Total your income and expenditures and compare. Hopefully your comparison of income to expenditures leaves you with earning more than you spend. If not, it’s time to look at your budget a little closer, especially the modifiable expenditures. Look to see where you can cut back or eliminate so that your income exceeds your expenditures.
Prepare a realistic budget. Now that you know how much money you have coming in and how much going out, and where it’s going, it’s time to get the most for your money. Make sure the budget is something you can follow
Review your budget regularly and make modifications if necessary.
In addition to giving you the financial information you need to pay your taxes and apply for financing, accounting can give you the data you need to understand your operations and make your business more profitable. These functions fall under the scope of management accounting because they are valuable for managers when making decisions and improvements.
The application of management accounting in an organization can include everything from tracking productivity to understanding sales trends.
Uses of Management Accounting
Productivity: To explain the use of management accounts and management information systems in performance management, you only need to collect and evaluate data about employee output relative to hours or payroll. If you track production and find that, on average, it takes about 15 minutes of labor to produce one unit you sell, you can use this information to evaluate outcomes when you change variables.
For example, if you purchase a new piece of labor-saving equipment, you can track productivity before and after you begin using it to determine how much effect it has on your payroll and your bottom line.
Sales trends: By using management accounting, you can evaluate in detail which products and accounts are earning you the most money. Sales figures can help you to pin down whether your products are attracting a particular demographic and whether it’s advantageous to market particular products at specific times and at targeted places. This management accounting information gives you the tools you need to target marketing efforts and pinpoint your production numbers.
Financial planning: Management accounting helps you to pay your bills and keep your business afloat. By understanding how much money you have available and how much cash you can expect to have during upcoming periods, you can make strategic decisions about when to borrow money and when to make long-term investments. Planning these moves carefully can save you the stress of running out of working capital and it can save you money on interest and late fees.
The Scope of Management Accounting
Management accounting covers any financial analysis that provides you with useful information about business operations. It generally concerns itself with internal data, or numbers that you collect in the course of your operations that reflect the ways your company has been earning and spending money. It is not uncommon for a business to have separate individuals or departments in charge of collecting this information and others responsible for analyzing and evaluating it.
Management accounting falls under the purview of managers because it involves big-picture insights and observations. Someone who sees what is going on in a range of departments is in a better position to make useful assessments about the ways these areas overlap and interact than someone who only understands a limited slice of the pie.
Management Accounting and Financial Statements
Management accounting also uses many traditional accounting tools. These statements provide the low-hanging fruit of figures that have already been collected because you need to report sales and profit to tax agencies and you may need to compile balance sheets and cash flow statements for lenders or shareholders.
This information that you’ve assembled for external purposes can also prove useful for understanding what’s working in your business and what isn’t, and then making strategic changes. Management accounting looks at the same information through a different lens, using it for gleaning insights rather than simply for reporting purposes.
Your profit and loss statement tells you whether your margins are sustainable enough for your company to earn money over time. It is used in tax reporting to determine whether or not you owe taxes and, if so, how much. It is useful in management accounting by showing whether your margins are sufficient to pay your stakeholders and invest in growth. Because it is broken down into categories for earning and spending, it will also show you if there is a disproportionately successful source of revenue such as wholesale or retail sales, and whether there are areas where you are spending too much.
Your balance sheet shows how your profits and losses have played out over time, including whether you have more debt than assets and whether your assets are liquid and available for investments and emergencies. A balance sheet is useful for management accounting because it provides information to take into account in strategic planning. If all of your assets are tied up in equipment and real estate, it would be prudent to set some of your future earnings aside for operating capital. If you have weeks’ worth of income tied up in accounts receivable, it may feel like you have no money but you can plan on receiving the bulk of those funds soon.
Advantages of Management Accounting
Objectivity: Management accounting uses actual data to learn about how your business is succeeding and where there is room for improvement. Unlike empirical observation, which can be limited by an individual’s perspective and availability, management accounting uses numbers that have been gathered over time.
Flexibility: No two businesses approach management accounting in the same way. Unlike tax forms and traditional financial reports, your management accounting information is collected and evaluated for internal purposes only so you can organize it however you want and collect and analyze it on whatever schedule makes sense for your business, whether daily or monthly.
Efficiency: It takes considerably fewer resources to review production numbers and identify areas where there is room for improvement than to sit back and let your business spend too much on inefficient processes. Even though the people analyzing data are usually paid more per hour than the people on the production floor, management accounting helps to make adjustments in processes where these savings show up week after week, year after year.
Disadvantages of Management Accounting
False sense of security: Because management accounting works with objective numbers, it may create the sense that you fully understand a situation when the numbers actually don’t reflect the whole story. For example, tracking the total number of production hours doesn’t tell you about who is working or the morale level during a particular shift.
Extra labor: Although management accounting provides insights that save you time and money, you must first invest the time and money to collect and assemble the relevant information. This requires an extra level of management and paperwork that may not make sense for your businesses, especially if you’re struggling to cover payroll and meet urgent deadlines.
Necessary level of skill. Not everyone can look over your company’s numbers and be able to recommend the correct course of action. An experienced manager may be able to tie observations to trends that play out over time, but a less experienced observer may draw faulty conclusions based on insufficient knowledge.
Making the Most of Management Accounting
The key to leveraging the advantages and mitigating the disadvantages of management accounting lies in your ability to approach the process with a broad perspective and a clear sense of the potential pitfalls. Keep in mind that, although management accounting processes can be indispensable to your company, they should also be backed up with empirical observation. Avoid devoting time to management accounting that could be used for more urgent concerns but also try to staff your company sufficiently that you have the capacity to gather and analyze data.
No matter how diligently you construct your business budget, you must acknowledge that it is based on forecasts. When actual numbers come in for sales, expenses, revenues and payroll, you may discover that your budget will need to be realigned. Current numbers are not the only criteria for changing your budget. You must adjust to new forecasts. This can help you set new objectives and realign your budget to meet those objectives.
You should review your performance targets quarterly, including sales and profits. If you are involved in manufacturing, there also should be targets for production. Performance targets should not be changed lightly, and normally they should remain in place throughout your fiscal year. If you notice a quarter where you miss your targets significantly, monitor the situation see if the change becomes a trend, and be prepared to adjust targets and budget accordingly.
Operating revenues are not the same as overall revenues. Overall company revenues can include the sale of assets or other one-time events, such as a tax refund. You need to monitor how much money you earn from sales. This is your operating revenue figure, and it is the amount you can count on to dedicate to the expenses your business incurs each month. If you discover operating revenues have dropped during a quarter, you should use this information to re-evaluate your budget.
Payroll can be the single largest expense for any business. If department managers hand out raises and bonuses without looking at the overall financial condition of the company, compensation can become a drain on your budget. Examine payroll expenses each quarter to determine what percentage of your budget you are using to pay employees. When you see compensation figures climbing in comparison to your income, you will know you have a problem either with declining sales or over-compensation.
When contracts must be renewed, you may find yourself paying more for rent, equipment leases and insurance. In addition, property taxes may have gone up. These increases may not have been in your original budget. Check each quarter to see if you are paying more in fixed overhead costs. If you are, these expenses are over-budget and you will have to make some adjustments.
Supplies and Materials
Costs for supplies and raw materials may have risen unexpectedly, meaning the increases are not in your budget. If these expenses are taking a toll on your profits, you will have to realign your budget to allow for the extra expense.
A review of your income and expenses may reveal that you are exceeding your budget, but a single under-performing quarter does not mean you must realign your budget. You must examine whether the numbers you see are the result of a long-term change, such as a declining economy, or a permanent change in demand for your goods and services. Create a new forecast for each element in your budget based on trends you see developing.
Realign your budget in response to long-term changes, not temporary peaks and valleys. For example, if materials costs are going up in an inflationary environment, you should change your budget to reflect ongoing increases for the foreseeable future. On the other hand, if your sales have dropped due to the loss of a single client, you may not want to adjust your sales expectations until you have time to replace that client. Always check to see if expenses like payroll can be adjusted by changing management approaches so that your budget is not subject to realignment due to problems you can prevent. In addition, your first action regarding misaligned expenses should be to renegotiate with vendors to see if you can pull expenses back in line with your original budget.
Small businesses should create and use budgets to do more than simply keep track of their income and expenses. Budgets can help businesses project profits, spot potential problems and opportunities as the year progresses, make adjustments to maintain financial stability and show potential investors or lenders proof of the businesses’ financial potential.
The first goal of a small business budget should be to project how the business will perform financially under a variety of scenarios. Project fixed expenses, such as rent, salaries, insurance premiums and loan payments. Estimate recurring variable expenses, such as utilities, office expenses and Internet costs. Estimate variable costs tied to sales, such as the amount of materials needed to make a product or labor necessary to bring a product or service to market. A budget allows you to compare your costs under several different revenue projections. This will allow you to forecast your material and labor needs as you grow.
After you create the first draft of your budget, plugging in all of your expected costs and comparing those under different sales scenarios, adjust your spending projections to help you achieve a profit.
Determine Break Even
Most small businesses don’t make immediate profits. Once you pay off initial investments in equipment, real estate, extra marketing or other purchases you won’t have long-term, you can estimate when you will start making a profit and how much capital you will need to run the company until it is profitable.
When you know your costs to run your business, you can set the prices for your products or services. A budget helps you identify non-manufacturing costs, such as overhead, debt service, professional fees and other costs you incur. Knowing your exact expenses will help you set realistic prices.
Track Progress and Make Adjustments
A critical goal of budgeting is to create a document you can update and examine each month to see if you are meeting your financial goals. Without a budget, you may not know your income is not covering your expenses until you are deep in financial debt. Using a budget to track your performance will allow you to make real-time adjustments to your business model, rather than waiting until the end of the year.
If you want to attract investment capital, secure loans from banks or obtain lines of credits from suppliers, you may need proof that you are able to pay your bills and debts. Some lenders require only that you secure your loan or credit line with collateral, such as your building, machinery or goodwill. Investors and banks may want to see your business plan, which should include budget projections and your current, up-to-date budget.
You can use trend analysis to forecast how your business will perform, but you have to be aware of the method’s limitations. When business variables, such as sales, revenue or customer complaints change over time, you can observe patterns that make up the trends, allowing you to project historical data to obtain future values. Knowing which factors influence the validity of your analysis lets you establish the pros and cons of using trend analysis for your particular situation.
How to Analyze Trends
Trends can increase or decrease linearly or exponentially and they may depend on cyclical or seasonal factors. You can analyze them using manual methods such as plotting graphs and matching curves or with software such as Excel spreadsheets. The overall pros and cons are influenced by how predictable the trends are, how likely it is that they have been influenced by random events and whether you have correctly identified variable factors such as weather, competitor initiatives or economic changes.
Trend analysis is often a quick method to gain insights into your business operations and obtain rough forecasts for key business variables. For example, if sales have increased 3 percent every year for the past five years, you can forecast a probable 3-percent increase for next year. If your summer season usually results in a 20 percent increase in revenue from outdoor goods, you can predict the same increase for next summer. Entering historical data into a spreadsheet lets you carry out more detailed analysis and output mathematical projections. The historical data is usually readily available and you don’t need any other inputs or outside help to make the relevant forecasts.
Because trend analysis is based on historical data, both accuracy and reliability of such forecasts suffer when the business environment changes or when you mistake cyclical trends for long-term influences. For example, if a new competitor enters your market, your sales, revenue and profit may all decrease unexpectedly and your trend analysis based on past data will give forecasts that are too high. If you come to the end of a recessionary business cycle and you have analyzed the cyclical influence as a long-term trend, your forecasts are going to be too low as an expansionary cycle takes hold. When you don’t know how changes might affect your business, your forecasts based on trend analysis are not reliable.
Working With Pros and Cons
You can make the best possible use of trend analysis by examining the data and your markets to take advantage of the pros and minimize the effect of the cons. Checking your trend analysis with additional data from industry publications and the public results of competitors helps validate your results. If your business situation and competition hasn’t changed, your trend analysis will be reliable. If historical data is consistent with few outliers and little data point variation, your results will be accurate. If forecasts differ for related variables, such as for sales and revenue, your trend analysis may be faulty and you will need additional methods, such as an analysis of current market conditions, to obtain reliable and accurate forecasts.
Budgets represent internal reports that detail how a company spends capital. Managerial accounting activities often include the preparation of several different budget types and the calculation and interpretation of variances. Companies review variances to determine areas where the company is working well and not working well. The interpretation of budget variances is often a monthly process for managerial accountants. This process commonly falls under the flexible budget process, in which accountants compare actual expenses to the budgeted expenses.
Gather the previously prepared budget and a copy of the cash disbursements journal.
Compare the budget amounts for various expenditures to the actual capital spent in the cash disbursements journal.
Determine if the variance is favorable or unfavorable. Favorable variances indicate a company spent less money than expected, whereas unfavorable variances indicate expenditures that are higher than expected.
Review each variance to assess why the difference exists. Unfavorable variances may occur due to increased demand for goods, which requires more money spent to acquire materials and labor.
Use a previous budget variance analysis to determine if a variance is occurring in each period. This may indicate that more money is necessary to complete a business process.
CASH FLOW ANALYSIS AND BUDGET
Knowing when your money comes in and when you pay invoices gives you a perspective on your financial situation a budget, profit-and-loss statement, general ledger or balance sheet can’t. Even if your business is profitable, poor cash flow management can lead to costly or embarrassing situations you might have easily avoided. That’s why it’s beneficial to do a cash flow analysis.
Maintain Adequate Cash Reserves
Knowing when your customers’ payments will arrive and when your bills are due lets you see if you will have enough cash on hand to pay your bills. If you book a $20,000 sale that costs you $10,000 to fulfill, that sale might hurt you if you must pay your suppliers and employees that $10,000 within 30 days but your customer doesn’t have to pay the $20,000 bill for 60 days. A cash flow analysis allows you to maintain adequate cash reserves to cover situations such as these.
Manage Credit Better
If you use credit to pay your bills, a cash flow analysis helps you prepare to keep enough credit availability or arrange for a loan in plenty of time. In addition to estimating cash flow based on expected expenses and income, build in a cushion for cost overruns and late payments or bad debt. Mismanaging your credit not only leads to an inability to pay your bills, but it can also result in declined charges, interest penalties, fees and damage to your credit report and score.
Helps You Adjust
Knowing your cash flow situation will help you make adjustments to keep your business operating. For example, if you are paying down debt each month, a cash flow analysis might alert you to the fact that you need to save that cash to build your reserves one quarter. You might be able to reduce your spending in a specific area during a period of slow receivables. In some instances, you can defer your salary, paying yourself what you didn’t take when your revenues are better. You might ask customers to pay earlier or work with your creditors to delay payments to help you through a short-term cash crunch.
Avoids Production Interruptions
If you have plenty of profits on paper, that won’t help you keep your staff working or suppliers sending materials if you can’t pay them on time. When you can’t make payroll, put down deposits or order supplies and materials, you can lose your ability to make your product or provide your service. Even a temporary loss of production can put a significant dent in your profits and throw your budget out of whack. In addition, an inability to fill orders starts rumors spreading about your company and might cause your customers to find a new supplier.
Most businesses incorporate cash budgets in their overall budgeting process. Cash budgets review anticipated cash receipts and cash disbursement for the budget period. Managers use this information to determine if the company needs additional financing for the budget period. Like all processes, cash budgets come with several disadvantages.
Use of Estimates
The budgeting process relies on estimates of future events. Managers try to anticipate the future activities of the company. The cash budget relies on estimates of future sales and future collections received on those sales. The cash budget also relies on estimates of future expenses that the company expects to incur. Managers base estimates on their instinct rather than facts. Estimates limit the effectiveness of the cash budget because factual knowledge is not available.
Lack of Flexibility
The budget process involves creating numbers to enter in the budget, publishing the budget numbers and distributing those reports to management. Once published, these numbers don’t change. Cash budgets include information regarding the company’s expected financing needs. Once management reviews the cash budget, they make decisions based on the expected financing needs. If the actual financing needs are less than the budget, management has already committed to the financing for the budget period. If the actual financing needs are more than the budget, management has not committed to enough financing and will incur a cash deficit. Management will need to borrow money at higher than planned interest rates to meet their cash needs.
Managers with ulterior motives manipulate budget numbers to reflect well on themselves. A manager making decisions that impact the cash budget may underestimate her expenses for the budget period. This reports budgeted cash disbursements that are too low. The manager receives praise for her work on the budget. However, when the actual expenses occur and do not meet the budget numbers, the cash disbursements will incur a variance. By that time the manager may be in a different position and not feel the repercussions of her actions.
Lack of Nonfinancial Factors
When using a cash budget to analyze financing needs and financing options, nonfinancial factors are omitted. A business owner may choose to borrow funds from one of two banks. One bank may offer a lower interest rate, which can be quantified and reported on the cash budget. The other bank may offer better customer service and offer nonfinancial perks for borrowing from them. The nonfinancial factors are not reflected in the cash budget.
Spending money you don’t have or budgeting for revenue that never materializes can kill your business. Having a formal budget-setting policy helps you manage your finances. Depending on the size of your company, the policy may be a few simple guidelines or a written budget policies and procedures manual.
Why A Budget-Setting Policy?
It’s possible to set your budget without a budget and forecasting policy. Look at your resources, fixed costs and variable costs. Project your future revenue and decide what you need to spend it on.
When you sit down to draw up your budget, though, those decisions can get tough. If your revenue has grown, should you save the extra for emergencies? Buy new equipment? Give the team bonuses? All of the above? By drawing up a budget-setting policy before you start planning, you can clarify your priorities.
Principles and Policies
A good first step to developing a policy is to write down one or two basic guidelines. For example:
Having a large contingency fund is a top priority.
It’s essential to attract and retain talented employees.
Delivering quality, defect-free products is vital to your success.
It’s best to keep your own pay low for now so you can grow the company and enjoy a big payoff.
Once you write down your principles, you can turn them into a budget policy.
Your contingency fund should be large enough to keep the doors open for three months.
Revenue will be plowed back into research and development until you can guarantee a no-defect product.
You’ll increase your own salary only in proportion to sales revenue growth.
A big part of budgeting is projecting revenue and expenses for the coming quarter, or year or three years. As forecasting involves lots of variables, often leading to multiple possible outcomes, it helps to have a policy about how you’ll deal with uncertainty.
Say you’re launching a new product line and also slashing prices on your old products. Your revenue projections may vary wildly based on the prices you set, the amount you manufacture and whether the new product is a hit, a flop or a moderate success. With several possible futures, it helps to have a policy for how to evaluate the different forecasts:
You look at the most likely, most realistic scenario and adopt that.
You’re a risk-taker, so you select the option with the potential best payoff.
You adopt the forecast with the lowest amount of possible profit. That way you’re less likely to anticipate revenue that doesn’t materialize.
You look at the potential losses and pick the path with the smallest risk of loss.
From Policies to Procedures
If you’re a one-person business, you don’t need a budget policy and procedure manual. As you grow, though, you may have to bring in more employees; if you incorporate, you’ll also have a board of directors to answer to. Having a manual that spells out the financial policies and procedures for your small business may start to look like a good idea.
A sample procedure could be:
Review your strategic plan for the company.
Set business goals based on the plan.
Identify your fixed expenses, such as rent, insurance and employee expenses.
List variable costs, such as overtime.
Draw up projects that advance your business goals. Identify the costs of the project.
Set your profit margin.
Submit the budget to your board or stakeholders for approval. If they have objections, either convince them to support your budget or make the requested changes.
You should also have procedures for a regular budget review to see how close you come to your projections. If, say, there’s an emergency requiring a cash fix, you’ll have to adjust your budget. If one of your departments is overspending, you may have to rein them in or cut spending somewhere else to balance it out.
PROJECTED BALANCE SHEET AND INCOME STATEMENT
Although no business owner has a crystal ball to predict future earnings and expenditures, a set of thoughtful projected financial statements can provide benchmarks for planning and financing. Together, a pro forma income statement and a projected balance sheet provide an idea of what to expect if your assumptions are sound and offer a road map for short- and long-term strategy.
A projected income statement will show how much cash you expect to have coming in and left over at the end of an upcoming period. A projected balance sheet will show how your anticipated earnings or losses play out in terms of debts, assets and cash on hand.
Creating Projected Financial Statements
A projected statement of financial position should be based on real information rather than wishful thinking. The more accurate the information you incorporate, the better your chances of creating useful and meaningful projections.
Use past information as the basis for assumptions about the future. Your books from previous accounting periods can provide numbers telling what percentage of revenue you typically spend on direct costs such as materials and payroll. They can also help you project fixed costs, especially if your business infrastructure is reasonably stable and costs like rent and utilities aren’t going to change significantly during the projection period.
Do research to back up assumptions for new projects. If your business is new or if you’re launching a new product, you can still gather information to ground your projections in reality. Your local library will have information about demographics in your area, and this will help you to develop an idea of how many potential customers you may be able to reach. City and county offices can provide data about similar businesses that may affect or compare with your company’s performance outcomes.
Create projections for a range of outcomes. Of course you’re hoping for and expecting unbridled success, but your project may take a while to get off the ground, and it may not even gain traction at all. Do a series of different projections showing best-case, worst-case and medium-case scenarios. These different versions of your projected financial statements will help you prepare for a variety of possibilities by showing how much you have to earn to break even and under what circumstances you may need extra capital.
Making Income Statement Assumptions
An income statement summarizes your revenue and expenses during a particular period and calculates your net earnings based on these numbers. It will include lines for variable costs or those that fluctuate directly relative to the volume of business you do and also fixed costs such as rent, which stay steady as your sales increase. A projected income statement shows how much you expect to spend and how much you expect to earn and breaks these areas into categories such as wholesale, retail sales, materials and payroll expenditures.
The assumptions behind a projected income statement will affect the information you input and the outcomes you receive. It seems reasonably safe to assume that variable costs such as labor and materials will stay reasonably consistent as a percentage of your variable sales.
However, there are situations when this may not be the case, such as if you achieve beneficial economies of scale or if the cost of essential materials suddenly increases. Although you can’t always predict these developments and events, you can at least insulate yourself from some uncertainty by understanding the assumptions you’re making and the ways they may be problematic.
Income Statement Assumptions for New Businesses
If your business is brand new, you won’t even have past income statements to use as the basis for future projections. Industry and market research can provide valuable starting points, but there are still many critical unknowns that will affect the actual outcomes. It’s unlikely that your projected income statement will accurately reflect all the ways your business will unfold, especially if you have very little entrepreneurial experience. However, the process of creating a projected income statement is a valuable exercise to help you think through problems and possibilities and to prepare you for launching your company.
Making Balance Sheet Assumptions
A balance sheet is a snapshot summary of your company’s financial position at a particular moment in time. It lists everything you own on one side and everything you owe on the other side and then summarizes the relationship between the two in a calculation called “owner’s equity.” Creating an actual balance sheet is reasonably straightforward: You check the money in all of your bank accounts as well as your cash on hand, and you compare it with the balances due to individuals and on loans and credit cards.
However, like income statements, balance sheets are actually founded on a series of assumptions that should be kept in mind to avoid a false sense of security. A projected balance sheet could easily be built with the assumption that every cent you earn will increase your net worth, but you could buy equipment or inventory that ends up being useless.
Balance sheets also include subjective items such as good will, which put a dollar figure on your company’s intangibles and are based on assumptions about how others will perceive the real worth of your reputation and information systems.
Balance Sheet Assumptions for New Businesses
If you’re just starting out, you probably won’t have a clear idea of how your sales will translate into assets. At the very least, be aware of the assumptions you’re making when you create a projected balance sheet for a startup business, such as how quickly you will pay off debt, and include footnotes detailing these premises. This document isn’t supposed to be a magically accurate prediction but rather a tool to help you foresee how loan-worthy your venture will appear to lenders and when you may need extra capital.
Using Projected Financial Statements
A projected balance sheet and income statement will come in handy when it’s time to make decisions about how to grow your company. Your pro forma income statement is your opportunity to map out expected costs relative to anticipated income so you can see whether a product or project you’re contemplating is financially viable.
Your pro forma balance sheet can give an idea of how your strategies for financing this move will show up as debts and assets. Preparing these statements for a number of different points in the future, such as one year and three years, will give you long-range perspective on your venture.
Lenders and investors will ask to see projected income statements and balance sheets before providing funds. This requirement gives them the opportunity to see whether your assumptions and expectations are realistic and whether your project is a risky or sound investment. The requirement to provide these statements also provides the basis for conversation, as they raise questions and you provide answers that show the strengths and weaknesses of your projections.
Striking a Balance
When creating a projected balance sheet and income statement, try to strike a happy medium between confidence and realism. Use these documents to show your company’s potential to grow and pay back the financing you’re seeking, but also offer numbers that are well researched and firmly rooted in reality. The better you’re able to chart a course between practicality and optimism, the better you’ll be able to convince a lender or investor of the worthiness of your project.
Bookkeeping is the process of keeping track of your business’ financial transactions. Although it often feels like a chore, it is actually an invaluable source of information. If you stay current with your bookkeeping, you will have up-to-date information about whether you are spending too much on certain types of expenses and you can take steps to remedy the situation. In addition, timely and accurate bookkeeping helps you to pay your taxes on time, which enables you to avoid penalties and late fees.
Bookkeeping records should include an accurate tally of business income, including all sales and transactions that result in a payment either immediately or at some point in the future. Set up your bookkeeping system to enter sales amounts at intervals that correspond to your sales rhythm. If your business relies on a limited number of large sales, track each sale individually. If your business makes numerous small sales, tally the results by day. If you receive income from multiple sources, such as several sales locations, break down your sales to track the amount transacted at each location. Tally your gross income periodically, and at least once a month.
Set up your bookkeeping system to track your business expenses. Break down these expenses into categories such as materials, rent, labor and advertising. Tally your monthly totals in each category, and track the percentage of your gross income that you spend in each category.
If your business makes transactions for which it does not receive immediate payment, set up your bookkeeping system to track the payments that you receive on customer accounts. Develop a schedule that integrates the payment terms for each client, such as 15 or 30 days, with their purchasing history so that you know when their payments are due. Follow up with delinquent accounts by calling their bookkeeping departments and reminding them that payment is due.
Keep track of expenses that your business incurs that you pay over time, such as invoices for materials that allow payment terms such as 15 or 30 days, or utility bills with specific due dates. Stay abreast of payment schedules and plan ahead to budget for upcoming payments.
Your business accrues taxes with virtually every transaction it makes, but pays taxes much more infrequently, such as monthly or quarterly. Keep track of taxes that you collect in the form of sales tax, and taxes that you withhold from employees’ paychecks. If possible, deposit these amounts in a separate bank account and, at the very least, know how much you owe for each tax period so you do not mistake these funds for available capital. Fill out your tax forms and pay your taxes on time.
SIX SIGMA STEPS
Define. This step consists of creating parameters to set the scope of a project, laying out what you intend to do, how you intend to do it, when you expect it to be completed and which tasks lie outside the purview of your current objectives. This definition stage may also include a budget, customer needs and the overall purpose of the endeavor.
Measure. This phase of the process is an opportunity to assess your organization’s current capabilities to provide a baseline for measuring progress as you improve. It may include measuring your production capacity as well as other metrics such as level of waste or rate of customer returns due to malfunctions or irregularities.
Analyze. This process involves taking a close look at the information you gathered during the measurement stage with the objective of charting a path for improvement. If your productivity numbers aren’t what you’d like them to be, the analysis stage provides the opportunity to ask why your operation is underperforming and to set goals defining the improvement you’d like to see.
Improve. In the improvement stage, you and your staff make tangible changes to implement the changes you’ve laid out in the course of your analysis. This is where you do the work, make adjustments and gather a new set of data about what works and what doesn’t.
Control. The improvements you made during the current phase of your organization’s improvement cycle will provide lasting benefits once you take the final step of standardizing them or making them into controls. This involves documentation of workflow and results and setting a new baseline for future improvements.
Benefits of Six Sigma
Six Sigma is a tested and teachable process for doing better work. It improves the quality of your products, increasing customer satisfaction and increasing sales through retention and referrals. It also makes your business more profitable by improving efficiency and reducing waste as you evaluate and improve your processes. The process of quantifying these aspects of your operation allows you to see measurable results.
Implementing a Six Sigma process can also improve employee engagement. If your employees are involved in the improvement process and see real results from their work, they are more likely to stay interested, bring their best to the workplace and stay with your company over time. They are involved in ongoing learning, which motivates them and contributes to overall morale.
Six Sigma and Lean Manufacturing
As an approach to improving productivity, Six Sigma uses the lean manufacturing philosophy popularized by Toyota and other successful companies. Lean manufacturing is based on reducing inventory levels that can bloat budgets without increasing actual cash flow and profitability, reducing bottlenecks that slow down work flow and improving the throughput cycle between receiving and delivering an order.
While traditional accounting systems list inventory on the books as an asset, lean manufacturing rethinks this assumption and instead focuses on the benefits of keeping your cash liquid rather than tied up in materials or finished products that you may not sell soon. This lean inventory approach also helps you to target production so you’re directing company resources more effectively toward the work that is most likely to bring in necessary cash.