Is a budget necessary?
In order to provide the best start-up conditions possible for the company, one needs a set of plans as well as a system for measuring the effects of the actions taken. Consider the following:
You work within the framework of financial constraints. And all your decisions have consequences. Without a budget you are likely to remain in the dark – you do not know where to head, and you do not know how far you have reached.
How to device a budget?
The business plan is normally a fair starting point. So are the annual accounts from last year (provided you have been in business that long).
1. Profit demands
Work through the accounts, one by one. Use a spreadsheet, for instance the one below for the first crude version of the budget:
| Acc. | Account name | Last year | Change | Budget next year |
| 3000 | Sales | 500 000 | + 5% | 525 000 |
| 4300 | Costs of goods sold | 300 000 | + 5% | 315 000 |
| 5000 | Salaries, wages | 100 000 | + 3% | 103 000 |
| 5092 | Holiday pay | 10 000 | + 3% | 10 300 |
| 5400 | Payroll tax | 15 538 | + 3% | 16 004 |
| 5990 | Other social benefits | 15 000 | No change | 15 000 |
When you have considered all income sources and all expenses, the second phase of the budget development starts. Is the profit great enough to satisfy your and/or the owners’ ambitions?
In a limited liability company (AS), the owners will often demand a yield in the form of dividends. Often you will have to reconsider all expenses, check out changes and look at opportunities for increased sales.
When your budget shows a satisfactory profit (or even satisfactory loss), you are ready for:
2. Monthly budget
If you want to compare your budget with the accounts on a monthly basis, you have to prepare a time limited budget.
What are the income and expenses each month? You have to consider seasonal variations and calculate sales and supply of raw materials month by month. Are the seasonal variations also affecting the cost of labour?
3. Liquidity (cash flow projections)
If you plan new investments, new loans or generally have poor liquidity, cash flow projection may be a good idea. The projection system simulates loan down payments, credit times, investments, handling of taxes, etc. Note that a spreadsheet may not offer sufficient flexibility when the number of variables is large. Thus, it may be smart to seek assistance from a professional accounting agency. We have, however, included a link to a spreadsheet suitable for a small business at the end of this chapter.
4. Funding alternatives
A well designed liquidity budget may reveal unnecessary capital constraints and poor funding. Considering the framework conditions (e.g. income, expenses, credit times, interest rates, etc.) that are entered into the budget system, you can observe how the liquidity develops month by month.
A shop selling clothes has typically 60% of the turnover in the second half of the year. Obviously, with such major variations, the impact on the liquidity will be substantial.
5. Budget simulation
Having a comprehensive liquidity budget, one has a very sound starting point for assessing the effect of investments and new funding.
The budget offers the opportunity to simulate the operation on paper (or screen). What happens if the gross profit margin is raised by 1%? What if the credit time is reduced by 10 days? And what happens if we get rid of the overdraft allowance and instead get a mortgage loan? This is a fun, interesting and very important exercise you can do by yourself, together with your accountant or your auditor. You will probably be surprised to see the impact of even minor actions. People experienced with budgeting may give you valuable advice on how to improve both the profitability and cash flow of your business.
6. Comparing with the accounts
The last step in the budget process is to check the real profit and loss statement against the budget. Most accounting software is able to present the accounting together with the corresponding budget entries in one single report.
When you check how you perform compared to the budget, you will realise if the business is doing as well as you planned when you made the budget.
At an early stage you will be able to detect discrepancies compared to the budget. Note however, that some deviations are acceptable. If you struggle with the profitability, any deviation requires a correction of the course. And you should do it when you still have the steering power! Maybe you have to return to step 1 in the budgeting process to revise the plans?
Tools and information:
Tips and hints:
- Use last year’s accounts as a starting point
- Create realistic budgets
- Use your budget to measure performance
- Review your budgets on a regular basis
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