Happy New Year from The Virtual CFO!.
I hope that 2007 is a better and more profitable year for you and your company than 2006.
The capital expenditures budget is probably the easiest item of the small business budget to estimate because it involves the capital investments (major asset purchases, such as buildings, machinery, and automobiles) that you plan to make during the period.
You probably already know the major asset purchases your company wants to make in the coming year (or what ever period the budget covers). Capital purchases can be made to replace equipment that has reached the end of its useful life or new equipment that is necessary to expand production or increase efficiency.
After you determine what capital expenditures you will be making in the coming year, you need to estimate all of the costs that will be associated with the purchases. This includes any down payments, depreciation, and interest and principal payments that will be paid during the budget period.
After you have completed the capital expenditure budget, you need to revisit the general and administrative budget and add any expenses, such as depreciation and interest that resulted from this process.
The general and administrative budget (sometimes called overhead) covers all of the cost of running your operation that cannot be directly tied to producing a product or service. These costs include expenses such as payroll, depreciation, sales and marketing, rent, insurance, bad debt, etc.
Non-production payroll includes managers, sales staff, accounting, clerical, and other support staff members who are not directly involved in production.
Depreciation is a means used to expense the cost of a capital asset (a major asset purchased such as machinery, computers, and equipment) over the life of the asset. To calculate the depreciation, you divide the cost of the asset by the asset’s expected life. You then expense the proportional share to the depreciation for the period covered in the general and administrative budget. (I know that this is a very simplified explanation of depreciation and I am familiar with MACRS and other means of accelerated depreciation. However, this explanation will suffice for this summation. Also, I recommend that you consult with your CPA about the accelerated depreciation options available to your company).
Sales and marketing efforts are also considered to be general and administrative cost, rent, insurance, bad debt, and any other expenses that are related to the operations of your firm but cannot be directly tied to production are also items included in the general and administrative budget.
Purchases are the cost associated with acquiring the materials necessary for future production. Small businesses tend to order materials in large quantities in order to take advantage of quantity discounts. These orders have to be made in advance of the production that will use the materials. Normally, purchases are made at the end of a month (or some other suitable period) in anticipation of the next month’s production. Additionally, the amount of materials purchased is determined by subtracting the materials you have in inventory from the materials that will be needed for the next period’s production.
Direct labor costs are the personnel costs that are directly tied to producing a unit of your product or service.
When you subtract the sales revenue budget from the production budget, you have the budgeted gross income for your company.
The production budget is the second step in the budget creation process and it is directly tied to the units to be sold in the sales revenue budget. The production budget includes all of the costs that are directly attributable to producing units of the product or service you sell. These costs include material cost, purchases, and direct labor cost.
Materials are those items that are pulled from inventory and used in the assembly of the units you sell. Depending on your industry, material prices can remain relatively steady or they can be rather unstable. Recently, the construction industry has experienced a significant increase in material cost because of rising oil prices (oil is a component of both asphalt and polyethylene pipe, which is used for underground utilities such as water and high-pressure gas lines). When forming your production budget, you must take into consideration the price dynamics of the markets in which you purchase your materials.
The second step in forming the sales budget is to estimate the price that you will be able to charge per unit of your product or service. This step can be a little tricky because there are many factors that can affect the price you can charge your customers.
As with the units to be sold budget, I recommend that you determine the highest and the lowest price you think your customers will be willing to pay for your product or service during the budget period. You can then estimate the most likely price your customers would be willing to pay.
When you multiply the estimated units to be sold by the estimated price per unit, you get the gross sales revenue budget.
I have one word of caution regarding the sales budget. It is tempting to try to back your way into your sales revenue budget. This begins by determining the profit you want to make, next determining the total expenses for the period, and then manipulating your sales prices and sales mix (the percentage of total sales for each type of product you sell) in order to confirm the profit you want to make. This practice results in a budget that looks good on paper, but will not reflect a true estimate of the sales your company expects to make. This practice will also prevent your budget from being a useful business tool.
The sales revenue budget represents the gross income you expect to make from selling your products and services during the period covered by the budget. The sales budget is also where you need to start in the budget creation process. Constructing the sales budget is a two step process.
First, you estimate the number of units you expect to sell and then the price that you can sell those units for. Most small businesses owners and entrepreneurs are optimistic about the sales he/she expects to make. I strongly recommend creating a best case and worst case unit sales estimate. You can then use a figure that falls somewhere in between the best and worst case as the most likely number of units you expect to sell.
Almost every successful small business uses a budget, which is an estimate of revenue, expenses, and cash flow for a given period of time.
A budget serves two basic purposes: (1) it makes you plan for the future, and (2) it provides a benchmark by which you can chart the progress of your firm by comparing budgeted figures to actual figures as the year progresses.
Budgets are generally created for income and for cash flow. Income is the profit or loss for a period (regardless of whether cash from sales is received). Cash flow is your company’s actual inflow and outflow of cash.
Below are the steps normally taken in creating a budget for a small business:
A budget usually covers a calendar year, but your company circumstances may cause you to create a budget covering a shorter or longer timeframe. Additionally, most budgets are broken down into monthly increments within the period covered by the total budget.
I’ve decided to update and post the series on small business budgeting I ran in July.
I’m thinking seriously about adding an index to The Virtual CFO Blog main page that list the topics of the series I have written. I know that I need to do this either on the blog or on the CPA for Small Business, LLC website that will be unveiled soon (a little marketing teaser from an accounting guy :).
Have a good weekend and I hope that you find the upcoming series on budgeting informative and helpful.