The Virtual CFO

Capital Expenditure Budget

The capital expenditures budget is probably the easiest item of the small business budget to estimate because it involves the capital investments that you plan to make during the year. Capital investments are major asset purchases for items such as buildings, machinery, and automobiles.

You probably already know the major asset purchases your company needs or wants to make in the coming year (or the period your budget covers if the period is not a year). Capital purchases can be made to replace equipment that has reached the end of its useful life. You may also need additional or new equipment to expand production, increase efficiency, or adequately serve customers’ needs.

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, sales tax, delivery and installation, depreciation, and interest and principal payments that will be paid during the year.

After you have completed the capital expenditure budget, you will need to revisit the general and administrative budget and add any expenses, such as depreciation and interest that resulted from the capital expenditures budget process.

General and Administrative Budget

The general and administrative budget (sometimes called overhead budget) 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 non-production and supervisory payroll, depreciation, sales and marketing, rent, insurance, etc.

Non-production payroll includes managers, sales staff, accounting, clerical, and other support staff members who are not directly involved in production. There are times, however, where you do allocate or expense all of a front-line managers time to the production budget, depending on the managers responsibilities.

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. Essentially, it is how you report the expense associated with the use of the asset.

For budgetary purposes, I recommend using straight-line depreciation because it best reports the use of your firms’ assets. To calculate this type of depreciation, you divide the cost of the asset by the asset’s expected life. You then expense the proportional share as the depreciation expense 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 for tax purposes.

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.

Production Budget – Part 2: Purchases and Direct Labor

Purchases are the cost associated with acquiring the materials necessary for future production.

Many small businesses order materials or supplies in large quantities in order to take advantage of quantity discounts. These orders have to be made in advance of the production or projects that will use the materials or supplies. Normally, these 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 or supplies purchased is determined by subtracting the materials you have in inventory from the materials that will be required 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. Direct labor costs include payroll taxes, unemployment taxes, and any benefits the company pays employees who are considered direct labor.

When budgeting for direct labor, you need to determine if your current direct labor force can handle any significant increases in production that you have budgeted. If not, you’ll need to include additional headcount in your direct labor budget.

When you subtract the sales revenue budget from the production budget, you have the budgeted gross income for your company. Gross income is the income your firm enjoys from its operating activities.

Production Budget – Part 1: Materials

The production budget is the second step in the budget creation process and it is directly tied to the units to be sold, or services to be provided, 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. In recent years, many industries have experienced a significant increase in material cost because of rising oil prices. When forming your production budget, you must take into consideration the price dynamics of the markets in which you purchase your materials.

I'll discuss purchasing and direct labor in my next blog post.

Sales Revenue Budget – Step #2

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 for the services you provide. 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 may also prevent your budget from being a useful business tool because you skipped the important step of analyzing and forecasting independently the units you estimate you can sell and the price you can sell those units for.

Sales Revenue Budget – Step #1: Determine How Much You’ll Sell

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.

The sales revenue budget is often difficult for entrepreneurs to calculate. This is especially true for start-up business with no historical sales history to analyze. This is why I strongly recommend that every small business owner and entrepreneur prepare and maintain a business plan. A business plan is not a onetime activity, but rather a living document that reflects the current state of your business. Preparing a business plan forces you to analyze, contemplate, and document every aspect of your business, including anticipated revenue. I regularly refer to a client’s business plan while preparing their budget.

Constructing the sales budget is a two step process. The first step is to estimate the number of units you expect to sell or the number of customers you expect to serve during the period. The second step is to determine the price you will be charging for those units or to serve those customers.

Most small businesses owners and entrepreneurs are optimistic about their sales projections (you wouldn’t be an entrepreneur if you weren’t optimistic). I strongly recommend creating a best case and worst case units to be sold or customers to be served estimate. You can then use a figure that falls somewhere in between the best and worst case as the most likely sales number for your budget.

In my next post, I’ll discuss the second step in preparing a sales revenue budget.

Budgeting for Small Business, Introduction #2

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:

1. Sales Revenue Budget - this is the revenue you expect to make during the period from selling your products or services.
2. Production Budget - these are the expenses that are directly associated with producing your products or services.
3. General and Administrative Budget - (sometimes called an Overhead budget). These are the expenses that cannot be directly tied to producing a product or service, such as non-production related payroll, depreciation, sales and marketing, rent, insurance, and bad debt.
4. Capital Expenditure Budget - this is where you estimate the expense for the major purchases, such as machinery or automobiles, you plan to make during the period.
5. Interest and Tax Budget - these are all the revenues and expenses that are not directly related to the operations of the company, but do have an effect on the income or loss used for tax purposes.
6. Cash Flow Budget - this is where you estimate the actual cash you will receive and the actual cash expenditures that will be made during a certain period.

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.

Introduction to Budgeting for Small Business

Practically every successful small business uses a budget, which is an estimate of revenue, expenses, and cash flow for a given period of time. In the current recession, having a budget is vital to a small businesses survival and success.

Budgeting is particularly helpful when you regularly compare actual results to your budget. This practice helps you determine what areas of your business are succeeding and which areas need attention.

I once told a business owner that not having budget and a good accounting system is like driving through a thick fog on the interstate at sixty-five miles per hour. You won’t know there’s something standing in the road until you hit it. A budget, used in conjunction with actual results from a good accounting system, will often give you the warning you need to take corrective actions to avoid hitting the obstacle.

Over the next few weeks, I’ll be posting a series of blog posts about budgeting for small businesses. I hope you find these posts informative and helpful to your business.

CPAs: the Regulated Tax Preparers

Business Week recently published an article entitled “A Boom for Tax Preparers”. This article is built around the premise that the new federal stimulus package will open a floodgate of tax fraud as unethical and inexperienced tax preparers “juice” client’s returns with inappropriate tax deductions and credits.

One of the topics the author discussed was how the tax preparation industry is virtually unregulated. One of the people interviewed in the article stated, "There are too many areas of this country where you have to go through more work to be licensed as a beautician than to do someone's taxes” (see my blog series “I Have People (Who Are Paid $7.00 an Hour)” for an insider’s view of the tax preparation business).

There is one segment of the tax preparation industry that is regulated, certified public accountants. We are held accountable for our professional actions by our respective boards of accountancy. Additionally, most states have codified the American Institute of CPA’s (AICPA) regulations which include standards that must be followed my CPAs, such as the Statements on Standards for Tax Services which are issued by the AICPA.

We are also required to earn a minimum of forty hours of continuing professional education (CPE) every two years. Twenty of the forty hours have to be in technical areas such as accounting and auditing, tax, ethics, and management advisory services.

Every fourth quarter, the Nashville Chapter of the Tennessee Society of CPAs  hosts a federal tax update seminar. The seminar covers a variety of topics, including new and old federal tax regulations, hot topics that affect both personal and individual returns, as well as strategies for lowering a client’s tax burden.

I can attest that the tax CPEs I receive definitely make a difference in the quality of advice and service I provide clients throughout the year.

If your tax preparer is not regulated you may find yourself receiving bad guidance that will enable you to gain in the short term, but may lead to IRS scrutiny in the future.