Successful businesses typically establish goals to set the tone for the upcoming year and provide a road map for success. These goals are usually tied to revenue increases, overhead expense reduction, hiring plans, client retention goals, and more.
The centerpiece of business goal planning is your budget. Without a budget, your business might drift with whatever marketplace and economic currents come its way, much like a ship without a rudder.
Why is budgeting important?
Just as every high-net-worth individual’s household establishes and follows a monthly budget, so do successful businesses. Next to your business plan, your budget plays the most prominent role in your company’s daily operations and overall success.
Budgeting is critical because without planning for revenue and expenses, you can’t hit your net margin goal, which is crucial in remaining solvent. A company that has lofty revenue projections without budgeting and planning its spending on overhead expenses—both fixed (rent, utilities, payroll, capital improvements, etc.) and variable (i.e., sales commissions)—will be relying heavily on luck to meet its profit goals.
Types of business budgets
Understanding the different types of business budgets is fundamental for every business owner and manager. Here are four types of business budgets:
- Master budget: A company’s central financial planning document. It includes a sales budget, labor budget, cash flow forecasts, financial statements, and a financial plan.
- Static budget: Uses predicted amounts of revenue and expenses for a given period before the period begins and remains unchanged even with increases or decreases in sales and production volumes.
- Operating budget: A detailed forecast of the revenues and expenses for one or more future periods, typically the next quarter or year.
- Cash flow budget: Estimates all cash receipts and expenditures expected to occur during a specific period.
Working from all four of these budgets gives you a distinct advantage over your competitors, who may be operating based on only one, two, or none.
What should a business budget include?
Just like your personal budget includes necessities like food, housing, and insurance, your business budget also should have the following:
- Estimated revenue
- Variable costs
- Additional costs
- Unexpected costs
- Cash flow
- Savings
- Estimated profit
Tips for creating a business budget
Knowing that you need to have a business budget is the first step; creating it is your next challenge. Here are five tips to guide you in putting together your budget:
- Research industry standards and trends to get an idea of what you may need to budget for
- Maintain a spreadsheet that includes your estimated revenues and expenses, and update it daily
- Give yourself padding, and expect the unexpected
- Consider drafting a quarterly budget––checking your fiscal condition should be done more frequently than annually
- Use sub-accounts to separate finances because it’s easier for accounting purposes
How to choose the right business budgeting method
Just like there are several types of budgets, there are several methods of budgeting.
Incremental budgeting
Considered a conservative approach to budgeting, with incremental budgeting, the current budget is used as a base to which incremental assumptions are added or subtracted from the base amount to determine new budget amounts.
Pros
- Simplicity
- Consistency and operational stability
- Funding stability
- Reduces internal rivalry
Cons
- Can promote unnecessary spending
- Discourages innovation
- Fails to account for changes and external factors
- Lacks an incentive for a comprehensive review
Zero-based budgeting
Zero-based budgeting is a budgeting technique that allocates funding based on efficiency and necessity rather than budget history. It only includes operations and expenses essential to running the business.
Pros
- Final output is aligned with the company’s overall business strategy
- Encourages collaboration within the company
- Improves performance by challenging assumptions and examining expenditures
- Provides a better chance of making cost reductions
Cons
- Requires qualified personnel and specialized training
- Can harm the company’s brand image
- May be cost-prohibitive
- More complex than traditional budgeting
Value proposition budgeting
Value proposition budgeting is a happy medium between incremental and zero-based budgeting. It analyzes each budget category or line item to determine why it’s included in the budget and its value to stakeholders, employees, and customers.
Pros
- Help remove items providing little or no value
- Keeps the business more customer-centered
- Helps better direct marketing efforts
- Cuts wasteful spending
Cons
- Can be challenging to quantify ‘value’
- Can lead to more short-term thinking rather than long-term thinking
- May change based on social, economic, or technological factors
Activity-based budgeting
This method uses a top-down approach focusing on the key outcomes a business wants to achieve in the next period. It works well for companies that don’t have enough historical information to create the next period’s budget.
Pros
- Provides a forward-looking view giving insight into possible improvements
- More likely to identify inefficiencies in processes
- Helps company stay goal-focused
- Easier to make changes based on current events
Cons
- Lengthy and time consuming
- Requires individuals experienced in budgeting and fiscal planning
- Can lead to short-term thinking
- Can be unreliable if end results are not as planned
Performance-based budgeting
Performance-based budgeting focuses on a company’s results rather than its expenditures. It is commonly used by private and public organizations and helps define the purpose for which funds are required.
Pros
- Allows for better cost estimates
- Finds areas for improvement
- Helps eliminate unnecessary expenses
Cons
- Employees often disagree about where funds should go
- Easy to manipulate
- Company must be willing to decentralize their accounting process
Aligning your budget with your business goals
Creating a business budget is time-consuming and can create friction between employees and departments. But successful business owners take the time to choose the right type and budgeting method and do their best to encourage cooperation between stakeholders and staff members.
We recommend having an experienced budgeting advisor to help you better understand the budgeting process and make choices that will work best long-term for you and your business.
