Small-business budgets come in many formats, types and degrees of complexity. In most cases, though, they serve three purposes.
The first purpose of a budget is to establish performance targets over a specified period of time. Usually a budget plans for revenues and expenditures on a monthly, quarterly, annual and multi-year basis. Managers and employees can then devise action plans to achieve the targets provided by the budget.
The second purpose of a budget is to measure performance. A budget serves as a benchmark to evaluate the performance of your company over a period of time. If your company increases sales by 50 percent during the year, for example, that may in absolute terms be considered a success, but if the budget called for a 100 percent increase in sales, the results are actually below expectations.
The third purpose is to determine compensation for employees. Measuring actual performance against a budget provides a tangible, quantitative basis for calculating raises, bonuses, commendations and promotions. Decisions made and actions taken by employees at any level will affect revenues, expenses or both. Without the benefit of a quantitative budget serving as a guide, the compensation determination process is left exposed to subjectivity, bias and other negative influences.
Consider the following recommendations when developing a budget.
Use Several Benchmarks as a Starting Point
When developing an initial budget, the values will be based on estimates and educated guesses derived from the experience of managers. As your business grows, budgets should incorporate past performance and competitor results. A budget developed from these three sources—manager experience, past performance and competitor results—can provide the most realistic budget and help ensure the numbers are based on reality. Sometimes these three sources may provide very different results for a particular budget line item. In these cases, it may be best to act conservatively and select the value (or a blend of value) that is least favorable to your company; this can mean either a lower revenue estimate or a higher cost estimate.
Provide a Rationale for All Assumptions
Budgets consist of projections. A detailed budget may consist of dozens or hundreds of individual projections. Each projection should have a logical explanation defending it. If a budget determines that replacement parts for a key piece of machinery will increase in cost by 10 percent, the person responsible for this projection must be able to justify it. Some projections are easy to justify because they're established by contract. Others are less predictable and may require more work to arrive at a justifiable number.
Avoid Developing a Budget in Isolation
A proper budget requires input from employees throughout the organization, regardless of size. Since you probably don't have perfect knowledge of every aspect of your business, producing a budget in isolation can carry several significant risks. An unrealistic budget will provide unrealistic targets for your company and could unnecessarily hurt employee morale as they fail to achieve the targets. It also could cause you to pursue a strategy that will ultimately fail because it's too aggressive.
Expect Revisions and Make Them in a Timely Manner
A key budgeting challenge for many small-business owners is knowing when to make a revision. Maintaining a strict “no changes” policy may not provide sufficient flexibility to adapt to the realities of a changing environment. But operating at the other extreme—where changes are made continually—can defeat the purpose of having a reliable benchmark against which to measure performance.
It’s helpful to have a policy in place, even if it's simple and drafted in an MS Word document, to determine when changes to a budget should be made.
The most challenging types of changes to make are those related to revenues, which can at times be very subjective. Salespeople may recommend reductions to help them “beat the budget.” Cost centers within the company can also be subject to the same pressures, at times exaggerating upward revisions to cost to come in under budget at the end of the year. A written policy that clearly states the parameters and conditions under which a budget will be changed can help to minimize these risks.
Map Links Between Jobs and Budget Line Items
To help ensure that proper credit and responsibility are assigned to each department or employee, you should create a map of which positions affect which budget line items and to what extent. The janitor, for example, has a direct impact on cleaning and maintenance costs. It may be a small percentage of the overall cost structure, but performance can be measured. The same principle holds for key positions.
A hidden benefit of using budgets is the education that takes place during the development phase. To produce a useable budget, you should delve into the details of your operations, engage employees, understand how different segments of the business interact and make educated guesses about sales. This process can reveal new ideas to enhance performance and, ultimately, improve the overall financial results of your business.
The information contained in this article is for generalized informational and educational purposes only and is not designed to substitute for, or replace, a professional opinion about any particular business or situation or judgment about the risks or appropriateness of any financial or business strategy or approach for any specific business or situation. THIS ARTICLE IS NOT A SUBSTITUTE FOR PROFESSIONAL ADVICE. The views and opinions expressed in authored articles on OPEN Forum represent the opinion of their author and do not necessarily represent the views, opinions and/or judgments of American Express Company or any of its affiliates, subsidiaries or divisions (including, without limitation, American Express OPEN). American Express makes no representation as to, and is not responsible for, the accuracy, timeliness, completeness or reliability of any opinion, advice or statement made in this article.
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