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For most business owners, the first thing on their mind is strategies to best generate and conserve cash flow in the business. If you missed our post Three Strategies to Help your Cash Flow you can read it here. After developing these strategies, owners and management should take the next step and make an operational budget for the business or operating division.
Budgets are one of the most common, yet misunderstood, business tools. They provide a financial roadmap to achieving a company’s business goals, while providing a gauge on how far away the actual results are from the pre-determined goals. Although it’s rare that actual results will ever match the budget, the analysis of the difference will provide important feedback to owners and management on those areas that fell short. This allows owners and management time to focus their energy on improving such shortfalls. Of course, if actual results are better than the projected budgets, the entire team can give themselves a strong pat on the back for the hard-work done to achieve such great-results.
The following steps are typically involved when creating an effective budget:
This can be on a weekly, monthly or annual basis. The goal here is to prepare a budget that can be compared to actual results. For example, if a company or business division produces a weekly production/operational report, or if management prepares a weekly summary report of the business operations, then a weekly budget would be a good comparative for measuring the company’s performance. Since a weekly budget can be excessive and time consuming, comparing the monthly operational results with the monthly budget may be a better alternative while still providing timely information to management.
Reasonable sales targets are subjective. Historical same-period sales data (e.g., unit sales, sales growth, etc.) can provide a good indicator of what the budgeted sales target should be. The next piece is to then estimate what the related costs and investments (e.g., in capital assets) are to achieve these sales targets. If the company has historical information available, management should be able to reasonably determine the necessary costs. If not, an estimate will need to be made and then compared to actual results to provide useful operational feedback to management.
We recommend first focusing on the overall sales, costs and net profit for the company. This provides the basic outline of the company’s anticipated operations. Next, it is essential to drill down to the specific pieces making up the overall sales and costs. For example, pieces making up overall sales can be broken down into price per unit and number of units sold for product lines, and number of customers and fees per customer for service lines. Similarly, costs can be broken down between those that remain relatively independent on revenue levels, such as rent and insurance expenses (i.e., fixed costs), and those that are dependent on revenues, such as materials costs in product manufacturing (i.e., variable costs). Once you’ve established the individual components that make up the overall big picture, it is always recommended to take a step back and review the budgeted operational results to see if they are reasonable, and to see how they compare to historical results. If significant differences exist, there should always be a good reason for the meaningful changes.
When preparing budgets, one should always remind themselves that the budget’s main purpose is not about cutting costs. Budgets are created to support sales and profitability and help owners and management in making decisive strategies in overall growth of the business. Once a budget is prepared, we recommend that the preparer take a step back and review whether the budget is consistent with the overall objectives and strategic plans, as well as how historical (actual) results, if any, compare with the budget.
You may notice a common theme in our steps illustrated so far: reasonability, consistency and comparability to actual results. In order for a budget to be effective, owners and management need to diligently review and analyze any differences between actual results with those budgeted for the same period. Stay tuned for our next blog where we finish the final steps in creating an effective budget.
CPA, CA, CBV
Partner - Advisory Services
Mike has over 25 years of experience providing accounting and business advisory services, with a focus on the Canadian insurance industry.
CPA, CA, CBV
Alex Wong is a partner at Smythe Advisory and is focused on being a trusted business advisor to his clients.
CPA, CA, CBV
Director of Valuation Services
Paul Woodhouse focuses on providing financial advisory and litigation support services to clients.
Gagandeep specializes in M&A advisory engagements, as well as business valuations in the contexts of management buyouts and succession planning.
Arthur’s mandate is to assist Smythe clients in Western Canada in preparing for and executing business divestitures or acquisitions.