The Importance of Budgeting
What’s the first thing you think of when you hear budgeting? You might think it sounds like a lot of time to spend in Excel just to build financials that won’t be “correct” anyway. But building a budget is as much about the process as it is the outcome — and budgeting is a crucial piece to help judge a business’s financial feasibility and success as it scales.
First, let’s establish the difference between a budget and a financial model. Budgets are used to track monthly income and expenses against expectations for an existing business model. A financial model, in contrast, is used to evaluate the impact of a strategic decision on a business. If you are going to hire more staff, throw it in the budget. If you are trying to decide whether to invest in a new partnership that would change how you do business, you’re going to want a financial model.
One of the things about a budget is it allows you to analyze your business’ health in real-time. As you track monthly progress, you can use your budget to identify when it is time for a marketing blitz or a key pivot away from an underperforming business line.
Here are three easy ways you can get your budget off the ground:
1. Set a goal for your year-end sales
It’s a great technique to use your budget to help you set goals for your company. A budget should reflect an achievable goal – remember this isn’t the revenue target you’re hoping for, it’s the revenue you expect. Because of this when you are setting a goal for year-end sales, it’s a good idea to be somewhat conservative. Better to underestimate revenue and exceed your goal than the other way around.
Once you have identified your goal, you can work backwards to identify the expected revenue per month. One way to do this is to average the yearly goal evenly across all months and then use past information around seasonality to tweak monthly values up or down. Another approach, if you expecting a year of significant growth, is to ramp up your projected revenue over time with significantly more of your projected revenue happening in the last half of the year.
2. Start with data you have
When first building a budget it can sometimes feel like you are pulling numbers out of thin air. But that doesn’t need to be the case — use the financial data that you already have to build estimates. When looking at revenue, use the same month from the previous year as a benchmark.
In every business, there are two types of expenses: fixed and variable. Fixed expenses are items that do not have a direct correlation to revenue, such as rent or insurance. To estimate your fixed expenses, you can generally use the same values as the previous year to determine monthly amounts. Variable expenses are items that are partially dependent on revenue, such as Cost of Goods Sold (COGS) or Salaries. For these, historical information can a basis for your projections, but you’ll need to factor in growth.
For salaries, this means determining the monthly amount you pay out to all employees and projecting any potential hires. For some items, you might not have the data to make a reasonable projection and can instead use percentages. Perform some quick math on your historical information to figure out what percentage of revenue you spent on certain expenses, such as COGS. Apply this same percentage to your new monthly revenue targets to build estimates in your budget.
3. Keep it simple
When you’re first building a budget, don’t get tied up estimating every value; when in doubt keep it simple. You’ll never estimate the exact values, but that’s okay. The goal when budgeting is not to be precise, it is to be accurate. Estimating your energy bill to the penny matters much less than getting your salary estimates in the right ballpark.
Smaller value line items, such as utilities or personal expenses tend not to fluctuate that much from month-to-month, and these fluctuations typically will not make or break your budget. So spend your time and energy on building accurate estimates for the large line-items in your budget, (revenue, COGS, salaries, etc.) and don’t sweat the small stuff. This frees up your time to focus on the high value line items that will determine your growth trajectory and ability to invest in your business.
Your budgeted values will not be exactly in line with your actual financial performance. But that’s the point! A budget’s primary use is as a tracking tool, and as actual monthly values are recorded you can perform what is called a “budget vs. actuals.” This will help you measure your progress against goals and see where you are under or overachieving. As you complete this exercise year over year, you will build in-depth knowledge of your business’ financial drivers and your estimates will improve.
Remember, finances aren’t just something to be sent to your bookkeeper or delegated to another team member. To lead your organization requires a robust understanding of what drives your business growth, and how your business currently makes and spends its money. Building a budget is a great start.