You probably know that running a business on a budget is a good idea. But the vast majority of business owners operate without one. Why is that? They may not be motivated by a clear understanding of WHY it’s so important. Or they may not know exactly where to begin in creating one.
Begin here. Budgeting is the perfect harmonizing of past, present, and future. The process is a chance to step back and look at the big picture: How did we get here? Where are we going? A budget is a stake in the ground, a commitment to a path, and a chance to review every aspect of your business. The process results in two things: alignment that is critical for strong leadership, and clarity on the two or three guiding principles for the year ahead.
Budgeting can be complex, but here is a simple three-step process that will work for most micro and small businesses.
Step One: Revenue. Gross revenue is a simple top-line metric, a universal KPI, and a good starting place for creating a budget.
What to do: Analyze the past, project into the future. Look at the monthly trend over the past year; what drove the higher months? What happened in the lower months? Is there any pattern behind the ups and downs?
This is a good time to get friendly with the metrics that drive your revenue. Some examples:
- What were product sales by month, by unit type?
- How many clients generated the revenue in each month?
- Is the price right? In line with the market? Creating profitability?
- What is your sales cycle? What is the lag time between winning a deal and receiving cash?
Once you have sketched out a clear picture of revenue drivers over the past year, set targets for each month of the year ahead. These should be targets for not just gross revenue, but unit sales, clients, pricing, jobs – anything that is generating that revenue. It’s easier to march to “We need 4 new retainer clients by April 1” than “We need to bring in $250k in revenue in March.”
What not to do: Make a bold declaration about what you want to have happen: “We are going to break $4m in gross revenue this year.” No matter what the law of attraction says, stating what you want with confidence and repetition will not make it happen. Run the numbers, ground your goals in reality.
Step Two: Expense. The key to successful expense budgeting is creating assumptions that are intimately connected to your revenue projections.
What to do: All of the principles of revenue budgeting above apply. Look at the past by month, analyze what drove expenses to be higher/lower than average, get friendly with your metrics on the expense side.
- What were your FTEs by month? This stands for Full Time Equivalent; two half-time people = one FTE. This is a measure of your human capacity.
- How well did you utilize human resources? In client services, percent billable is everything. Time tracking data can offer a world of insight. I like to look at total hours billed per month for the whole shop and by person.
- In product sales, what is your cost per unit? Have materials costs increased or decreased?
When you analyze the trend and project into the year ahead, be sure the expenses are in synch with the revenue. If your revenue is growing, how many more people do you need to service that business? When should you hire to account for onboarding time? What level of sales and marketing spend is going to generate the new business?
There are other important considerations around spending that have to do with what the business is becoming. I have a client that firmly believes their semi-annual company retreats are the number one key to their success, and they don’t pinch pennies on these events. I have another who is investing in a custom piece of software that will deepen and diversify their offering. How can you reinvest into the business this year in a way that will provide a huge return?
What not to do: Don’t leave the budget half-baked. I had a client budget 40% revenue growth, but only one new employee. My analysis showed each FTE would have to generate 75% more revenue in the coming year, which we all agreed was unrealistic. They chose to keep their budgeted margin at an unachievable 32%, saying they would hire more people if they actually made their budgeted revenue targets. A cohesive budget would include the full number of FTEs needed to support the revenue.
This doesn’t mean you have to hire anyone until you’re ready! The budget is a benchmark, not a script. If revenue is lagging, you delay hiring accordingly, of course.
Step Three: Zoom Out.
Now that you’ve crunched your numbers and built up a budget based on thoroughly considered assumptions, take a step back. Look at the full year budgeted revenue, expense, net income, and margin. Compare this to each of the last three years. Is it a huge leap? Is it flat versus last year?
Then check in with your vision for where you want the company to be three years from now. Is the budget for the coming year tracking to that vision? In business, you’re playing the long game. It’s important to look at the horizon and feel inspired by the future; this will help pull you through the temporary ups and downs.
Note the following best practices for the budgeting process:
- The budget should be a plan that represents a doable stretch. It has to be challenging enough to keep you pushing. Don’t sandbag your budget, making it too easy, or you could shortchange your organization’s potential.
- Highly aggressive or conservative assumptions are actually valuable benchmarks which can emerge from the budgeting process. You may even run a best-case budget just to see what’s possible, or a worst-case so you think about safeguards. Keep those on the side for reference during the year.
- Make notes for each item to document all final assumptions. When you’re doing your variance reporting during the year, knowing your budgeted assumptions helps explain the discrepancies.
- Collaborate with others in the organization. Definitely get input and buy-in from the lead sales and marketing people. Talk to the head of operations to find out their concerns and priorities. If you’re not savvy with number crunching and generating metrics, work with someone who is. I guarantee the budgeting process will spark valuable conversations. Be sure key stakeholders are aligned behind the finalized budget.
When the budget is done, blessed, and pinned on the wall, come up with two or three guiding principles that emerged as the very key priorities, goals, or actions for the year ahead. In the uncertain territory of tomorrow, these will be the mantras that keep you steady and centered as you lead your company to its full potential.