If you’re like the vast majority of business owners that we see, you run your business without a formal budget and, at best, have noted somewhere what your expected sales are for the current and maybe next week or month. We’ll get into why this is fraught with danger another time but suffice to say that if this is you, your business is either failing or succeeding by accident.
For those of you who do prepare formal budgets, I’d like to challenge you on how you prepare those budgets to see if you can’t get a better outcome from doing so. If you are going to the effort of preparing a budget, why are you doing that? Is it because your accountant said you should? Is it because you read somewhere that it is a good thing to do?Or is it so that you can try to predict how profitable the business will be and what will likely be the cash position at the end of any given month, quarter or year.
I hope it is the last one.
I’d also like to put it out there that the budget should be there to assist you in determining the actions you need to take in order to achieve the results of your budget. What I mean by this is that a budget by its very nature is your best guess as to what is going to happen in the future.
This means that the expected financial results are based on a number of assumptions:
- Assumptions about how much income the business will generate;
- Assumptions about what margin the business will achieve on those sales;
- Assumptions about how quickly your customers will pay you;
- Assumptions about what expenses you will need to incur to keep the doors open.
As an example of what I’m talking about, I’d like to challenge you on how you come up with the “sales” figure.
I suspect that, like almost every small business owner I’ve ever met:
- you pluck a figure out of thin air;
- you work backwards from how much money you need to make to earn a living; or
- you take last year’s income figure and increase it a bit.
My questions to you are:
- How do you know that income figure is right;
- How do you know what you need to be doing to meet the budgeted sales figure; and
- When comparing actual results to the budget, if the sales are not at budgeted levels, how do you know why they have fallen short?
The quick answer is that you can’t. The solution is in how you prepare your budget.
In this “sales” example, instead of using some arbitrary number, try to actually calculate the income figure using your business model as a guide.
Let’s say that you own and operate a plumbing business. In very broad terms, your income equation goes something like this:
Existing Customers
+
(Leads x Conversion Rate) = New Customers
=
Total Customers
X
Average No. of Jobs per Customer
X
Average Price per Job
=
Total Income
If you look at the above Income Formula, you will note that it includes the following components:
- Customer Retention
- Lead Generation
- Sales Process (i.e. Conversion Rate)
- Service Offering
- Pricing
Each of these gives you, as the business owner, an area to focus on in order to improve the business and therefore its income levels. It also results in your ability to look at which one of these is not where you thought it would be if you haven’t reached budgeted income levels. For example, income might be below budgeted levels because the number of jobs is down or it might be that the number of jobs is up but the amount we are charging per job is too low etc. You can use this budgeting methodology across many aspects of your business (e.g. debtor days, stock days etc). Preparing a budget this way is not difficult with the right help but it does take more time and can be quite challenging if done properly but the result is laser sharp focus on what needs to be done to make the business successful and a high level of clarity on what isn’t working if you are not achieving budget.
I strongly urge you to give this a try and reap the benefits of budgeting correctly.