A key factor contributing to a business’ success is how well they handle budgeting. When founders have clear and sensible budgets in place, they can set realistic goals, allocate resources more accurately, and easily evaluate their performance. It’s checks and balances that keep a business grounded and focused.
7 Steps to Building Operating Budgets
As part of Connecting Founders’ Money & More series, Michael C. Rabonza discussed the 7 simple steps that businesses should follow to build their budgets.
Step 1. Define your goals
Where does your business want to be 5, 10, 15 years from now? First and foremost, you need to know your destination, so that you can set priorities accordingly, and come up with a strategy and plan to position yourself for success. Crystalize your vision and use budgeting to layout checkpoints on how to get to your destination.
Step 2. Articulate your assumptions
Assumptions are the building blocks of your budgeting process, what you use to make projections. How much market share can you expect to capture in year 1? How fast and by how much do you think this will grow? Will more competitors enter this space and will market demand change considerably over the next 5 years? This is a very important step in your budgeting process, and you will likely need to draw from a variety of sources to validate your assumptions – market research, due diligence on competing businesses, and a fair amount of educated guessing. Also, assumptions are not meant to be static – as economic and market conditions shift, businesses need to brace for change and make necessary adjustments.
Step 3. Forecast sales volumes
Once your assumptions are set, you can proceed to forecast sales volumes – how many products and/or services you expect to sell. A good starting point is to examine your past performance – or that of similar businesses, if feasible – to get a better understanding of customer behavior, price sensitivities, percentage of repeated buyers, etc. Does demand peak at certain times of the year? What are the best-selling products and how often do customers repeat the purchase? These are all important factors to guide a business in sales forecasting.
Step 4. Forecast revenue
Use the existing backlog of sales activities and sales pipeline information to project future revenue generations. It is a good idea to document your quantity-price assumptions, and factor in potential production constraints to keep it realistic and avoid overestimating revenue.
Step 5. Forecast Costs of Goods Sold (COGS)
How much will it cost you to produce the goods you are selling? This is what is captured in the Costs of Goods Sold (COGS), which measures the business expenses linked to producing goods or services, such as raw materials, labor, and shipping. As COGS are variable costs, they vary depending on the number of units produced or services rendered – the more units, the higher the variable costs. This means that businesses looking to cut costs should consider options to cut COGS, whenever possible.
Step 6. Estimated fixed expenses
The next step is to estimate fixed costs, which are the recurring and consistent expenses that must be paid to keep the business running, such as rent, salaries, utilities, and general administrative services. These are the costs that you need to cover every month, rain or shine. Knowing the fixed costs tells you the bare minimum that you need to make for your business to survive.
Step 7. Calculate operating income
The final step is to calculate your operating income. You can have impressive revenue figures but if your costs are too high, your business will still end up short. Use gross profit and operating income as reliable indicators to measure the overall health of your business and your performance:
Gross Profit: the amount of income left after subtracting the costs of goods sold (COGS) from the total revenue. It shows how efficiently a business operates based on direct costs.
Gross Profit = Revenue – COGS
Operating Income: the total income that remains after subtracting both the fixed costs and variable costs from sales revenues. It shows businesses their actual performance outside factors under management’s control.
Operating Income = Gross Profit – Fixed Expenses
- First Plan, Then Build. Forecasts are an expression of our goals. Budgets are the maps that help us get there.
- What Gets Measured, Gets Done. Budgets get everyone on the same page. Measuring performance is only meaningful when we are accountable.
- Budgets are Meant to be Beaten, not Broke. Budgets keep businesses on the right track but to stay relevant, they need to be revisited often as assumptions change. Plan, budget, execute, measure, correct. Repeat.
For Connecting Founders’ Money & More series, visit: https://connectingfounders.thinkific.com/courses/moneyandmore