Budgeting is all about planning your income and expenditure, so you’ve got enough money for the things you need. If you don’t plan and manage your budgets tightly, just like in your personal life, your business will run out of money. Equally, if you don’t spend it on the right things, you’ll risk wastage and missed opportunities.
That sounds simple enough, but there are many different approaches you can take to creating a small business budget. AAT has summarised some of the best ways to approach your planning and what you’ll need to include in your own small business budgets.
What budgeting method should I follow?
If you’re an established business, you’ll probably already have a process in place for planning budgets. Most of the time your budget will cover a 12-month period and the planning phase for the next budget period will begin three to six months ahead.
Whilst annual budgets are far more common, some businesses opt to use a rolling budget. At the end of each month, a new month’s budget is added to the end of the period. This allows the business to be more accurate and responsive but is time-consuming as you’ll need to plan a new budget each month.
During the planning phase, there are three main methods for creating a budget:
This is the traditional approach to budgeting where the majority of the previous year’s budgets are revised by adding a bit extra for inflation. Incremental budgeting is quick and simple to do, and provides consistency, while maintaining the status quo.
Zero-based budgeting is, effectively, the opposite of incremental budgeting. Essentially, managers start with a blank piece of paper and write the budgets from scratch. When zero-based budgeting is used, every cost must be justified, with clear benefits to the business.
Priority-based budgeting is similar to zero-based budgeting. However, its core budgets are less rigorously reviewed, with projects subject to prioritisation. It's frequently used in the public sector where funds are limited and the needs of different sections of society must be balanced against each other and prioritised. It can also be used in a similar way within the private sector where limited funds mean that the business needs to focus on what is a priority.
Each have their advantages and disadvantages and there’s plenty of sense in using a mixture of all three.
Where do I start with my small business budget?
Depending on the scale of your business, it’s likely you’ll need a few different budgets which each focus on different operational elements of your business. They should all work together in tandem. Let’s run through what they are:
The sales budget contains an itemised list of forecasted sales both in units and value. This will usually be split into individual product/service lines and may be broken down into further sections looking at geographic regions or product type. Most businesses start with the sales budget because the estimated sales will help to inform other expenditure – eg. stock purchases, staff wages, and production costs.
Stock and production budget
Now you have an idea of your estimated sales throughout the budget period, the next port of call is your stock and production budget. This budget will need to consider the following areas:
- Inventory/stock levels and restocking policy for both finished goods and raw materials
- Production costs to ensure stock levels are maintained
- Direct labor (wages for employees directly involved in production process)
- Raw materials
For bigger-sized businesses, stock and production budgets may need to be devised for each department.
All businesses have overheads and therefore overhead budgets. The overheads are any costs not directly related to sales or production. For example, staff wages (those not involved in production), electricity, communications infrastructure, and other expenses such as licenses and software.
Although marketing expenditure could be included within your overhead budget, in most cases businesses will choose to have a dedicated marketing budget. This will typically include paid advertising activity, content creation, software, and other marketing-related items. It may also include the wages of your marketing staff.
How do I distinguish between long-term and short-term planning?
To distinguish between running costs and long-term investments, businesses may choose to create Revenue and Capital budgets, which then feed into your master budget.
Revenue budget: These are the budgets we work with daily because they're the budgets for the day-to-day income and expenses of the company.
Capital budget: These budgets are for large value purchases of items of equipment, machinery, vehicles and even buildings. Capital budgets will be for items that the business needs for longer periods of time, and are normally purchased using invested funds, retained earnings or loans.
Whilst you’re likely to be closer to the revenue budget on a day-to-day basis, splitting out your budgets this way keeps you alert to immediate situation whilst also thinking about the business’s long-term strategic direction.
What about cash flow?
Having a cash budget is vital too. If the business is unable to keep cash flowing then it will be unable to pay staff, suppliers, and cover its overheads.
The cash budget is the plan of when cash is expected to come in and go out of the bank. It will determine whether the other budgets are feasible. For example, you may have plans to ramp up production in April, but your cash position is insufficient to cover the costs. It’s important to know this in advance as there may be ways to adjust your budgets at other points in the year or, alternatively, look at financing options to enable investment.
The key thing to remember is this budget focuses on when cash is received and not the sales made.
What about planning for unexpected events?
The COVID-19 pandemic has highlighted the importance of preparing for the unexpected – though, few businesses will have been prepared for anything on the scale of the last 18 months.
However, prudent businesses do prepare contingency funds as part of their budget planning. If you’re in a decent financial position, it’s definitely a good idea to put aside some of your income towards an emergency or contingency fund. You might decide, for example, that 1% of all sales income goes into this fund. Not only can this money be used in case of an unwanted event, it can also be utilised when business opportunities come up.
This article is written by AAT. AAT are a market-leading provider of practical finance and accounting training - and have recently launched a series of online courses for small businesses: AAT Business Finance Basics. This course includes modules on planning and creating budgets from scratch.