As we get close to the end of the year, most companies are finalizing their annual budgets for 2011 (hopefully).  Working with small businesses you see a variety of methodologies used to create budgets.  However, some businesses actually operate without an annual budget.

So, what is a budget?

In simplest terms, it is a numerical plan of operation.  Recently I met with a prospect who intended on shifting his company revenue mix from 70% Consumer (30% Commercial) to 50% Consumer and 50% Commercial.  The plan was in his head.  He had not created a budget for it.  His employees were operating as they always have - in the 70/30 mindset.

So, why do we budget?

Again, in simplest terms - we see how we are progressing in relation to our plan of operation.  Using the above prospect as an example - a budget could tell him (and his staff) in any given month where he was in relation to his plan to reach his goal of 50/50 revenue mix.  Whether he is ahead or behind, they would know it and could adjust accordingly.

What else is a budget good for?

It helps management understand the business better by:

• Helping management identify the relationship between revenue, costs and profit.
• Helping management model the effect of business decisions - prior to making them.
• Helping management track overhead - in relation to revenue.

Now comes the easy part.   How do we budget?

A good starting point is to establish the desired rate of return on investment (ROI) and determine how much Net Profit is needed to meet that goal.  This is measured by dividing Net Profit (this can be pre-tax or after tax) by Owners Equity.

Next estimate all costs - fixed and variable.  Fixed costs are those that do not change with the volume of revenue (i.e. RENT).  Conversely Variable costs are those that will change with revenue. Variable costs can consist of Direct Costs, Indirect Costs and Selling General and Administrative Costs.

Now add the desired Net Profit to the Fixed Costs which gives us the amount of money that must remain after paying Variable Costs.  This is the Contribution Margin (CM).  The CM ratio is the percentage of sales that remain after all variable costs are subtracted out.

By dividing the sum of the Net Profit and Fixed Costs by the CM ratio and you will have the level of sales needed to meet your desired ROI.  Of course, if the Sales number seems to be unreasonable in relation to your current operating structure (i.e. too high or low) you may have to modify your targeted ROI or review how you estimated your cost percentages.

Some companies will layer departmental or functional budget into a comprehensive financial budget such as Capital Expenditures, Sales, Production, Material, Labor, R&D, SG&A, etc. - however the process is conceptually the same.

Your budget is now complete.  It’s as simple as that.