How to create an operating budgetOct 19, 2023
Last week we talked about strategic planning. This week we dive into the operating budget.
I'm excited to break this down!
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HOW TO CREATE AN OPERATING BUDGET
Budget season is either upon us or almost upon us for a lot of businesses.
For some, that means absolutely nothing.
A budget is a tool to help you operate your business and offload decision-making to those in the right positions to make them.
When done well, a budget helps a business stay on track and achieve its goals.
When done poorly, it creates friction in the business and restricts them from
When not done at all, well… good luck.
Don’t get me wrong. A TON of businesses have success without a budget. But a budget done well is an extremely powerful tool to ignore.
So, let’s define what a “budget done well” is:
- Clear in objective
- Adopted by all parties
- Addresses contingencies
- Flexible to changing needs
- Used to operate the business
Today we’re going to talk about operating budgets. Next week we’ll talk about capital budgets. But, before we jump in, let’s define what these are.
Operating Budget vs Capital Budget
I prefer to update both operating and capital budgets on an annual schedule, but some like to update them on a different schedule.
Some update Operating Budgets as the business changes throughout the year, but that tends to cover up assumptions you made and makes it harder to correct them in the next year.
I prefer to review actuals against the budget each month and create a “notes” document that I review as I prepare the budget each year.
There isn’t a right or wrong with this, just personal preferences.
Next week, we’ll dig into a capital budget and how to create it.
The levels of an Operating Budget
We’re going to look at this from the perspective of a small to medium business. As the business grows, this level of detail is not sustainable. But, for this size of businesses, it’s helpful to understand their numbers this deeply. As you get larger, you remove the lowest levels except in situations where you’re introducing new ideas.
So, what are these levels?
- Company: sounds simple right? But, if you have multiple entities, you’ll need to make a judgment on whether you budget it together or separately. Here I’d rely on how you operate: do they operate separately? If so, create 2 different budgets.
- Responsibilities: This will be based on the structure of the business. You could organize by departments, locations, reporting structure, etc.
- Accounts: Each account on the Income Statement should be given to one person or one group who is responsible. This assures that nothing drops through the cracks and stops dual responsibility disagreements.
- Line items: No, I’m not asking you to budget each different type of office supplies. But within accounts, you’ll have different types of expenses. For example, in Software, we want to have a line item for each software you have a subscription to. We want to think of these line items as variable, fixed, or one-time costs.
Let’s talk about the line items.
I know this can seem complicated, but when I implemented this at my last CFO job, it was really eye-opening. With some systems, you can have accounts and sub-accounts and sub-accounts are a great way to make this line item tracking easier. You want to be careful that you’re not creating a sub-account for one-time events, as that’ll mean your account structure becomes untenable really quickly.
So for example, I won’t create sub-accounts for individual conferences a company attends, but I will create them for company events like Christmas parties, summer picnics, or volunteer days. If they’re repeating every year and something you’d want to watch the cost on, it’s a great opportunity to track a sub-account.
When thinking about my line item/sub-account tracking, I like to think about 3 different types of expenses:
- Variable: grows with business and driven by other items in the budget
- Fixed: does not grow linearly with business but instead by by contract or static dollar amounts
- One-time: not repeated (thus don’t want it rolled into a permanent budget)
Variable costs fluctuate in proportion to the level of goods or services that a business produces.
If the business grows, so do variable costs… even if you don’t mean to!
When you sell more product, cost of goods sold goes up because the product you sold has cost.
But this also impacts other areas. Microsoft charges per seat, or person, so the number of licenses (and cost) you have goes up as you hire more people.
If you’re billing hours and paying overtime for that busy season, your variable costs will increase.
- Office Supplies
- Cost of Goods Sold
- Direct Labor Expense
- Commissions & Bonuses
- Per user software subscriptions
With these, we need to ask: what is driving the increase?
If it’s revenue, we assign a proportion of revenue.
If it’s a number of employees, we assign a dollar amount per employee.
I love running budgets in Excel because I can tie the calculations to variable changes, which means less work for you.
One thing I see missed often is clearly delineating the calculations you’re using. Without it, budgets become a maze of unknowns. When you outline this on the face of the document, anyone looking at it can understand how things are interlinked.
These costs do not scale with the business. This could either be because you are locked into a contract or because they go up in levels.
While variable costs go up in proportion to revenue, fixed costs generally go up in steps.
- Rent & Utilities
- Salaries (plus raises)
- Loan payments & interest
- Locked-in software contracts
Fixed costs are why companies can scale and become more profitable. Say you capture 40% of cash after the Cost of Goods Sold. If sales are $1 million, that’s $400,000. If Fixed costs are $400,000, you have $0 (and 0%) profit. But if you grow to $1.3 million and fixed are able to remain $400,000, you’ll now have $300,000 profit or 23% profit margins.
In the same way, fixed can be the devil. If sales go down, you start to lose money and often can’t cut fixed by a ton… especially if you have contracts.
Getting these right requires reviewing contracts and estimating the changes if they’re not locked in for the full year.
This is where budgets tend to get out of control.
You re-did your website, so you increased the marketing budget by $10,000. But next year you forgot about that project. Here’s how the conversation normally goes:
“Last year we had a budget of $50,000. We want to do some special gifts and promotional materials for our 10-year anniversary and expect that’d cost $15,000, so we requested $65,000.”
Did you catch it? The $10,000 was a part of the $50,000. Now, they’ve added the $15,000 on top instead of taking the base budget ($40,000) and adding $15,000 to it.
It’s so easy to do and why I recommend small to medium businesses get this granular. When profits and cash are below $1 million, these changes can add up to allow you to hire more production staff, test new initiatives, or take more home as the owner.
As numbers get bigger, these things become less important as they’ll barely move the profit percentage.
Operating Budgeting Process
Now that we’ve set the foundation for what the budget should look like, let’s discuss the process for developing it.
While historical data will be gathered by accounting, the budget owners will be responsible for participating and driving most of the other steps.
Step 1: Look at historical data
While we don’t want to just roll historical data forward and call it good, we can absolutely use historical data as the base of our budget.
We’re using this data to look at 3 things:
- What to eliminate
- What to repeat
- What to add
We look at all spending with a critical eye to understand what it is and why we spent it. From there, we can make judgments about elimination, repeating, and adding.
I use this process to categorize all spend into accounts and sub-items.
By default, you’re reviewing by account, so we only change that if we realize it’s a miscode. We then look for trends and identify sub-items we might want to track in the future.
Yes, this is time-consuming. But it has been one of the most beneficial processes I’ve done in small businesses to really lock this budget in.
Once you establish this process, every year it gets easier, too.
Step 2: Analyze trends or business impacts
What do you need to add to the operating budget that you didn’t have before?
We want to think in terms of:
- Account by Account
- Strategic Objectives
- SWOT Analysis
As we look at each account, we use the “what do we add?” question as well as “what will be different?” to identify potential new items.
The goal isn’t to figure out this budget yet. It’s to put a placeholder so you don’t forget the budget later on.
Step 3: Build the budget
As we go down the budget, we think in 3 types of costs:
- Variable Costs
- Fixed Costs
- One time costs
We won’t break these down since we did that above.
The key here is to be patient and think through each of these one by one
Step 4: Compare against your Revenue Forecast
We won’t address this here as we’ll be talking about it in the coming weeks, but I will briefly hit on the relationship between the Forecast and Budget.
The Forecast tells us what’s possible with the budget. We want to make sure both are realistic and that we’re not making budget decisions based on an over-optimistic forecast.
We need to ask:
- What is reasonable?
- What is likely?
- What budget gets me to my minimum profit?
Using this knowledge, we have to make the hard decision about what to cut with the budget.
This is not the final step, so you don’t have to “cut it all” but you do need to set a goal.
Step 5: Adjust, refine, & adjust again
This is the meat of the process. This is where the budget gets passed back and forth between the appropriate parties for digestion, hard feedback, and adjustment.
Ideally, people would get more than one pass at the budget to make sure they go over it fully.
I like to ask budget owners to create a presentation to the appropriate parties with their suggested budget. This allows them to add color to their request.
From that color, the reviewers will mark it up and return it. From there, a follow-up meeting is set to address the adjustments.
If everyone agrees, that’s the end. If not, you might have another round (yuck).
The goal here is to build a process that works well within your organization and culture.
Step 6: Identify the timing of spending
Now that we’ve got a “final draft,” it’s time to check for feasibility.
By mapping out the timing of the spend, we get a sense of the year's schedule.
Sometimes things can look good on paper, but in reality, you only have 5 people when you need 10. Creating a schedule of spending allows you to figure those things out and get a sense of the cash flow, which we map in the next step.
We’re not going to project how we’re spending office expenses. We’re going to look at expenses and figure out who has:
- Upfront payment
- Down payments
- Events/things spent around a date
So, for example:
- Insurance payments paid over 8 months instead of 12
- Software with a big down payment
- Christmas Parties & conferences
All these items concentrate spending in a specific month and so we need to make a note of that.
Step 7: Create a Cash Flow Projection
I know, we haven’t talked capital budget. In reality, capital budgets are happening alongside this process. So, know that next week we’ll address this piece.
We’ll talk cash flow projections later, so we’ll expand on this later.
Step 8: Final review & approval
This is one last look-through with all the elements in front of you. Everyone should get a crack at this.
Ideally, you’re making small, clerical level, changes. But, sometimes more is necessary. Only you can determine this.
We made it!
This was a beast of a post. Thanks for sticking with me.
Next week I hope capital budgeting will be shorter… for my sanity.
Until then, let me know if there is anything I can clarify about this section.