How to create a business budget in four steps

28 July 2020

All organisations, regardless of size or industry, have been affected by COVID-19. There is little point gazing into your rear vision mirror at past business performance. We suggest looking forward to assess what is possible in this post pandemic economy and building a financial roadmap for your organisation that reflects this new world order.

Many small business owners don’t take the time to build a budget, but the process of analysing your business and building a financial roadmap for future growth are the keys to a sustainable business model.  BDO’s Financial Education team have created a simple financial analysis tool which helps owners build a budget with sufficient top line revenue to deliver bottom line profit.

Step #1: Start from the bottom up (net profit)

Building a high-level budget should start by taking a good look at your bottom-line profit, usually referred to as your net profit. The first step in building a budget is working out how much profit you anticipate making in the next 12-months after everything has been paid, including operating expenses, direct expenses and salaries (including a market-based salary for the business owner).  The reason we start at the bottom is to ensure the business is commercially viable.  Using the history to determine the future, particularly in the current environment, is a flawed process.

Step #2: Review your operating expenses

Next, do a deep dive into your operating expenses. An operating expense is any cost you incur in your normal business operations. For example, rent, administration costs, insurances, phone and internet.

Not all costs should be included in operating expenses. It’s critical you extract all Cost Of Goods Sold (COGS) from operating expenses. This is any cost you incur that directly contributes to making or selling your product or service. For example, inventory, freight, merchant fees even some employee wages costs. Accurately categorising expenses as either an operating expense or cost of goods sold helps to validate your pricing strategy and with budgeting for growth.

A simple but powerful visualisation tool we use in the Business Growth Program is called the “Power of One”. This tool shows you the impact of 1% changes across your financial model. This is important for building ‘what if› scenarios.

As part of the budgeting process, we encourage you to look closely at your operating expenses. Consider what can be reduced, removed or renegotiated. Is your landlord offering rent reductions or rent holiday in response to the COVID-19 crisis? Have staffing levels been adjusted to suit current demand? These all need to be factored into your overall forecast.  Small changes can have a big impact. 

Step #3: Reclassify direct expenses

Your next task is to reclassify expenses as COGS or direct expenses. Can you see why it’s important to understand financial terminology? The easiest way to determine if an expense is an operating expense or a direct expense is to consider if the expense tends to go up as you sell more products or deliver more services. We find many business owners have not accurately classified direct expenses in their Profit and Loss Statement.

Accurately capturing all direct expenses is important because you need to fully account for all the costs of delivering your product or service to ensure you are pricing your product or service correctly.  If you do not have sufficient gross profit margin in your business, you will not be able to generate sufficient net profit for the business to be commercially viable.

Review your gross profit margin by using this calculation: 

Income – direct expenses = gross profit. Your gross profit needs to be enough to cover all your operating expenses (and leave you with a profit).

If your gross profit is not covering all operating expenses and delivering you a profit, the businesses pricing strategy needs to be adjusted. This is how businesses can find themselves in the situation of growing broke. They are growing their top line revenue without charging enough to cover all direct and operating expenses to deliver a bottom-line profit.

Step #4: Set realistic targets to allow for change

Lastly, you need to calculate a top line revenue target. If you have followed this process, simply add your profit target plus operating expenses plus direct expenses.  This will reveal the top line revenue required.

For example, this year you want to make a profit of $150,000. Your operating expenses are $200,000 and direct expenses are $330,000. To achieve this profit, your annual revenue needs to be $680,000. 

We recommend breaking this annual revenue into monthly targets, taking into consideration any seasonal adjustments. Consider if these revenue targets are realistic, particularly in the current economic environment.  If they are not realistic or achievable, then revise the numbers.  Do you need to reduce expenses, increase prices or reduce your profit target?

In this post pandemic world, it’s more important than ever to stay close to your numbers. Building a financial roadmap means you have set business goals and targets to strive towards and a clear path to help you get there. Regularly reviewing your financial data means you can respond, adjust and reforecast targets and reduce expenses. Having more insight into your financial data will enable you to be in control of your financial decisions.

BDO’s Financial Education team has built a customisable financial analysis tool to help you manage the process of creating a financial roadmap. You can access this tool via either our self-paced, online course or a virtual workshop.