According to a survey conducted by Clutch, 61 percent of small businesses have not created a formal budget. Without a budget, you may not understand how your business is performing.
Creating a budget helps you understand how much money you have, how much you have spent, and how much money you will need in the future. A budget can drive important business decisions like cutting down on unwanted expenses, increasing staff, or purchasing new equipment. If you end up with insufficient money, the budget can guide you in altering your business plan or prioritizing your spending on activities.
With the right budgeting plan, you can keep your business out of debt or find ways to reduce the debt it is currently facing. A comprehensive budget can even be used for obtaining business loans from banks or other financial institutions.
In this guide, you will learn about the importance of a business budget, the components of a good budget, and the different types of budgets.
So, what exactly is a business budget?
A business budget is a spending plan for your business based on your income and expenses. It identifies your available capital, estimates your spending, and helps you predict revenue.
A budget can help you plan your business activities and can act as a yardstick for setting up financial goals. It can help you tackle both short-term obstacles and long-term planning.
Different types of budgets
Your final budget is usually a combination of inputs from several other budgets that are prepared at a departmental level. Let’s look at the different types of budget and how they contribute to drafting a business plan.
1. Master budget
A master budget is an aggregation of lower-level budgets created by the different functional areas in an organization. It uses inputs from financial statements, the cash forecast, and the financial plan. Management teams use master budgets to plan the activities they need to achieve their business goals. In larger organizations, the senior management is responsible for creating several iterations of the master budget before it is finalized. Once it has been reviewed for the final time, funds can be allocated for specific business activities.
Smaller businesses often use spreadsheets to create their master budgets, but replacing the spreadsheets with efficient budgeting software typically reduces errors.
2. Operating budget
An operating budget shows a business’s projected revenue and the expenses associated with it for a period of time. It’s very similar to a profit and loss report. It includes fixed cost, variable cost, capital costs, and non-operating expenses. Although this budget is a high-level summary report, each line item is backed up with relevant details. This information is useful for checking whether the business is spending according to its plans.
In most organizations, the management prepares this budget at the beginning of each year. The document is updated throughout the year, either monthly or quarterly, and can be used as a forecast for consecutive years.
3. Cash budget
A cash flow budget gives you an estimate of the money that comes in or goes out of a business for a specific period in time. Organizations create cash budgets using inferences from sales forecasts and production, and by estimating the payables and receivables.
The information in this budget can help you evaluate whether you have enough liquid cash for operating, whether your money is being used productively, and whether there is and whether you are on track to earn a profit .
4. Financial budget
Businesses draft this budget to understand how much capital they’ll need and at what times for fulfilling short-term and long-term needs. It factors in assets, liabilities, and stakeholder’s equity—the important components of a balance sheet, which give you an overall idea of your business health.
5. Labor budget
For any business that is planning on hiring employees to achieve its goals, a labor budget will be important. It helps you determine the workforce you will require to achieve your goals so you can plan the payroll for all of those employees. In addition to planning regular staffing, it also helps you allocate expenses for seasonal workers.
6. Static budget
As the name suggests, this budget is an estimate of revenue and expenses that will remain fixed throughout the year. The line items in this budget can be used as goals to meet regardless of any increases or decreases in sales. Static budgets are usually prepared by nonprofits, educational institutions, or government bodies that have been allocated a fixed amount to use for their activities in each area.
Components of a budget
If you are starting a new business, the first budget you create might be a challenge, but it is a good learning experience and a good way to understand what works best for your business. The best place to start is getting to know your budget components. Initially you may need to make several assumptions to get your budget started.
1. Estimated revenue
This is the money you expect your business to make from the sale of goods and services. There are two main components of estimated revenue: sales forecast and estimated cost of goods sold or services rendered. If your business is more than a year old, then your experience will guide you in estimating these components. If your business is new, you can check the revenue of similar local businesses and use those figures to conservatively create some estimated revenue numbers. But whether your business is new or old, it is important to stay realistic to avoid over-estimating.
2. Fixed cost
When your business pays the same amount regularly for a particular expense, that is classified as a fixed cost. Some examples of fixed costs include building rent, mortgage/utility payments, employee salaries, internet service, accounting services, and insurance premiums. Factoring these expenses into the budget is important so that you can set aside the exact amount of money required to cover these expenses. They can also be a good reference point to check for problems if your business finances aren’t going as planned.
3. Variable costs
This category includes the cost of goods or services that can fluctuate based on your business success. For example, let us assume you have a product in the market that is gaining popularity. The next thing you would like to do is manufacture more of that product. The costs of the raw materials required for production, the distribution channels used for supplying the product, and the production labor will all change when you increase production, so they will all be considered variable expenses.
4. One-time expenses
These are one-off, unexpected costs that your business might incur in any given year. Some examples of these costs include replacing broken furniture or purchasing a laptop.
Since it is difficult to predict these expenses, there is no certain way to estimate for them. But it’s wise to set aside some cash for this category to stay prepared.
5. Cash flow
This is the money that travels in and out of the business. You can get an idea of it from your previous financial records and use that information to forecast your earnings for the year you’re budgeting for. You’ll want to pay attention not only to how much money is coming in, but also when. If your business has a peak season and a dry season, knowing when your cash flow is highest will help you plan when to make large purchases or investments.
The final budget component is profit, which is a number you arrive at by subtracting your estimated cost from revenue. An increase in profit means your business is growing, which is a good sign. Once you have projected how much profit you are likely to make in a year, you’ll be able to decide how much to invest in each functional area of your organization. For example, will you use your profit to invest in advertising or marketing to drive more sales?
A budget is a road map for your business. It helps you predict cash flow, identify functional areas that need improvement, and run your operations smoothly. Successful businesses invest a lot of time and effort into creating realistic budgets, because they’re an efficient way of tracking the extent to which the business has achieved its goals. Creating a budget can get a bit overwhelming for new businesses as there are no previous figures to guide their budget estimates, but with some estimates based on the performance of competitors and an understanding of the components of a budget, you can complete your first budget and have a good road map for future budgets.