Budgets take a lot of time – why bother?
The truth is, any business owner will tell you a budget is essential to the survival and growth of a company. Large organizations devote a huge portion of their time and energy to create an operating budget every year. The budget serves as a guide for spending the money needed to achieve the business’ goals and to measure how well this business is doing in reaching those goals.
Families create budgets for the same reasons. They have a limited amount of income. They have some things they must do with that money, like buying food and paying rent. And they have goals, like buying a house or helping their kids go to college.
But creating a budget can be hard, especially for companies. In fact, the top 3 reasons why businesses fail are lack of planning, inadequate marketing, and poorly managing capital.
Fortunately, creating a budget is much easier for small businesses using cloud-based accounting programs like Xero.
Key Benefits of Making a Budget
- Gives you a plan to guide your spending through the year. There are going to be bumps and distractions along the way. Your budget will help you stay on track.
- Forces you to identify your goals. Having an estimate of how many meals you’re going to serve (if you’re running a restaurant) or how many kitchens you are going to remodel (if you have a construction business) helps you to identify the steps you need to execute to reach your goal. Creating a budget helps you determine which goals are important and which are not.
- Once you know which goals are relevant to your business, you will see right away what you can do to meet them. It will help you decide whether you need to adjust your marketing campaign or delay some purchases.
The Three Basic Steps to Creating a Budget
Know how much money your business made and how much it spent last year. Organize this information into categories like insurance, utilities, rent, and payroll.
Figure out how much more or less you will have to spend next year. Do this for each category mentioned in the previous step. For example, is rent going to go up? What about insurance or payroll? Most likely prices in each category will go up next year, so you will have to either sell more of your product or try to raise prices enough to keep up with inflation.
The last step is simply breaking down the previous information by month.
Now, let’s go into more detail.
Creating a Budget with Xero or QuickBooks
The first time you create a budget is going to involve some serious work. But it gets much easier the second time, especially if you are using Xero or QuickBooks Online. The accounting program will have all of your income and expenses neatly summarized for you at the end of the year.
So, for the second year, you won’t need to go through piles of receipts with a 10 key. Just look at the monthly breakdown from last year and make necessary adjustments for the coming year.
Are your raw materials going to cost more? Will you need to spend more on advertising? You need to answer these questions once a year when you are making your budget for the coming year. Luckily, the accounting software saves you loads of time by summarizing all of the previous year’s spending into the categories you are familiar with.
Some Basics of Accounting Software
A budget is basically a plan that foresees how much a business is going make and how much it needs to spend. Budgets typically cover one year and are broken down by month.
The hardest part of a plan to understand is expense categories when they are broken down into detail. But, initially, these categories are easy to figure out: rent, payroll, raw materials (food for restaurants, nails, and lumber for contractors, for example), equipment, internet/telephone, etc.
The good news is that accounting software organizes income and expenses into a general ledger (GL) using a chart of accounts (COA).
Say what? Take a look at the example below. All of the expense and income categories (with numbers next to the name) are called “accounts” in accounting lingo. The accounts are on the left side of the screen. The list of all of these accounts is called the Chart of Accounts. The record of all transactions of money going in and out of your business is called the General Ledger.
Every transaction is categorized using the Chart of Accounts. If the transactions are categorized correctly, then when you run a report you can see exactly how much your business spent on advertising, bookkeeping services, permits, etc.
But enough talk! Let’s see how Xero works with an example.
The budget below is for my fantasy restaurant, Joel’s Tacos. This is my budget for 2018. All expenses and income are from preparing and selling tacos.
Step 1: What’s my income?
Projecting your income is essential. If you have been in business for a while, then you already have some idea of what your monthly income should be. You might not have broken it down by month. It’s on Line 1, Schedule C from your income tax. This is your total sales. Divide that by 12 to get your monthly sales. Enter that in the Jan-18 field and use the green arrow to copy it to all of the months on the Sales line in 2018.
My goal is $60,000.00 in sales in 2018 or $5,000 per month.
In reality, people buy more tacos when the weather is nice. So I edit the monthly Sales projection to adjust for seasonal variation. If I had used Xero last year I could just look at the monthly sales totals from last year. But I didn’t, so I’m going to make my best guess at how much sales are going to go up and down according to the weather.
Figure 1 – Xero Budget Manager
Step 2: How much am I going to spend?
Now you need to enter your expenses, by category. If you’ve been in business for a few years this should be pretty easy, especially if you’ve been using Xero. If not, but you have been handing a shoebox full of receipts to your accountant, then go back to Schedule C. If you just started, then you will need to set aside a few hours to get the ball rolling.
If you were already using Xero it will show you how much you spent in each category in each of the previous months. Just scroll to the left to see the months in 2017.
Don’t forget to adjust for things like insurance or rent increases, or hiring another cook.
Figure 2 – My Completed Budget in Xero
Don’t forget to stay on top of your budget!
Now that you put all that effort into creating your budget, you can really benefit from it. Xero’s Budget Variance report compares your actual sales and spending to your budget.
The screenshot below shows the difference between what I budgeted for January 2018 and my actual sales and expenses. At this point, I have $0.00 in actual sales! Since the month hasn’t started yet, there’s nothing to worry about. But if today was January 15, this would be a big problem.
Figure 3 – Xero Budget Variance Report
Make sure all the transactions you enter going forward are properly categorized. If you do your own bookkeeping, then be sure to use the same categories to record the transactions that you used when you created the budget. If you use an outside bookkeeper, then review the categories with them to make sure they understand your categories and use them going forward. Ideally, you want to have them help you set up the budget. That gives them a chance to make recommendations and ensures they will use the categories.
Review your Variance Report at least once a month. Check both the monthly and Year To Date variance columns. The YTD numbers will show you if there’s a trend you need to fix.
Is everything green? You’re doing it right! But seriously, in the real world, there will always be some small differences between what you budgeted and your actual income and expenses. Don’t worry about those. What you need to be watching out for are the big differences.
Look at both the Var USD and the Var % columns. Utilities aren’t a major part of the budget, but if you see a variance of -100% you might have a problem you need to address. A big variance one month might mean that someone left the water running all weekend, but a significant YTD variance could mean that it’s time to replace the refrigerator!
Studying your Variance Report will help you spot issues that are costing your business money. Knowing where your money is going is key to running a profitable business.