Know Your Business: The Essential Building Blocks of a Budget

Creating a budget is an essential part of any business. It provides insights into operations and forms the basis for analysis. Learn how to create a budget that works for your business with these tips on revenue, cost of goods sold, and operating expenses.

We’re 2.5 months through the year, is your budget already in shambles?

Having a proper budget is a crucial part of any business. But did you know a budget’s true benefit isn’t just setting our annual goals? A properly created budget provides deep insights into business operations and forms the basis for analyses. So how do we create such a budget?

There are 3 large pieces to a budget: revenue, cost of goods sold, and operating expenses. Each requires a different strategy.

There are three major components to consider when developing a budget: revenue, cost of goods sold, and operating expenses. To ensure accuracy and effectiveness, each component necessitates a distinct strategy.

Let's start by discussing revenue. It's the most important piece but also the hardest to get right. A revenue model should always be built upward with the key drivers of the business. If we're a SaaS company, how many subscriptions do we expect each month? If we're an e-commerce company, we need to know how many sales we expect by product and/or channel and what is our average order value. For a service-based company, how many billable hours and clients can we get? By getting into the minute details of revenue, our analysis and reporting will be extremely detailed and nuanced. Instead of just being able to note revenue missed in a month, we can now pinpoint the exact reasons and make quick decisions to change our marketing spend and strategy.

Cost of goods sold is much easier, most are tied directly to revenue. If we know our costs are typically $40 per sale, we just multiply sales by 40. 40%, same thing. Because we built our revenue so detailed, COGS follows quite simply. Now that we have our revenue and COGS, we can calculate our gross profit and profit margins. These should be consistent with prior year unless there is a fundamental shift to operations.

Operating expenses are where some creativity is necessary but also where some critical decisions arrive. The most important here, is payroll. What new hires will we need within the next year and what salary ranges can we anticipate? What is the ROI on each hire but also what return are we getting on our current workforce? As we add and reduce payroll, how much of our gross profit is dedicated to workforce? Balancing business needs and our people against revenue can be difficult. The second key expense is typically marketing. If we expect our sales to increase, we need to increase marketing to match. Can we improve marketing efficiency and cost to acquire to reduce the required spend? Are sales following our spend or must we reevaluate? Can we afford to increase marketing if sales are lagging? A lot of strategy and analysis should always be based in marketing for these reasons.

Capital expenditures (CapEx) aren’t always present in every business but are an important consideration for many industries that require big assets to run their business. Some industries where CapEx are normal are manufacturing, construction, freight/shipping, and many more. A good CapEx forecast will estimate at what points in time the business needs to purchase vehicles, heavy equipment, furniture, computers, real property, and any other necessary assets. This model’s inputs will often “drive” other sub-model assumptions. For instance, maybe a construction company can service another 10 jobs per week for every truck it purchases and 3 employees it hires. Other notable components of a CapEx forecast are estimates for routine servicing, maintenance, and replacement of assets.

The remaining expenses are usually much simpler. We can model a percentage of revenue for some instances. Others will be a flat amount we know we'll spend each month like rent. Remainder of optional expenses like travel, we can just set ourselves a monthly budget and aim to average. We now have all pieces together, can calculate net income and we’re done right? Wrong! Now we review the impact all our changes had on the bottom line forecast and several rounds of iteration follow until we dial it in. We want to be aspirational and anticipate growth but also rooted in reality. A budget that immediately fails by the end of March, will not be helpful for anybody. We want a moderately aggressive budget where even if we miss slightly, we had a great year.

Now the benefit begins. We can build our KPIs and reporting and present the budget to actual performance. How are we doing this year vs forecast and prior year? Why? The budget guides us to the right questions to ask and form the beginning of our strategic decision-making. So what do we do if we find by the end of Q1 our budget is way off base? We can always reforecast.

Ready to take control of your finances? Start creating your own budget today with the tips and strategies outlined in this post. Remember, it's never too late to get started on the path to financial stability and success. Compass CPA PC can help you get started with creating a budget that works for your business. With our experience in financial planning and management, we can provide you with the guidance and support you need to achieve your financial goals. Contact us today to learn more about our services and how we can help you master your finances.