Chapter 5
IN THIS CHAPTER
Getting the right perspective on controlling costs
Comparing your P&L numbers with your balance sheet
Focusing on profit centers
Becoming familiar with the budgeting process
Preparing your first budget and applying advanced techniques
Using the budget as a business management tool (and more)
What’s the first thing that comes to mind when you hear cost control? Cutting costs, right? Well, it may come as a surprise, but slashing costs is not the main theme of this chapter. Cost control is just one element in the larger playing field of profit management. The best, or optimal, cost is not always the lowest cost.
A knee-jerk reaction is that costs should be lower. Don’t rush to judgment. In some situations, increasing costs may be the best path to increasing profits. It’s like coaching sports: You have to play both defense and offense. You can’t play on just one side of the game. Making sales is the offense side of business; defense is keeping the costs of making sales and operating the business less than sales revenue.
The planning process includes numerous elements, ranging from obtaining current market information to evaluating personnel resources to preparing budgets or forecasts. The first part of this chapter focuses on one of the most critical elements of the planning process: preparing a budget.
Budgets aren’t based on the concept of “How much can I spend this year?” Rather, budgets are more comprehensive in nature and are designed to capture all relevant and critical financial data, including revenue levels, costs of sales, operating expenses, fixed asset expenditures, capital requirements, and the like. All too often, budgets are associated with expense levels and management, which represent just one element of the entire budget.
The budgeting process doesn’t represent a chicken and egg riddle. From a financial perspective, the preparation of budgets, forecasts, projections, proformas, and the like represent the end result of the entire planning process. Hence, you must first accumulate the necessary data and information on which to build a forecasting model prior to producing projected financial information (for your company). There is no point in preparing a budget that does not capture your company’s true economic structure.
Of course, don’t waste money on excessive or unnecessary costs. If possible, you should definitely save a buck here and there on expenses. There’s no argument on this point. Small business owners don’t particularly need tutorials on shaving costs. Rather, they need to stand back a little and rethink the nature of costs and realize that costs are pathways to profit. If you had no costs, you’d have no revenue and no profit. You need costs to make profit. You have to spend money to make money.
Controlling costs requires that you evaluate your costs relative to your sales revenue. Suppose your business’s salaries and wages expense for the year is $225,000. Is this cost too high? There’s no way in the world you can answer this question, except by comparing the cost against your sales revenue for the year. The same goes for all your expenses.
In an ideal world, your customers are willing to pay whatever prices you charge them. You could simply pass along your costs in sales prices and still earn a profit. Your costs would be under control no matter how high your costs might be. Because you earn a profit, your costs are under control and need no further attention.
It’s hardly news to you that small businesses face price resistance from their customers. Customers are sensitive to sales prices and changes in sales prices for the products and services sold by small businesses. In setting sales prices, you have to determine the maximum price your customers will accept before turning to lower price alternatives, or not buying at all. If the price resistance point is $125 for a product, you have to figure out how to keep your costs below $125 per unit. In other words, you have to exercise cost control.
Cost control is part of the larger management function of revenue/cost/profit analysis. So, the best place to focus is your P&L report. (Book 3, Chapter 2 explains the P&L report, also known as the income statement.) This profit performance statement summarizes your sales revenue based on the sales prices in effect during the year and your expenses for the year based on the amounts recorded for the expenses. (There are some issues regarding the accounting methods for recording certain expenses, discussed in the upcoming section “Selecting a cost of goods sold expense method.”)
Suppose your business is a pass-through income tax entity, which means it doesn’t pay income tax itself but passes its taxable income through to its shareholders, who then include their shares of the business’s annual taxable income in their personal income tax returns for the year.
Figure 5-1 presents the income statement of a hypothetical business (you can say it’s yours) for the year just ended and includes the prior year for comparison (which is standard practice). This report includes the percents of expenses to sales revenue. It also breaks out a facilities expense — the cost of the space used by the business — and reports it on a separate line.
Facilities expense includes expenditures for leases, building utilities, real estate taxes, and insurance on your premises. Depreciation isn’t included in facilities expense; depreciation is an unusual expense and it’s best to leave it in an expense by itself.
In this case, the business moved out of the red zone (loss) in 2018 into the black zone (profit) in 2019. Making a profit, however, doesn’t necessarily mean your costs are under control. Dealing with the issue of cost control requires closer management analysis.
Figure 5-1 is the income statement for your business as a whole. At this level, you look at the forest and not the trees. It’s helpful to divide your business into separate parts called profit centers. Basically, a profit center is an identifiable, separate stream of revenue to a business. At this level, you examine clusters or stands of trees that make up different parts of the forest.
For example, Starbucks sells coffee, sure — but also coffee beans, drinkware, food, CDs, and other products. Each is a separate profit center. For that matter, each Starbucks store is a separate profit center, so you have profit centers within profit centers. Last, you can drill down to particular, individual costs. At this level, you look at specific trees in the forest.
You increased sales $634,062 in 2019 (refer to Figure 5-1). This is good news for profit, but only if costs don’t increase more than sales revenue, of course. For revenue/cost/profit analysis, it’s extremely useful to know how much of your sales revenue increase is due to change in volume (total quantity sold) versus changes in sales prices. Unfortunately, measuring sales volume can be a problem.
An auto dealer can keep track of the number of vehicles sold during the year. A movie theater can count the number of tickets sold during the year, and a brewpub can keep track of the number of barrels of beer sold during the year. On the other hand, many small businesses sell a very large number of different products and services. A clothing retailer may sell several thousand different items. A hardware store in Boulder claims to sell more than 100,000 different items.
In the example portrayed in Figure 5-1, you increase sales volume 20 percent in 2019 over the prior year, which is pretty good by any standard. You made much better use of the sales capacity provided by your workforce and facilities in 2019. You increased sales per employee and per square foot in 2019— see the later sections “Analyzing employee cost” and “Looking at facilities expense.” The 20 percent sales volume increase is very important in analyzing your costs in 2019. A key question is whether changes in your costs are consistent with the sales volume increase.
The example portrayed in Figure 5-1 is for a situation in which product costs remain the same in both years. Therefore, cost of goods sold expense increases exactly 20 percent in 2019 because sales volume increases 20 percent over the previous year. (Of course, product costs fluctuate from year to year in most cases.)
Sales revenue, in contrast, increases more than 20 percent because you were able to increase sales prices in 2019. In Figure 5-1, note that sales revenue increases more than the 20 percent sales volume increase. Ask your accountant to calculate the average sales price increase. In the example, your sales prices in 2019 are 7.7 percent higher than the previous year.
You did not increase sales prices exactly 7.7 percent on every product you sold; that situation would be quite unusual. The 7.7 percent sales price increase is an average over all the products you sold. You should know the reasons for and causes of the average sales price increase. The higher average sales price may be due to a shift in your sales mix toward higher priced products. (Sales mix refers to the relative proportions that each source of sales contributes to total sales revenue.) Or perhaps your sales mix remained constant and you bumped up prices on most products.
$261,921 profit increase ÷ $634,062 additional sales revenue = 41.3% profit from additional revenue
This scenario may seem almost too good to be true. Well, you should analyze what happened to your costs at the higher sales level to fully understand this profit boost. Could the same thing happen next year if you increase sales revenue again? Perhaps, but maybe not.
This expense may appear straightforward, but it’s more entangled than you may suspect. It’s anything but simple and uncomplicated. In fact, the later section “Looking into Cost of Goods Sold Expense” explains this expense in more detail. For the moment, step around these issues and focus on the basic behavior of the expense. In the example in Figure 5-1, your business’s product costs are the same as last year. Of course, in most situations, product costs don’t remain constant very long. But it makes for a much cleaner analysis to keep product costs constant at this point in the discussion.
The 20 percent jump in sales volume increases your cost of goods sold expense 20 percent — see Figure 5-1. Pay special attention to the change in your gross margin ratio on sales. Your basic sales pricing strategy is to mark up product cost to earn 45 percent gross margin on sales. For example, if a product cost is $55, you aim to sell it for $100 to yield $45 gross margin. However, your gross margin is only 42.0 percent in 2019. You gave several customers discounts from list prices. But you did improve your average gross margin ratio over last year, which brings up a very important point.
How is it that your sales volume increases 20.0 percent and your sales prices increase 7.7 percent in 2019, but your gross margin increases 40.2 percent? The increase in gross margin seems too high relative to the percent increases in sales volume and sales prices, doesn’t it? What’s going on? Figure 5-2 analyzes how much of the $351,741 gross margin gain is attributable to higher sale prices and how much to the higher sales volume.
Suppose you want to increase gross margin $100,000 next year. Assume that your 42.0 percent gross margin ratio on sales remains the same. If sales prices remain the same next year, then your sales volume would have to increase 8.15 percent:
$100,000 gross margin increase goal ÷ $1,226,636 gross margin in 2019 = 8.15% sales volume increase
If your sales volume remains the same next year, then your sales prices on average would have to increase just 3.42 percent:
$100,000 gross margin increase goal ÷ $2,920,562 sales revenue in 2019 = 3.42% sales price increase
In short, a 1 percent sales price increase has more profit impact than a 1 percent sales volume increase.
As the owner of a small business, your job is to judge whether the ratio of each expense to sales revenue is acceptable. Is the expense reasonable in amount? Your salaries, wages, commissions, and benefits expense equals 22.7 percent of sales revenue in 2019 (refer to Figure 5-1). In other words, your employee cost absorbs $22.70 of every $100.00 of sales revenue. This expense ratio is lower than it was last year, which is good, of course. But the fundamental question is whether it should be an even smaller percent of sales. This question strikes at the essence of cost control. It’s not an easy question to answer. But, as they say, that’s why you earn the big bucks — to answer such questions.
It’s tempting to think first of reducing every cost of doing business. It would have been better if your employee cost had been lower — or would it? Could you have gotten by with one less employee? One less employee may have reduced your sales capacity and prevented the increase in sales revenue. In the example, you have ten full-time employees on the payroll both years. For your line of business, the benchmark is $300,000 annual sales per employee. In 2019, your sales per employee is $292,056 (see Figure 5-1 for sales revenue):
$2,920,562 annual sales revenue ÷ 10 employees = $292,056 sales revenue per employee
Summing up, your employee cost looks reasonable for 2019, assuming your sales per employee benchmark is correct. This doesn’t mean that you couldn’t have squeezed some dollars out of this expense during the year. Maybe you could have furloughed employees during the slow time of year. Maybe you could have fired one of your higher-paid employees and replaced him or her with a person willing to work for a lower salary. Maybe you could have cut corners and not have paid overtime rates for some of the hours worked during the busy season. Maybe you could have cut health care and vacation benefits during the year.
Business owners get paid to make tough and sometimes ruthless decisions. This is especially true in the area of cost control. If your sales prices don’t support the level of your costs, what are your options? You can try to get more sales out of your costs. In fact, you did just this with employee costs in 2019 compared with 2018. Your sales revenue per employee increased significantly in 2019. But you may be at the end of the line on this course of action. You may have to hire an additional employee or two if you plan to increase sales next year.
The total of your advertising and sales promotion costs in 2019 is just under 7 percent of sales revenue, which is about the same it was in 2018. As you probably have observed, many retail businesses depend heavily on advertising. Others don’t do more than put a sign on the building and rely on word of mouth. You can advertise and promote sales a thousand different ways (see Book 5 for a lot more on marketing and promotion).
Maybe you give away free calendars. Maybe you can place ads in local newspapers. Maybe you make a donation to your local public radio or television station. Or perhaps you place ads on outdoor billboards or bus benches.
Like other costs of doing business, you need a benchmark or reference point for evaluating advertising and sales promotion costs. For the business example, the ratio is around 7 percent of annual sales. This ratio is in the typical range of the advertising and sales promotion expense of many small businesses. Of course, your business may be different. Retail furniture stores, for example, spend a lot more than 7 percent of sales revenue on advertising. Locally owned office-supply stores, in contrast, spend far less on advertising.
Of course, you can keep an eye on your competitors, but they aren’t likely to tell you which sales promotion techniques are the most effective. You increased your advertising and sales promotion costs more than $30,000 in 2019, which is more than 20 percent over last year (see Figure 5-1). Sales revenue went up by an even larger percent, so the ratio of the expense to sales revenue actually decreased. Nevertheless, you should determine exactly what the extra money was spent on. Perhaps you bought more newspaper ads and doubled the number of flyers distributed during the year.
Depreciation expense is the cost of owning fixed assets. The term fixed assets includes land and buildings, machinery and equipment, furniture and fixtures, vehicles and forklift trucks, tools, and computers. These long-term operating resources aren’t held for sale; they’re used in the day-to-day operations of the business. Except for land, the cost of these long-term operating resources is allocated over the estimated useful lives of the assets. (Land is viewed as a property right that has perpetual life and usefulness, so its cost is not depreciated; the cost stays on the books until the land is disposed of.)
You should understand the following points about the depreciation expense:
The income statement shown in Figure 5-1 includes a separate line for facilities expense. You should definitely limit the number of expense lines in your income statement. But this particular expense deserves separate reporting. Basically, this expense is your cost of physical space — the square footage and shelter you need to carry on operations plus the costs directly associated with using the space. (You may prefer the term occupancy expense instead.)
Most of the specific costs making up facilities expense are fixed commitments for the year. Examples are lease payments, utilities, fire insurance on contents and the building (if owned), general liability insurance premiums, security guards, and so on. You could argue that depreciation on the building (if owned by the business) should be included in facilities expense. However, it’s best to put depreciation in its own expense account.
In the business example portrayed in Figure 5-1, you use the same amount of space both years. In other words, you did not have to expand your square footage for the sales growth in 2019. The relatively modest increase in facilities expense (only 5.2 percent, as shown in Figure 5-1) is due to inflationary cost pressures. Sooner or later, however, continued sales growth will require expansion of your square footage. Indeed, you may have to relocate to get more space.
The cost control question is whether it’s worth your time to investigate these costs item by item. In 2019, these assorted costs represented only 1.5 percent of your annual sales revenue. Most of the costs, probably, are reasonable in amount — so, why spend your valuable time inspecting these costs in detail?
On the other hand, these costs increase $15,594 in 2019 (see Figure 5-1), and this amount is a relatively large percent of your profit for the year:
$15,594 increase in other expenses ÷ $95,651 net income for year = 16.3% of profit for year
Interest expense is a financial cost — the cost of using debt for part of the total capital you use in operating the business. It’s listed below the operating profit line in the income statement (see Figure 5-1). Putting interest expense beneath the operating profit line is standard practice, for good reason. Operating profit (also called operating earnings, or earnings before interest and income tax) is the amount of profit you squeeze out of sales revenue before you consider how your business is financed (where you get your capital) and income tax.
Obviously, interest expense depends on the amount of debt you use and the interest rates on the debt. Figure 5-3 shows the balance sheets of your business at the end of the two most recent years. At the end of 2018, which is the start of 2019, you had $400,000 of interest bearing debt ($100,000 short-term and $300,000 long-term). Early in 2019, you increased your borrowing and ended the year with $600,000 debt ($200,000 short-term and $400,000 long-term). Based on the $600,000 debt level, your interest expense for the year is 8.3 percent.
Because you negotiated the terms of the loans to the business, you should know whether this interest rate is correct. By the way, the interest expense in your income statement may include other costs of borrowing, such as loan origination fees and other special charges in addition to interest. If you have any question about what’s included in interest expense, ask your accountant for clarification.
A small business owner should definitely know the proper sizes of assets and liabilities relative to the sizes of the business’s annual sales revenue and expenses.
Three critical tie-ins between the income statement and balance sheet are the following:
You should instruct your accountant to do these calculations and report these P&L/balance sheet ratios so that you can keep tabs on the sizes of your assets and liabilities.
One additional purpose for comparing your P&L numbers with your balance sheet is to evaluate your profit performance relative to the amount of capital you’re using to make the profit. Your 2019 year-end balance sheet reports that your owners’ equity is $741,780 (see Figure 5-3). This amount includes the capital the owners (you and any other owners) put in the business (invested capital), plus the earnings plowed back into the business (retained earnings). Theoretically, the owners could have invested this $741,780 somewhere else and earned a return on the investment. For 2019, your business earned 12.9 percent return on owners’ equity:
$95,651 net income for 2019 ÷ $741,780 2019 year-end owners’ equity = 12.9% return on owners’ equity capital
Small business owners have a tendency to take cost amounts reported by accountants for granted — as if the amount is the actual, true, and only cost. In contrast, small business owners are pretty shrewd about dealing with other sources of information. When listening to complaints from employees, for example, business owners are generally good at reading between the lines and filling in some aspects that the employee is not revealing. And then there’s the legendary response from a customer who hasn’t paid on time: The check’s in the mail. Business owners know better than to take this comment at face value. Likewise, you should be equally astute in working with the cost amounts reported for expenses.
The cost of goods sold expense is the largest expense of businesses that sell products, typically more than 50 percent of the sales revenue from the goods sold. In the business example, cost of goods sold is 58 percent of sales revenue in the most recent year (refer to Figure 5-1). You would think that the accounting profession would have settled on one uniform method to record cost of goods sold expense. This isn’t the case, however. Furthermore, the federal income tax law permits different cost of goods sold expense methods for determining annual taxable income. A business has to stay with the same method year after year (although a change is permitted in very unusual situations).
Deciding which cost of goods sold expense accounting method to use isn’t the main concern of many small businesses that carry a sizable inventory of products awaiting sale. The more important issues to them are losses from inventory shrinkage and from write-downs of inventory caused by products that they can’t sell at normal prices. These problems are very serious for many small businesses.
Also, at the close of the year, a business should do a lower of cost or market test on its ending inventory of products. Product costs are compared against the current replacement costs of the products and the current market (sales) prices of the products. This is a twofold test of product costs. If replacement costs have dropped or if the products have lost sales value, your accountant should make a year-end adjusting entry to write down your ending inventory to a lower amount, which is below the original costs you paid for the products.
Recording inventory shrinkage expense caused by missing products is cut and dried. You don’t have the products. So, the cost of the products is removed from the asset account — that’s all there is to it. In contrast, writing down the costs of damaged products (that are still salable at some price) and determining replacement and market values for the lower of cost or market test is not so clear-cut.
A business consists of different revenue streams, and some are more profitable than others. It would be very unusual if every different source of sales were equally profitable. A common practice is to divide the business into separate profit centers, so that the profitability of each part of the business can be determined. For example, a car dealership is separated into new car sales, used car sales, service work, and parts sales. Each profit center’s sales revenue may be further subdivided. New vehicle sales can be separated into sedans, pickup trucks, SUVs, and other models. In the business example used in this chapter, you sell products both at retail prices to individual consumers and at wholesale prices to other businesses. Quite clearly, you should separate your two main sources of sales and create a profit center for each.
Determining how to partition a business into profit centers is a management decision. The first question is whether the segregation of sales revenue into distinct profit centers helps you better manage the business. Generally, the answer is yes. The information helps you focus attention and effort on the sources of highest profit to the business. Comparing different profit centers puts the spotlight on sources of sales that don’t generate enough profit, or even may be losing money.
Generally, a business creates a profit center for each major product line and for each location (or territory). There are no hard-and-fast rules, however. At one extreme, each product can be defined as a profit center. As a matter of fact, businesses keep records for every product they sell. Many owners want a very detailed report on sales and cost of goods sold for every product they sell. This report can run many, many pages. A hardware store in Boulder sells more than 100,000 products. Would you really want to print out a report that lists the sales and cost of goods of more than 100,000 lines? The more practical approach is to divide the business into a reasonable number of profit centers and focus your time on the reports for each profit center.
A profit center is a fairly autonomous source of sales of a business, like a tub standing on its own feet. For example, the Boulder hardware store sells outdoor clothing, which is quite distinct from the other products it sells. Does the hardware store make a good profit on its outdoor clothing line of products? The first step is to determine the gross margin for the outdoor clothing department. The cost of goods sold is deducted from sales revenue for the outdoor clothing line of products. Is outdoor clothing a high gross margin source of sales? The owner of the hardware store certainly should know.
The report for a profit center doesn’t stop at the gross profit line. One key purpose of setting up profit centers is, as far as possible, to match direct operating costs against the sales revenue of the profit center. Direct operating costs are those that can be clearly assigned to the sales activity of the profit center. Examples of direct operating costs of a profit center are the following:
Accounting represents more of an art than a science. This concept also holds true with the budgeting process, as it helps to be creative when preparing projections. Before creating your first budget, you should prepare by taking the following four steps:
Delve into your business’s financial history.
To start, you should have a very good understanding of your company’s prior financial and operating results. This history doesn’t stretch back very far when you’re starting out (obviously), but the key concept is that sound information not only should be readily available but it should be clearly understood. There is no point in attempting to prepare a budget if the party completing the work doesn’t understand the financial information.
Although the history of a company may provide a basic foundation on which to develop a budget, it by no means is an accurate predictor of the future.
Involve your key management.
The budgeting process represents a critical function in most companies’ accounting and financial departments — and rightfully so, because these are the people who understand the numbers the best. If you have other managers looking after different departments or sections of your business, be sure to get them involved. Although the financial and accounting types produce the final budget, they rely on data that comes from numerous parties, such as marketing, manufacturing, and sales. Critical business data comes from numerous parties, all of which must be included in the budgeting process to produce the most reliable information possible.
Gather reliable data.
The availability of quality market, operational, and accounting data represents the basis of the budget. A good deal of this data often comes from internal sources. For example, when a sales region is preparing a budget for the upcoming year, the sales manager may survey the direct sales representatives on what they feel their customers will demand as far as products and services in the coming year. With this information, you can determine sales volumes, personnel levels, wages rates, commission plans, and so on.
Although internal information is of value, it represents only half the battle because external information and data is just as critical to accumulate. Having access to quality and reliable external third-party information is absolutely essential to the overall business planning process and the production of reliable forecasts. Market forces and trends may be occurring that can impact your business over the next 24 months but aren’t reflected at all in the previous year’s operating results.
Coordinate the budget timing.
From a timing perspective, most companies tend to start the budgeting process for the next year in the fourth quarter of their current calendar year. This way, they have access to recent financial results on which to support the budgeting process moving forward. The idea is to have a sound budget to base the next year’s operations on.
On the timeline front, the following general rule should be adhered to: The nearer the term covered by the projection means more detailed information and results should be produced. That is, if you’re preparing a budget for the coming fiscal year, then monthly financial statement forecasts are expected (with more detailed support available). Looking two or three years out, you could produce quarterly financial statement projections (with more summarized assumptions used).
The concept of garbage in, garbage out definitely applies to the budgeting process. If you don’t have sound data and information, the output produced will be of little value to the owners. The data and information used to prepare your company’s budgets must be as complete, accurate, reliable, and timely as possible. Though you can’t be 100 percent assured that the data and information accumulated achieves these goals (because, by definition, you’re attempting to predict the future with a projection), proper resources should be dedicated to the process to avoid getting bit by large information black holes.
After you have solid historical data in hand, you’re ready to produce an actual projection model. To help start the process, you can use three simple acronyms as tools to accumulate the necessary information to build the projection model.
Complete, Accurate, Reliable, and Timely (CART) applies to all the data and information you need to prepare for the projection model. It doesn’t matter where the information is coming from or how it’s presented; it just must be complete, accurate, reliable, and timely:
Timely: The information and data accumulated must be done in a timely fashion. It’s not going to do a management team much good if the data and information that is needed is provided six months after the fact. Companies live and die by having access to real-time information on which to make business decisions and change course (and forecasts) if needed.
Don’t be afraid to utilize a Strengths, Weaknesses, Opportunities, and Threats (SWOT) analysis, which is an effective planning and budgeting tool used to keep businesses focused on key issues. The simple SWOT analysis (or matrix) in Figure 5-4 shows you how this process works.
A SWOT analysis is usually broken down into a matrix containing four segments. Two of the segments are geared toward positive attributes, such as your strengths and opportunities, and two are geared toward negative attributes, such as your weaknesses and threats. In addition, the analysis differentiates between internal company source attributes and external, or outside of the company source attributes. Generally, the SWOT analysis is meant to ensure that critical conditions are communicated to management for inclusion in the budget.
As an owner of a business, you must be able to understand the big picture and your company’s key economic drivers in order to prepare proper business plans, strategies, and ultimately, forecasts. The ability to understand and positively affect the key economic drivers of your business and empower the team to execute the business plan represents the end game. Getting lost in the forest of “Why did you spend an extra $500 on the trip to Florida?” is generally not the best use of the owner’s time.
Flash reports are a quick snapshot of critical company operating and financial data, which is then used to support the ongoing operations of the business. All types of flash reports are used in business, and they range from evaluating a book-to-bill ratio on a weekly basis, to reporting daily sales activity during the holiday season, to looking at weekly finished goods inventory levels.
The goal with all flash reports remains the same in that critical business information is delivered to you for review much more frequently. As such, flash reports tend to have the following key attributes present:
Flash reports should act more to “reconfirm” your company’s performance rather than representing a report that offers “original” information. Granted, though a flash report that presents sales volumes for the first two weeks of February compared to the similar two-week period for the prior year is reporting new sales information, the format of the report and the presentation of the information in the report should be consistent. Thus, you should be able to quickly decipher the results and determine whether the company is performing within expectations and what to expect on the bottom line for the entire month.
The best way to dive into preparing a budget, after all the necessary information has been accumulated, is to begin by building a draft of the budget that is more summary in nature and is focused on the financial statement, which is most easily understood and widely used. The reason more summarized budgets are developed at first is to create a general format or framework that captures the basic output desired by the parties using the budget. Offering a summarized visual version of the budget allows for reviews and edits to be incorporated into the forecasting model before too much effort is expended in including detail that may not be needed. Once the desired output reports and data points of the budget are determined, it can be expanded and adjusted to incorporate the correct level of detail.
On the financial statement front, for most companies, the forecasting process tends to starts with producing a projected income statement for three primary reasons.
Note also that most budgets are prepared in a consistent format with that of the current internally produced financial statements and reports utilized by your company. This achieves the dual goal of information conformity (for ease of understanding) and capturing your business’s key economic drivers. To illustrate, Figure 5-5 presents a summarized budget for XYZ Wholesale, Inc., for the coming year.
A budget is shown for the year ending 12/31/20 for XYZ Wholesale, Inc. The basic budget shown in Figure 5-5 is fairly simplistic but also very informative. It captures the macro level economic structure of the company in terms of where it is today and where it expects to be at the end of next year. When reviewing the figure, notice the following key issues:
Information prepared for and delivered to external users (a financing source, taxing authorities, company creditors, and so on) isn’t the same as information prepared for and utilized internally in the company. Not only does this fact apply to historically produced information, but it applies to financial information you forecast as well. The following examples show how a business can basically utilize the same information, but for different objectives:
Drilling down into the detail: When information is delivered to external parties, the level of detail is far less than what is utilized internally on a daily basis. This concept holds true for the budgeting process as well. The level and amount of detail that is at the base of the projection model will often drill down to the core elements of your business.
For example, the summary projected in Figure 5-5 displays corporate overhead expenses as one line item. This one line item could, in fact, be the summation of more than 100 lines of data and capture everything from the cost of personnel in the accounting department to the current year’s advertising budget (for the company). Again, an outside party should not (and does not want to) see that level of detail because it tends to only confuse them and lead to more questions being asked than are needed. However, by being able to drill down into the detail at any given time (and provide real support for financial information presented in the budget), you can kill two birds with one stone. Internally, you have the necessary detail to hold team members responsible for expense and cost control. Externally, you can provide added confidence and creditability to your partners (for example, a financing source) that the business is being tightly managed.
A living budget is based on the idea that in today’s fiercely competitive marketplace, business models change much quicker than they did a decade ago (see Book 1, Chapter 3 for more on business models). Although the budget prepared in the fourth quarter of the previous year looked good, six months later the story may change. Any number of factors, such as losing a key sales rep, having a competitor go out of business, or experiencing a significant increase in the price of raw materials to produce your products, may cause the best prepared budgets to be useless by midyear. So, you may want to keep in mind the following terminology when preparing budgets to ensure that the process doesn’t become stagnant during the year:
What ifs: A what-if analysis is just as it sounds. That is, if this happens to my business or in the market, what will be the impact on my business? If I can land this new account, what additional costs will I need to incur and when to support the account? Utilizing what-if budgeting techniques is a highly effective business-management strategy that you can apply to all levels of the budgeting process.
Figure 5-6 presents a company’s original budget alongside two other scenarios, one of which is a low-case scenario and the other a best-case scenario. By completing what-if budgeting, XYZ Wholesale, Inc., has provided itself with a better understanding of what business decisions need to be made in case either the low-case or high-case scenarios are realized.
Recasts: When you hear the term recast, it generally means a company is going to update its original budgets or forecasts during some point of the year to recast the information through the end of the year. Companies are constantly under pressure to provide updated information on how they think the year will turn out. Everyone wants updated information, so at the end of select periods (for example, month end or quarter end), the actual results for the company through that period are presented with recast information for the remainder of the year to present recast operating results for the entire year (a combination of actual results and updated projected results). Having access to this type of information can greatly assist business owners so that they can properly direct the company and adapt to changing conditions, not to mention provide timely updates to key external parties (on how the company is progressing).
Nobody likes surprises (more exactly, nobody likes bad ones), and nothing will get an external party, such as a bank or investor, more fired up than a business owner not being able to deliver information on the company’s performance.
Rolling forecasts: Rolling forecasts are similar to preparing recast financial results with the exception that the rolling forecast is always looking out over a period of time (for example, the next 12 months) from the most recent period end. For example, if a company has a fiscal year end of 12/31/18 and has prepared a budget for the fiscal year end 12/31/19, an updated rolling 12-month forecast may be prepared for the period of 4/1/19 through 3/31/20 once the financial results are known for the first quarter ending 3/31/19. This way, you always have 12 months of projections available to work with.
Rolling forecasts tend to be utilized in companies operating in highly fluid or uncertain times that need to always look out 12 months. However, more and more companies are utilizing rolling forecasts to better prepare for future uncertainties.
The real key to a budget lies in you, as the business owner, being able to understand the information and then act on it. This section reviews some of the most frequently relied upon outcomes from the budgeting process.
The variance report is nothing more than taking a look at the budget and comparing it to actual results for a period of time. Figure 5-7 presents a variance report for XYZ Wholesale, Inc., and compares the budgeted results for the quarter ending 3/31/19 against the company’s actual results.
Of keen importance is the increase in the company’s gross margin, which helped the company break even during the quarter compared to a projected loss of $174,000. Obviously, you need to understand what caused the gross margin to increase. Was it from higher sales prices or lower product costs? Of more importance, however, is that you need to act on the information. If the market is supporting higher prices in general, then you may want to revisit pricing strategies for the second through fourth quarters to take advantage of conditions that may allow the company to further improve its annual financial performance.
Another use of the budget is to support the implementation of specific plans and action steps. For example, if your second dry cleaning store is set to open in the third quarter of the year, then you need to secure the staff to support this store in the middle of the second quarter and then train them to ensure that they’re ready when the new store opens. Yes, all this data should have been accumulated and incorporated into the original budget prepared for the new store, but the idea is to turn the budget into a proactive working document (easily accessible for reference) rather than a one-time effort left on the shelf to die.
When preparing budgets, you must remember that you can use the base data and information accumulated to support other business planning and management functions as well. For example, you can use a well-developed budget to not only prepare forecast financial statements but to prepare the estimated taxable income or loss of a company. For some companies, the difference between book and tax income is small. However for others, the difference can be significant, as the following example illustrates.
A large provider of personnel services elects to implement a strategy to self-fund its workers’ compensation insurance costs. The preliminary analysis indicates that an average annual savings of 30 percent or more can be achieved if properly managed. At the end of the third year of the self-funded workers’ compensation insurance program, the company had established an accrued liability for more than $1 million to account for potential future claims (to properly reflect the fact that claims made under the program through the end of the year would eventually cost the company $1 million). For book purposes, the $1 million represented an expense recorded in the financial statements, which resulted in the company producing net income of roughly zero dollars. For tax purposes, the IRS would not allow the expense until the claims were actually paid, so the taxable income of the company was $1 million (resulting in a tax liability of $400,000). If the company didn’t properly budget for this business event, it may have been in for a rude surprise because, per the books, the company made nothing, yet owed $400,000 in taxes. You can be assured that this is not the type of surprise an executive business owner wants to experience on short notice.
Budgets also play a critical role in developing a business plan (see Chapter 1 in Book 2), especially when a company is attempting to secure capital to execute its strategy. Financial forecasts act as a visual or numeric display of your vision and outlook of where the company is headed. Effectively presented, financial forecasts can enhance the creditability of the management team and basis of the business plan, which, in turn, provides for fewer barriers to acceptance from potential funding sources. In effect, the financial forecasts must clearly present the “story” of the business.
You can also use the budget for other purposes as well, such as preparing information for specialized needs from external parties to training a new store manager on the basic economics of how his store should perform to ensuring that the vision of the company is properly aligned with your direct actions.