Many business owners think of a budget as a limitation. Instead, they should think of it as a set of guidelines.
The purpose of a budget is to identify the points at which you need to implement various contingency plans. And the process isn't necessarily restrictive; a budget prepares you to react not only when something bad happens, but also when something good does. If you find that a competing company is unexpectedly for sale, for instance, can you adjust your budget in order to buy them out?
You Can't Do the Math Without the Numbers
For a small business, creating a budget shouldn't take more than a couple of hours, and the benefits are tremendous. If you're doing it right, it forces you to consider the financial metrics that are actually driving your organization. Where is your company, and what can it achieve in the next year? Or three years? Or five years? What steps do you need to take during the next several months to get started toward those goals?
Once you've set your annual budget, you need to reevaluate at least once during the year to determine where you are relative to your projections. That simple process can make your company proactive rather than reactive.
Which Type of Budget Is Best for You?
There are different budget methodologies to choose from, depending on the type of business you have. Let's look at two of the most common.
Zero-based budget: As the name suggests, a zero-based budget involves starting from scratch. That makes it ideal for a startup. Basically, you sit down and figure out everything you're liable to spend money on: salaries and benefits, office space and infrastructure, hardware and software, attorney's fees and airline tickets, etc. Unless you're getting a good or a service for free, you need to account for it.
No matter how thorough you think you've been, you will inevitably discover that you've missed something. As a startup, the last thing you want is to leave yourself too tight on cash. If things don't go exactly the way you projected they would, either in your business plan or your budget, you'll need some leeway. Depending on the industry, you could need anywhere from 10 percent (for companies that can be more reactive) to a three to six months cushion (for companies with long revenue cycles or fixed expenses that are not easy to reduce).
In the early phase of a startup, it's critical to monitor how you're performing against your budget. I recommend reviewing your budget monthly, at a minimum. If cash is a concern because your capital is light, review your budget weekly.
Creating a budget and then monitoring it can help you to mitigate problems that can arise from cash flow issues. In some cases, a simple course correction is all you need — such as changing the way you're collecting cash and receivables. In other cases, you may want to revisit your commercial banking relationship or meet with your venture capital investors.
Run-rate budget: This is a more expedient approach to budgeting for existing companies that have already established a baseline. If you know you've spent X on a particular HR function in the past, you probably won't have to deviate too much from that. For most budget items, adding 3% for inflation should put you about where you need to be.
Of course, things can still go awry, even at successful, long-established companies. It’s important to keep a close watch on revenue. If your revenue is lower than you anticipated, you may need to adjust the amount you have budgeted to spend.
Identifying a Problem Is the First Step Toward Solving It
Unlike fine wine, business problems don't get better with age. The sooner you can identify them, the better your odds of overcoming them. Building a budget and measuring your performance against it helps you do that.