“I know that my company is doing OK,” the old joke goes. “I still have checks in my checkbook.” Many small businesses run on a version of checkbook accounting, where anything that isn’t paid out at the end of the month becomes the owner’s income.
These small entrepreneurs usually know the daily (or even hourly) receipts of their business. They know exactly how much they have to take in to pay all of the bills. They can probably tell you off the top of their heads the margins on each item they sell, how much is in inventory, and the number of orders they received from their best customers.
When your business is small enough to keep the critical financial measures in your head, do you really need to invest the time and energy to prepare a written budget? After all, it probably is just going to be a regurgitation of last year’s numbers, perhaps with a tweak reflecting your plan to generate some additional revenue in the coming year.
Budgets are a major part of the annual process in large corporations. Legions of financial experts project market trends, currency fluctuations and competitive product introductions. All that means little to an owner who is principally concerned about the next sale. Budgeting may seem a waste of time that could better be spent developing a new customer.
But budgets are important, even if they are merely a retelling of the prior year’s results. They provide a benchmark for measuring ongoing results, a snapshot of progress towards you goals, and a diagnostic tool to help determine what needs changing in order to increase profits.
Making your budget useful is less about the numbers than it is about the percentages. Every bookkeeping program, from QuickBooks to the most sophisticated financial accounting system, allows you to print reports in common size, that is, with each line item calculated as a percentage of sales. Common sizing is a tool that is largely neglected in managing a small business, but it is one of the easiest and most effective devices for tracking your results.
Let’s say your business did $756,349 in gross revenue in 2012, and your shipping costs were $61, 822. This year you brought in $822,947, and your shipping costs were $69,539. Is an increase in $7,717 in shipping expense appropriate for an additional $66,598 in business? Perhaps, but if I told you your cost to ship had gone from 8.17% of sales to 8.45% of sales, you would know in a moment that you are less profitable, at least after paying for shipping.
Employee salaries, utilities, benefits, and transportation costs seem to rise inexorably. Managing the budget doesn’t mean holding them to a number, it requires holding them to a percentage of sales.
Try this exercise, called The Power of One. Start a spreadsheet with your prior year’s revenues, cost of goods (gross profit), and overhead (G&A) expenses. Now, using those prior year’s numbers, increase the price of your product by 1%. Then increase the volume of sales by 1%. Reduce the cost of goods by 1%. Finally, reduce your overhead by 1%. If you have a 30% gross margin and a 10% pretax profit, the net impact of these small changes will add up to about a 20% increase in your profits!
If you’d like a copy of a spreadsheet to make this exercise easy, just email me at email@example.com.
Percentages are easily understood, and a quick way to know whether you are on track. If you aren’t, it’s simple to determine what needs to change. In order to get those percentages however, you need to start with a budget.
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