Budgeting and profit planning

Budgeting* by Gareth Cotten

You’ve set your goals now it’s time to move on to the actual nuts and bolts of your financial wellbeing – budgeting and profit planning. To do this properly you have to understand all areas of your business, and work with these parameters to ensure the sustainability and success of your enterprise.

Budgeting

A budget is essentially a forecast of what the business position and performance will be at/over a specific period of time. For established businesses, there would be some form of history to look back over and base a budget on; but budgeting for start-ups is much more of a thumb-suck. While many people will tell you to always start with projecting your sales, I’d highly recommend starting with your expenses, as these are generally easier to gauge.

Get to grips with your expenses

Reduced to their simplest form, you’ll have two distinct types of expenses: fixed and variable. A fixed expense (also called an overhead) is one that is incurred regardless of what output or activity occurs. These would be things like rental, basic salaries, most types of insurance, etc. If you were to sit around and twiddle your thumbs all day, these items would still need to get paid. Variable expenses, however, are fluctuating in nature. These would generally increase with increased outputs or sales of goods and/or services. Examples here could be telephone expenses, sales commission, fuel, and material costs. If you were producing more, these costs would go up on a similar trajectory.

Now, when drawing up a budget for the future, you should be able to put figures to most of your expenses. You know what most of your fixed expenses are going to be. Speak to suppliers, and find out what their pricing structures are. What are their projected price increases?  Do they give discounts for volume purchases? These answers will help you narrow down what it will cost to produce or provide the goods or services that you do. Record your fixed costs, and then explore a couple of scenarios for variable ones – these will be tied to your sales and revenue forecasts.

Guess your revenue

Unless you have guaranteed orders as far ahead as you can see, projecting sales and revenue is always more of a blind man’s guess than estimating your expenses. The smart move is to work up a couple of permutations of how things could pan out, and examine each of these.

A start would be to project a worst-case scenario, a best-case scenario, and then a likely or more realistic scenario somewhere in the middle. Remember to take any industry-specific, macro, or micro factors into account (seasonality of demand, effect of potential interest rate changes, results from marketing campaigns, etc.) Multiplying your projected sales numbers by selling price (more on your pricing in a bit) will give you your revenue number. Be sure to then tie these sales figures/unit numbers to your variable expenses as well, to give you as realistic a view as possible. Remember that in a sustainable business your revenue must exceed your expenses.

Price for profit

Right, now the magic question is: How much do I charge? While I couldn’t possibly answer this comprehensively (every situation is different), there are some basic principles.

The first is to always ensure that your sales price covers your variable costs for that unit, as well as its fixed cost allocation. Take Sandy as an example. Sandy produces hand-woven baskets from recycled metal and weaves them herself. She doesn’t employ anyone, and has the capacity to make 50 baskets a month. Her fixed costs are rental for her workspace of R3000 a month, and R500 a month for computer and ADSL rental.  She needs R35 worth of metal for each basket, and R2 for industrial glue and clips to hold each basket together – these are her variable costs. This means that each basket has R37 of variable costs.

The fixed cost allocation is calculated by spreading her fixed costs over the amount of products made. If she makes all 50 a month that she can, her fixed costs of R3500 a month are split between 50 baskets – coming to R70 a basket. Sandy works a standard 160 hours a month, and would want to be paid R8000 a month if she worked anywhere else. This cost also needs to be factored into the baskets, as she is giving up her potential earnings elsewhere. This means an extra R160 a basket. We now have a cost per basket of R267 (R37 + R70 + R160).

So, this means that she should sell her baskets for R267, right? While she could sell them at that price, it wouldn’t be a smart move, as all that she would be doing is compensating herself for her time. As a business owner, you want more than that – you want to create wealth, which comes from profit. So, the lesson (which too few business owners abide by) is to always factor profit into your pricing as well – not just expenses and liveable salaries. In the case of Sandy, if she were to sell her baskets at, say, R350, there would then be an element of profit being generated. Theoretically, she could employ someone else to make the baskets, pay them the equivalent salary of R8000, and still make money. Another lesson: Always try and generate wealth using OPT – other people’s time!

While this has only been a very light brush over some aspects of financial management, applying the principles of effective goal-setting, budgeting, and profit planning correctly will bring you exponentially closer to your overall business goals. Here’s to your success!

This article first appeared in Your Business Magazine.

* Gareth Cotten is an experienced financial consultant and is the course convener for the part-time University of Cape Town Basics of Financial Management short course, presented online throughout South Africa. Contact 021 447 7565 or visit: www.GetSmarter.co.za for more information.