Last time we discussed the thorny and vital task of projecting revenues for your business. This is our third and final part of the three part series considering budgeting, and here we will concentrate on the other side of the equation – the expenses.
There are two broad categories of expense:
• Direct.
• Indirect.
And it’s important we distinguish between the two as they have different behavior patterns.
Direct costs tend to vary proportionately with revenue while indirect costs do not.
Examples of direct costs would be:
• Labor.
• Material.
• Other direct inputs such as subcontractors, transportation and equipment usage.
Examples of indirect costs are:
• Advertising.
• Rent.
• Office management.
• Utilities.
• Insurance.
• Interest expense.
Indirect costs can be further subdivided into:
• Controllable Costs ( such as advertising, meals and entertainment, use of professional help).
• Uncontrollable costs (such as rent, utilities, insurance, office management expense etc.).
In the direct cost budgeting, we can use known industry ratios.
In the indirect cost budgeting we have to use a combination of knowledge of comparable rates and known amounts such as rent, insurance, utilities, etc.
A concept known as “zero based budgeting” should be used wherever possible. While it is tempting for budgeters to use known amounts based on past performance and/or industry standards, it is preferable to use zero based budgeting.
This is the method by which the budgeter assumes a cost center starts at zero and each expense is justified and built up from scratch.
For example, let’s say the budgeter wants to project trucking and automobile expenses for a delivery company. There are many ways:
The easy way is to assume the expense will be like last year and project accordingly. Let’s say last year’s actual cost for this cost center is say $90,000, which averages to $7,500 a month. The budgeter can assume this number for the next 12 months without critically reviewing this expense.
By far the better approach is to build up a number based on:
• Number and type of vehicles.
• Number of daily trips and miles per day.
• Figuring out likely consumption of gas based on this information.
• Using maintenance records, try to project likely maintenance costs.
• Try to model the changes in usage by time of year or season.
In other words, try to figure this amount from zero.
The advantage of this method is that no numbers are taken for granted, and it forces the budgeter to think it all through by calculating each expense or cost head using assumptions and basic logic.
It also gives him/her the chance to really think about the contribution of each expense to the bottom line and to consider whether a change, either spending more or cutting back, would help the business.
Just as revenue projection is hard and often educated guesswork, expense projections are equally difficult, but at least they can “hang off” an assumed revenue stream and this gives the budgeter a much better chance of arriving at a good number for each expense.
Once done, we would then look at the two projected streams, revenue and expense and ask ourselves:
“Is the net of these two enough reward for my risk?”
If the answer is clearly “yes” then we have the beginnings of a viable business model.
If “no,” the options could be to:
• Change the business model (double the amount of seating, change the menu, up the advertising budget to try to capture more of the market).
• Change assumptions (tweak the numbers).
• Essentially walk away (hard to do when there is emotional investment).
Arriving at a viable budget is just the start.
Using the budget: Tracking, monitoring, adjusting
Tracking your actual income against this budget is equally as important.
It forces the entrepreneur to address shortfalls, overages and other marked variances, and this can bring about changes in business practice and cause that person to rethink his/her budget assumptions and structure.
Spending on controllable costs can be cut back or increased in conjunction with the actual revenue stream. It is OK to change a budget once certain facts present themselves – in fact this should happen.
The benefits and rewards of the budgeting process are many. They should form a critical role in helping the person more intelligently manage his/her business. An invaluable tool, and not just for profit oriented enterprises — it’s for every enterprise — profit and non-profit.
The savvy business person would set the budget so the revenues have a measure of “reach” built into them. We want to try harder to reach our goals and not get them handed to us. This keeps us striving harder to excel and put those wolves at the door and naysayers well into our rear view mirror on our way to a successful business venture.
Neville Stein is a partner with Hancock Askew & Co., LLP. He can be reached at 912-234-8243 or nstein@hancockaskew.com.