Annual Budgeting Guide

The year's end is on the horizon, so it's time to start figuring out next year's budget. However, if you've never developed a business budget before, or your business has gotten significantly more complicated than last year, you might be unsure where to begin. To help you get started, we've compiled a quick guide on developing an annual budget.

The Goals of Your Annual Budget

Before we get into the steps on how to develop an annual budget, let's take a moment to talk about the reason why creating a yearly budget is important. 

• Avoid running out of money. This first reason might be the most obvious because you want to create a budget to avoid running out of cash. Besides creating a plan to spend within your means, your budget tracks your spending, so you can take action if spending veers off course. This is one of the primary purposes of your budgeting process – but it's not the only one.
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• Get visibility into where your business is headed. An annual budget is a planning exercise. To put together your budget for the year, you have to figure out where you expect to be as time progresses. Besides avoiding overdrafts, this means planning for future growth or business changes.
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• Identify what's driving your business. To effectively plan for the future, you need to understand what drives your outcomes. Working on your budget should prompt you to examine your business indicators and how they affect results. Examples of revenue drivers might be website traffic or sales leads – as they go up, your revenue might go up along with them. 
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• Determine what you can adjust to get results. When you've determined your business drivers, you can apply that knowledge to your budget to develop different scenarios based on those variables. How would things change if you added spending to an area that boosts a key driver? How would they change if you had to reduce spending instead?

Besides avoiding a cash crunch, your budget is essential for answering these questions and helping you better understand your business.

What to Think About Before Planning Your Budget

Since your budget is for the entire year, you'll need to forecast how your business will perform for the next twelve months. That's why when you sit down to start your annual budgeting process, it pays to carefully think through your plans for the upcoming year and how they might affect your income and spending.

• Consider upcoming business changes. While life sometimes throws you a curveball, odds are you have a pretty good idea of what you intend to do over the next year. Are you planning to launch a new product or offering? Hire more? Move to a new office or even go fully remote? All these things will impact your budget, whether it's anticipated income from a launch, expenses from new headcount, or changed rental status. Your annual budget plan should reflect your expectations for the impact.
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• Determine profitability and margin goals. If your company is bringing in revenue or you plan to start making revenue this year, you probably have targets you hope to meet for your margins. Likewise, if you're hoping to become profitable, you'll need to maintain a certain margin to stay that way. Keeping these margin needs in mind as you work on your annual budget lets you work backward from those goals to see what you need to do to achieve them.
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• Figure out fundraising plans. Whether raising a round or taking out a business loan, fundraising expectations will significantly impact your available resources. When preparing your budget, you'll want to consider how to allocate the new funds and your spending if fundraising takes longer than planned.

How to Develop Your Annual Budget

When you start developing your company's budget, there are two parts to consider: inflows (the amount of money you expect to bring in) and outflows (the amount of money you wish to spend, whether it's creating the product or day-to-day operations). So the result might look something like this:

Let's take a deeper look at what each section means.

Revenue. This is your company's income. Usually, this means money from sales, though if you have income from other sources (rent from property your company owns, licensing royalties, etc.), that money will be included here also. 

You should include your annual recurring revenue (ARR) if your business sells subscriptions or services. This is the amount of money you receive from your subscription contracts divided by the length of the service contract. For example, if a client buys a 3-year subscription from you for $6000, your ARR for that client would be $2000 ($6000 divided by three years equals $2000 per year). While this does not directly go into your financial statements, it's a great KPI to keep an eye on if you're a Software as a Service (Saas) business. 

Cost of Revenue / Cost of Goods Sold (COGS). This accounts for how much you spent to create your product or service. For companies that sell physical products, raw materials and labor costs are considered part of COGS; for companies that sell software or services, COGS include any costs directly associated with providing the software or services to your clients, such as the cost of hosting servers. (Note that promotion costs like sales and marketing are not included in COGS – these will be accounted for elsewhere.)

Gross Profit. This is the amount you make in profit from your sales before any other costs or expenses are added. To calculate gross profit, subtract your COGS from your revenue. The amount left over is your gross profit.

While your actual profits will be lower due to additional costs like operating expenses and taxes, gross profits help determine how efficiently you create your product. Therefore, if your gross profits are lacking, it's a sign that you should investigate ways to lower your COGS or increase your revenue.

Payroll Operating Expenses. This category covers any expenses related to paying your employees. Besides just salaries, this includes health insurance, paid time off (PTO), payroll taxes, and the costs of any other benefits you offer your employees.

Non-Payroll Operating Expenses. Any money you usually spend running your business that isn't related to employee compensation is listed under this category. This includes rent and utilities to marketing, and research and design costs.

Operating Income/Loss. This is one of the most critical lines on your budget that tells you if your normal business operations are making or losing money. To get this number, subtract your total operating expenses (payroll + non-payroll) from your gross profit. If the number is positive, your business is generating income overall. If the number is negative, then you're operating at a loss. 

Most startups aren't profitable until after several years, so an operating loss here won't be a surprise. However, this number is valuable because it allows you to understand your company's current operations and track if it's following your plan. 

Net Income/Loss. After all, expenses have been subtracted from your gross profits; this is your total income or loss. If you don't have additional costs outside your operating and capital expenses, this might be the same as your operating income/loss. However, if you do (for example, if you owe state franchise taxes), your net income will be your working income minus those remaining expenses.

Note that this is not necessarily your "cash burn" because the financial budget, especially if your books are done on an accrual basis, does not reflect the exact inflow and outflow of cash. For example, the timing around when your customers pay you and when you pay rent can all contribute to your actual cash burn. That's one of the reasons why annual prepayments can be so helpful for startup cash flows. 

Need more clarification on how accrual books work? Get the details on cash vs. accrual accounting.  ‍

How to Obtain the Numbers for Your Budget 

Now that you have the information needed to outline your budget, it's time to figure out the numbers required to plug into your budget outline. You get these numbers from your financial statement and through some budget forecasting. 

Financial Statements‍

Your business's financial statements are your starting point to get the data you need to build your budget. Each statement provides different helpful information:

• Your balance sheet tells you the state of your business at a specific point in time. It lists how much your company currently owns in assets and your current liabilities (money you owe for credit card payments, outstanding invoices to vendors, etc.). 
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• Your Profit & Loss (P&L) statement, also called your income statement, shows you how much your business brought in and spent during a specific period. It helps examine your business's trends, which can help you anticipate what might happen next.
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• Your cash flow statement shows the company's cash inflows and outflows. This is useful for determining your cash income and examining your current spending patterns.

Budget Forecasting‍

When it comes to budget forecasting, it's rare for anyone to get it 100% right. So you can take steps to make an especially-educated guess. How? 

• Use the best data you have available. Use your financial statements as discussed above, and if you have any historical data available, use that as a source of possible trends. If you don't have any historical data, that's ok too – everyone has to start somewhere, and next year you'll have more data to review. 
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• Examine trends, and think about what's changing (or not). Looking at the data available from your financial statements and any other sources, you may see trends emerge – maybe you've been steadily increasing sales at a certain pace, or your expenses in a specific area have been consistent. Once you have a trend, the next thing to ask yourself is if there's any reason to think it will change. If there isn't, for example, if you aren't planning to hire more sales reps or you don't expect to change your spending in that area, then you can reasonably assume your numbers will remain the same or similar.
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• Use your trends to estimate the effect of change. If planning significant changes, you can use the trend data to extrapolate the impact. For example, if you have two sales reps and make an average of 10 sales per month, you might estimate that hiring a third rep will increase sales to 15 per month.

Unsure how to develop your annual budget? We can help.‍

Annual budgeting is a complex task, even for experienced business owners. Expert guidance can significantly affect how effective your budget will be and how quickly it comes together. If you don't have a background in finance, it's essential to get help from someone who does.

Pilot offers outsourced CFO services, providing your company access to an experienced CFO when needed. Working with Pilot CFO Services is a cost-effective way to get expert input on constructing an annual budget that will set your company up for success. Learn how to make financial decisions confidently with Pilot.