A comprehensive, well-constructed budget is essential for effectively managing your business. Putting a good budget together, however, can be easier said than done – especially for founders or business owners without a finance background. Here’s what to keep in mind as you work on your budget, and what to do with it once it’s done.
When we say you need a “well-constructed budget,” what does that actually mean, and how do you know if you have one or not? The best way to assess your budget is actually not how it’s set up, but rather what it can do for you.
The most obvious purpose of a business budget is to avoid running out of cash, but your budget can actually do much more than just help ensure you stay afloat. While it’s obviously important to determine and plan around how much money you expect to bring in, a good budget is one that also:
Provides visibility into the future. Your budget should give you an accurate look at where your finances are going, including how much income you expect to make, how much you expect to spend, and where your expenses will be allocated.
Gives you the insight to make concrete business decisions. The visibility you gain from your budget should be detailed enough to be actionable. For example, your budget should provide what you need to make decisions around when and where to hire.
Helps you quickly course-correct when needed. As a tool for tracking your financial performance, your budget should reflect the factors that shape your outcomes, and indicate what levers you can pull to adjust your trajectory if things aren’t going to plan.
As you work through your budget, it can be helpful to approach it through a framework like this one:
Identify the key drivers of your business. What has the biggest impact on your business performance? For revenue, this might be something like website traffic, sales leads, or sales quota attainment. For costs, this could include things like resource usage per customer (for example, AWS bandwidth), internal efficiency, or suppliers.
Understand your key expected changes. Chances are, your business isn’t going to stay the same for the next twelve months. Identify and understand the most significant changes you’ll be making over the year, from adding new hires to renegotiating supplier contracts.
Use your best inputs. Building a budget means making estimates about the future. However, it’s hard to perfectly predict what will happen with your business, especially at a high-growth startup. What you can do is make sure that the numbers you’re inputting into your budget are the best you have, based on the information available. Often this means using historical data (which is another reason having accurate financial records is vital).
For example, if your margins were 70% the year before and your cost structure hasn’t changed, it’s reasonable to expect that 70% to stay the same in the future. Another example would be if you were seeing a 10% increase each month in website visitors, roughly the same conversion rate, and a 2% increase in average purchase size. If that trend has been consistent in your historical data, you could use it to make a reasonably realistic revenue forecast.
The main components of your business budget will include projections for a number of important elements from your financial statements.
Revenue. This is your income from normal business operations. Generally this means the money you brought in from sales, though if you have other sources of income they are included as well.
COGS. The Cost of Goods Sold (COGS) is how much it cost to create your product or service. This includes labor, and material costs if you have a physical product. COGS does not include indirect costs like sales, marketing, or distribution costs – those are covered elsewhere.
Gross Profit. This is the amount of money you actually make from your sales, which you calculate by subtracting your COGS from your revenue. This is useful for considering how efficient you are in creating your product. Note that this isn’t your actual profits, however, since you’ll have additional expenses that weren’t covered in COGS.
Gross profit is also not the same as gross profit margin, though the terms are sometimes used interchangeably. Your gross profit margin is calculated by subtracting COGS from revenue, then dividing the outcome by revenue again. This will give you a percentage, which is your gross profit margin.
Opex. Your operating expenses (opex) are the day-to-day costs of running your business. These can generally be divided into two categories: headcount and non-headcount.
Capex. Your capital expenses (capex) are your costs for acquiring assets. This is different from acquiring things like materials for manufacturing or inventory to sell. Capex purchases are investments in assets that will provide value to the business.
For example, renting an office building for your company is considered opex: your rent is a cost related to running your business. Buying an office building for your company is considered capex: the building increases the value of the company’s assets, and buying it is an investment in the company’s future.
Capex applies to both physical items (i.e. new equipment), and IP (i.e. buying the rights to something).
Net income. Once all your expenses have been factored in, your net income is how much money your business actually makes. To get this number, first subtract your COGS, opex, and capex from your revenue. Then, subtract any taxes from that number to get your net income amount.
So now that we know what to think about when working on your budget, and what components will go into it, how do all these pieces fit into a usable whole? Let’s take a look at an example: a six-month budget for SampleCo.
If we look closely, this budget tells us several things about SampleCo’s business.
Based on what we see in the budget, there are also several areas SampleCo may want to investigate further:
Your budget can be a valuable tool to help manage your business, and gain insights into your financial health. Familiarize yourself with the key components and drivers of your business’s finances – or get an expert to do it for you.