In the business finance world, budgets get a bad rep. And I’m not talking about Joan Jett’s “Bad Reputation,” which is undeniably cool. I’m talking about please-don’t-make-me-deal-with-this-awfulness bad reputation.
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While many people think of budgets as the ultimate spending jail, budgets are actually an amazing tool for managing your business finances.
An operating budget helps you strategize for a profitable business and allows you to plan for low earning or high spending months. A budget also guides your spending decisions and motivates you to stay on track with your revenue goals.
Ready to make your own? Here’s my step-by-step guide to creating an operating budget for your small business:
Step 1: Make a sales budget
The first step in creating your operating budget is to make a sales budget. A sales budget is a monthly projection of how many products and services you will sell and how much revenue you’ll earn. Projecting your sales for each month allows you to plan for seasonal changes in your income and adjust your spending accordingly.
Before you project your sales, list all the products or services your business sells and their prices. You don’t need to account for every variation of your products, like size or colors, but you do need an accurate list of your products and services with their price points.
Next, review your previous year’s sales data. Budgets are hypothetical documents. There’s no way you can be 100% sure they’ll pan out the way you’ve predicted. BUT you can improve their potential accuracy by looking at your past financial data and using that information as a starting point.
With your old financial statements in hand, for each product and service project how many units you plan to sell each month. If you work on an hourly rate, one hour equals one unit.
When projecting your sales consider:
- Your current monthly sales. This can include how many ongoing clients you have or returning customers.
- Seasonality of your products and services. When do you have more clients or customers? When do you have less? What are your lowest and highest earning months?
- Product or service launches. Are you planning on launching a new product or service this year? Or planning a relaunch of an existing product or service?
- Marketing campaigns. When will you need to make a big splash with marketing? Are there holidays or events that will impact your sales?
Here’s an example of how this would work for a social media manager:
In this example, our social media manager will be selling a lot of yearly planners in the first two months of the year and then the sales will peter out. They then plan to acquire two new clients right when their planner sales drop in order to substitute the income.
One of the bonuses of making a sales budget is that it doubles as a sales plan. Knowing your sales goals ahead of time means you can assess your progress and adjust your strategy.
Step 2: Budget your costs
Now that you’ve created a sales budget for the year, the next step is to budget your costs. Your costs are the direct expenses related to selling your products or services. Direct costs, also known as costs of goods sold, are:
- Cost of the materials you use to produce your product
- Cost of labor, or the work that you outsource that goes into producing a product
- Cost of labor to provide a service
- Cost of merchandise you resell
In other words, these are necessary costs that you must pay to sell your product or service. Operating, or overhead expenses, are not included in your costs. These costs aren’t directly related to your offerings but do keep your business functioning, like keeping the lights on in your workshop.
Before budgeting your costs for the year, go back to your list of products and services and list all the direct costs associated with each item. Then total your direct costs for each product or service.
Refer back to your sales budget. You’ve already projected how many units you plan to sell every month. All you have to do now is multiply your projected sales by their costs.
Here’s how it looks for our social media manager:
We can see that their costs increase and decrease related to how many workbooks and planners they sell.
Step 3: Budget your operating expenses
Now it’s time to tackle your operating expenses. This is definitely a step where you’ll want to have your past financial data handy, like your previous year’s Profit & Loss report and budgets.
Before starting your budget, make a list of all of your expense categories. You can use last year’s Profit & Loss report as a guide, or you can group your expenses into broad categories.
Now, you’ll identify your fixed expenses and variable expenses for each expense category.
Fixed expenses are expenses that you pay the same amount for every month or year. Examples of fixed expenses are:
- Software subscriptions
- Recurring website expenses
- Salaries (that don’t vary)
- License and permit renewals
- Insurance costs
Variable expenses are expenses that vary from month to month. These can vary based on seasonality and your business activities. Examples of variable expenses are:
- Marketing costs
- One-time software purchases
- Wages (especially for hourly workers)
- Postage and shipping costs
- Short-term contractors
For your fixed expenses, add up the recurring costs for each expense category per month. If you have annual fixed expenses, include that expense in the month that you pay it.
For variable expenses, estimate how much you spend per month. This is where your financial data comes in handy. You can easily see the average that you spent on variable expenses as well as spikes in spending.
When estimating your variable expenses, refer back to your sales budget and your business activities. If you plan to run a holiday marketing campaign, you’ll probably spend more on marketing that month. Also consider if you’ll be hiring anyone throughout the year, even on a short-term basis.
Let’s look at our social media manager’s budget:
In our example, the manager has much higher advertising expenses in January and February because they are running ad campaigns for their planner. Then in March, they have a one-time recurring expense to renew their business license. They also have a consistent, ongoing budget for office expenses.
Step 4: Account for unexpected expenses
Woohoo! Your budget is donezo, right?! Errrrrr… not quite.
While you’ve done your best to accurately project your expenses, you will likely have some unpredictable expenses throughout the year. Before we finalize your budget, we need to add a line for Unexpected Expenses.
There are two ways to approach unexpected expenses. First, you can set aside an annual dollar amount for what you think you’ll rack up in unexpected expenses. Then divide this annual amount by 12 and add it to each month.
For example, if you plan for $5,000 in unexpected expenses for the year, that would equal roughly $416 a month.
The second way is to increase your monthly expenses by a percentage that pads your budget for unexpected expenses. For example, if you predict that every month you’ll have 10% more in unexpected expenses, you would add that number on top of your monthly expenses.
Our social media manager has $899 in expenses for January and expects an additional 10% in unexpected expenses. The math is:
$899 x 0.10 = $89.90
$899 + $89.90 = $988.90 in monthly expenses
I recommend you choose a method that is intuitive to you and how you think about your money.
How do you actually decide how much you’ll pay in unexpected expenses? By using your previous year’s data! If you made a budget last year, compare your budget to your actual expenses and see if you went over and by how much. The difference becomes your padding.
If you didn’t make a budget last year, look at your current budget and compare it to your previous year’s data. Are you over or under your budget? If you’re over budget, the difference is your padding.
If you didn’t go over, then congrats—you’re a budgeting genius! But you should still plan for the unexpected. Adding five to 10% to your expenses per month is a safe estimate.
Step 5: Adjust your budget
We’ve finally got all your numbers into your budget! But is your budget realistic? Sustainable for your business?
In this step, you’ll review your budget and assess if your budget will actually work for your business. If it won’t, you’ll need to make adjustments.
First, calculate your net income every month. Your net income is your revenue (aka your total sales) minus your costs, expenses, and unexpected expenses:
Revenue – Costs – Expenses – Unexpected Expenses = Net Income
Ask yourself, “Is this enough?” Remember, your net income is your business’s profit. This is what you will use to pay off debt, save for taxes, save for business investments, and pay yourself. Every month you need to see if you have enough profit to sustain your business and you, the owner.
For example, our social media manager needs their business to profit $3,500 every month in order to cover their personal living expenses and pay off a small business loan. Here are their monthly profits, according to their budget:
In this scenario, there’s only one month where our social media manager is making enough money to meet their needs. That means they will have to go back to their budget and make adjustments.
The first place to make adjustments is in your expenses, especially your variable expenses. Is there anything you can reduce? For example, our social media manager could reduce their monthly education costs to $15, saving $35 a month.
Next, look at your fixed expenses. Are all of your fixed costs absolutely necessary to run your business? Can you find tools that are less expensive or free? Or can you downgrade your plan to cost less?
For example, while a co-working space might be convenient for our social media manager, they could eliminate this cost and work from a coffee shop or reduce the number of days they use the co-working space.
Now, look at your sales. Can you increase your sales without significantly increasing your expenses? Keep in mind, if you increase your sales of a product or service that has costs associated with it, your costs will also increase. Be sure to account for that in your budget.
Finally, reassess your unexpected expenses. These are the last to go because the point is that they are unexpected and you cannot predict that you won’t have them! But, you may need to reduce your unexpected expense budget slightly in order to meet your financial needs.
Step 6: Track your budget vs actuals
Budgets are like friends. You don’t just make one and then move on with your life, never to talk to them again. To truly get the most out of your budget you need to check in with it regularly.
Every month review your actual numbers—how much you’re actually making and spending—and compare them to your budget. This helps you get a deeper understanding of your spending patterns and fine tune your budget to be more accurate.
In what areas are you overspending? Where are you underspending? Are you meeting your revenue goals? Are your unexpected expenses higher or lower than you predicted?
Then adjust your budget accordingly. Yes, you are allowed to adjust your budget as the year progresses. Budgets are not static documents. They are meant to be tweaked and finessed throughout the year.
If after a few months you realize your variable expenses are higher than you expected, then you can adjust your sales budget accordingly or reduce your spending.
Now that you have an operating budget for your business you can really start channeling your inner Joan Jett. Grab your leather jacket and an air guitar and start headbanging your way to a more profitable and sustainable business.