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|Using Cost Structure Analysis|
Of all of the exciting things that come with running your own your business, setting an annual budget is rarely near the top of anyone’s list. In fact, many entrepreneurs never get around to it, or do a half-hearted job, as they get caught up in the excitement of pursuing their dream.
But those who don’t are making a big mistake, one that can make the difference between survival and failure. Fortunately though, while setting a budget will never be the most thrilling part of being an entrepreneur, it can be a relatively painless one.
In order to create a budget you’ll probably want to use QuickBooks or some other accounting software, and you should actually produce two types of budgets: an operating budget and a cash-flow budget. First, we’ll focus on the operating budget, which can then be used as a template to construct the cash-flow-budget.
The operating budget should list all of your projected revenues and expenses for a one-year period. It can be helpful to start with the expenses, as they are usually easier to quantify. Begin with your fixed costs, like rent and insurance, which are unlikely to change throughout the year, and then move on to include your best assumptions for variable costs such as marketing and travel expenses. Make sure to include everything that you will need to spend money on to keep your business running, down to the smallest expense.
The next step is to tackle the revenue side of the budget, and the most important thing here is to be realistic. This means that if you’re just starting out you shouldn’t assume that you’re going to hit the ball out of the park right away, and if you’ve been at it for a while you shouldn’t be projecting that you’re going to enter into a high-growth phase all of a sudden.
In forecasting both the revenue and expense sides of your operating budget, flexibility is the key to coming up with a set of numbers that are likely to provide an accurate guide to how your business will actually perform. This means that you should produce three different operating budgets: one that reflects a best-case scenario, one that reflects worst-case, and one that straddles the line between the two. (Don’t worry, once you’ve created a budget with one set of numbers, it’s really easy to tweak to examine other scenarios.)
Constructing multiple budgets in this way can be a huge help in seeing how changes in key metrics from employee compensation to the price you charge for your products can affect your bottom line.
Once you’ve completed your operating budget you’ll have a set of projections not just for your total revenues and expenses for the coming year, but a predictor of the amount of profit or loss that you’re likely to earn under each of your three scenarios. Of course, if you just file the budget away and forget about it until next year it’s not going to do you all that much good. Instead, make sure to review the budget on a regular basis—at least quarterly and ideally monthly—to see how your business is tracking and to make adjustments if necessary.
While a well-constructed operating budget can help you manage your profitability, it won’t tell you much about your business’s lifeline: its cash flow.
In order to better gauge financial well-being we need to look at cash flows, and in order to properly manage cash flow we need to create a cash-flow budget each year along with our operating budget.
To get started with your cash-flow budget, take the numbers from your operating budget and plug them into the same software you used to create that budget. The next step is to look at all of your receivables and payables and determine when the cash associated with each is likely to be moving into and out of your firm’s coffers.
For example, if customers have 60 days to pay their invoices in full, then January’s income should be represented as March’s cash flow. Of course, the same logic also applies to your expenses; your cash-flow projections for critical things like inventory should be budgeted for the period in which you actually have to pay for them, which can be prior to receipt.
Going through this exercise will highlight the difference between income and cash flow and can help you to identify and plan for times when cash is likely to be tight.
Say you need to make a lump-sum payment due in June but won’t have the cash flow to cover it until you collect the invoices that are due in July; if you’ve done your cash-flow budgeting you’ll see this coming months in advance and can make a contingency plan that involves borrowing money for the short term or temporarily cutting back on expenses. But if you don’t have a cash-flow budget it may be too late to do anything about the shortfall once you realize that it’s there.
It’s difficult to overstate the importance of cash flows, and by extension the cash-flow budget, yet many entrepreneurs seem to ignore this critical component and instead focus on revenue and net income. This is a huge mistake, as a business can operate at a loss for an extended period of time, as most start-ups do, but it’s impossible to survive with negative cash flows. Even profitable business can run into life-threatening trouble if they don’t properly manage their cash flows.
So, make cash-flow budgeting a core part of your financial due diligence, and review your cash-flow budget on a monthly basis to make sure that your finances are either on track, or that you have time to adjust when things aren’t going according to plan.
*Disclaimer*: Harvard Business Services, Inc. is neither a law firm nor an accounting firm and, even in cases where the author is an attorney, or a tax professional, nothing in this article constitutes legal or tax advice. This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances. Any action taken or not taken based on this article is at your own risk. If an article cites or provides a link to third-party sources or websites, Harvard Business Services, Inc. is not responsible for and makes no representations regarding such source’s content or accuracy. Opinions expressed in this article do not necessarily reflect those of Harvard Business Services, Inc.