Episode Host: Henry Lopez is a serial entrepreneur, small business coach, and the host of this episode of The How of Business podcast show – dedicated to helping you start, run and grow your small business.

Resources:

Books mentioned in this episode:

[We receive commissions for purchases made through these links (more info)].

• Profit First: Transform Your Business from a Cash-Eating Monster to a Money-Making Machine by Mike Michalowicz.

Related Podcast Episodes:

Episode 504: Annual Strategic Plan

Episode 439: Cash Flow Management

Episode 322: Mike Michalowicz – Fix This Next

You can find other episodes of The How of Business podcast, the best small business podcast, on our Archives page.

Transcript:

The following is a full transcript of this episode. This transcript was produced by an automated system and may contain some typos and some other minor inaccuracies.

Henry Lopez (00:11):

Welcome to the How of Business podcast. This is Henry Lopez and this episode is about the fundamentals of small business budgeting. Why should you create an operating budget and how do you create an annual budget that helps you maximize profitability in your small business? So I will share some best practices and tips and walk you through the key steps to creating your operating budget, and I also have a few free spreadsheet tools downloads that you can use to help you create and manage your small business budgets. You can find the show notes page for this episode, all of my other small business resources, and to learn more about my one-on-one coaching and group coaching programs, please visit TheHowOfBusiness.com. I also encourage you to please subscribe to my show wherever you may be listening so you don’t miss any new episodes. So on this episode, again, I’m going to share with you the fundamentals of small business budgeting.

Henry Lopez (01:02):

This is really for you if you’ve never done budgeting or maybe you’ve begun to do budgeting, maybe last year was the first time you took a stab at budgeting. Most of us as small business owners don’t really do any kind of formal budgeting, and so that’s what this episode is about. Hopefully get you to at least this year, put together a basic budget to help you manage those key expenses and the ultimate goal of achieving a targeted profit margin for the year. So I mentioned several free downloads, and so what you’ll find at the show notes page for this episode @thehowabusiness.com is the primary budgeting tool that I’ve created for this, which I’m calling a small business expense budget tool. It’s a spreadsheet that you can download and it will help you create a basic budget for your operating expenses. Then I also have specifically a marketing budget tool, which is if you wanted to budget just your marketing expense, which is a great place to start if you’re not doing any budgeting because that’s an expense that can easily get out of control or that maybe you’ve approached it like most small business owners where you really don’t have a plan for your marketing budget.

Henry Lopez (02:07):

So this tool will not only serve to help you budget, so I’m going to allocate a certain percentage of my projected revenues and stick to a plan. The idea of budgeting for marketing and for other variable expenses is to measure it and manage it and control it. So related to that, let me start with why do you need a budget? In my opinion and experience and the experience of other successful business owners, creating a budget is one of those fundamental aspects of running a more sophisticated business. As you are growing your business, it really is a critical component to helping you manage your business financially. And here are some of the specific reasons I would like you to think about to consider to begin budgeting in your small business. First and obvious is financial control. So a budget allows you as a business owner to establish control over your finances.

Henry Lopez (02:57):

It helps you in managing cashflow and ensuring that your expenses are going to be covered, but also avoiding overspending or avoiding a particular category, a variable expense category, getting out of hand. What you have, I’m sure found, and what I have found is, again, when you focus on something, when you measure it, when you keep it visible and you set a goal, you’re much more likely to be able to manage that expense and not be surprised at the end of the year. Of course, the other reason is it should be part of your planning and goal setting. Budgeting should be an essential tool for your planning, especially at the beginning of the year and part of setting your financial goals for the year. It’s going to provide you with a framework for making then informed decisions about how to allocate your resources to achieve your goals for the year.

Henry Lopez (03:45):

As business owners, we have limited resources and we’re trying to generate as much profit as possible based on our business model. So managing our expenses is one component to that. It’s not the only thing. Obviously increasing revenues, other things are important as well, but managing our expenses is critical to that, and for most of us as we’re starting our business, we really don’t focus as much on that. We’re in that startup mode and we probably don’t have that same rigor or attention to detail on the financials, but it’s important. If you can start that way, fantastic. Or if you’re at the point now where you’re a couple years into your business or maybe longer and you’ve never done budgeting, this is a great time to think about starting with a business budget because then the other thing that allows you is to measure your performance.

Henry Lopez (04:30):

The budget serves as a benchmark against which you measure your actual business performance monthly and quarterly as you progress through the year and you’re identifying where there are variances where you might need to make adjustments where there might be a trend that’s troubling that you might want to get on top of instead of waiting until the end of the year to try to change it or fix it. So budgeting is not just a financial exercise, it’s not, again, something you just do once. It really should be a comprehensive process. It doesn’t have to be complicated, especially if you haven’t done it before, but a process that reflects and shapes the strategic direction of a small business, at least from a financial perspective. So it helps you with setting priorities, making informed decisions, and steering the business towards its goal. In particular, the ultimate goal, which is to have a highly profitable small business.

Henry Lopez (05:20):

So there are all types of budgeting, technically speaking, but since I’m not an accountant, and you’re probably not an accountant either of you’re listening to this episode, we’re going to keep this very simple. Essentially for most small businesses, you’re either going to do some form of incremental budgeting, which simply means that last year you had a budget and now you’re going to create this year’s budget based off of incrementing perhaps or adjusting last year’s budget. Or like a lot of us, we might do zero based budgeting, which is we’re starting from zero either because you don’t want to be influenced by last year’s budget or you haven’t done budgeting, and so you’re going to start from zero, hence the term zero based budgeting. The other thing to consider related to budgeting is cashflow budgeting or forecasting cashflow. If you have seasonal fluctuations or you have considerable receivables or you make a large inventory purchases periodically throughout the year or you’re planning to make a large capital investment, and so you need to manage your cash very carefully.

Henry Lopez (06:22):

So that is a type of budgeting. Now, if that’s the challenge for you and that’s really what you have to improve this year, then I would recommend listening to episode 4 39 on that episode, episode 4 39, cashflow Management. I do a deep dive on cashflow management and forecasting, and the spreadsheet that I mentioned here is also available for that episode, which is to help you forecast your cash needs. So that is a type of budgeting. In essence, we’re kind of doing some of that when you create a traditional budget, but without the forecast of adding in what we have in the way of cash on hand and how much cash we might need to add. So what I’m going to walk you through in this episode is essentially the steps for zero based budgeting, which is you’re going to start from scratch either to create a comprehensive budget, meaning it would cover most if not all of your operating expenses or you start on a specific group of those expenses, which is the approach I prefer if you haven’t done budgeting so that it’s not overwhelming and you start on those key expenses that you want to manage better this year.

Henry Lopez (07:27):

So we’ll focus on an expense budget. We’re not going to talk about revenue budgeting or projections. If you’re looking to do or you haven’t done your annual strategic plan yet, then go back to episode 5 0 4 on annual strategic plans, and there you’ll have some of these same steps. So if you went through that and you’ve done that, some of this might sound repetitive, so you can skip some of these steps if you’ve already done your high level financial projections. For example, if you’ve already completed reviewing last year financials, then you’ll move forward to the budgeting steps here. If you’ve already done that work, I have outlined nine steps to creating your operating budget, and you can find this outline on the show notes page for this [email protected]. I’m going to walk you through them here at a high level so that you understand the basic steps, the high level steps to creating a operating budget.

Henry Lopez (08:18):

So first is to review last year’s financial performance. You got to start by analyzing what your business did last year financially, and this means that of course you have to have updated and accurate financials if your financials are a mess, and that’s okay if they are, that just means you have to start there. If you don’t have that cleaned up first, you’re not going to be able to do very accurate budgeting, so focus on that first. If that’s where you are, you have to have your previous year’s financials so that you can refer to them. And step number two, which is to set your business goals. So first step is to look at last year’s performance from a financial perspective. That’s the baseline upon which you will create your budget for this year, and as you’re reviewing that, you’re identifying perhaps those expense categories, especially those variable expense categories, or maybe there was a problem or a challenge or a lot of money was spent that you weren’t really projecting to.

Henry Lopez (09:10):

So those things like maybe marketing expense or maintenance, these variable expenses that you now want to have better control this year on, and the way that we do that is by giving them increased visibility and the tool that we use to do that is this budget that you’re going to create. So that’s step number one, reviewing last year. Step number two, as I said, is to define your goals. If you’ve created your strategic plan, then you’ve got this already. If you haven’t or you’re not going to create a strategic plan, you need to at least set some target goals financially for the year. In particular, you’ve got to set a goal for revenue that’s realistic based on your performance last year and what you’re anticipating and projecting your growth will be for this year. So forecasting your revenue, an estimate of your revenue for this upcoming year, and this is of course based on past sales data marketing trends and any known changes like new products that you’re bringing to the market or price adjustments.

Henry Lopez (10:06):

You want to be realistic, what your projections. But of course, budgeting is based on, like I said, a percentage of projected revenues for each of your expense categories based on in part what you needed to allocate or what was allocated to those expense categories last year. And equally important is to set a target profit margin, a net operating margin, so the money that’s left over after all of the expenses, but before taxes. That’s that money that is available to distribute, although you may not distribute it all, but that final bottom line profit, what is that as a percentage of the revenues that you’re targeting to achieve the income that you’re targeting or sales that you’re targeting for this year. So those two numbers are essential to do your budget to put together your budget for this coming year.

Henry Lopez (11:01):

This is Henry Lopez briefly pausing this episode to invite you to schedule a free coaching consultation with me. I welcome the opportunity to chat with you about your business plans and offer the guidance and accountability that we all need to achieve success. As an experienced small business owner myself, I understand the challenges you’re experiencing, and often it’s about helping you ask the right questions to help you make progress towards achieving your goals. Whether it’s getting started with your first business or growing and maybe exiting your existing small business, I can help you get there. To find out more about my business coaching services and to schedule your free coaching consultation, please visit the how of business.com. Take that next step today towards finally realizing your business ownership dreams. I look forward to speaking with you soon.

Henry Lopez (11:54):

So that’s step number two. Step number three is to estimate your fixed costs. These are all of those things such as rent, perhaps salaries, although there could be some fluctuation in salaries if you’re looking to hire or make wage increases, but typically they’re fairly fixed. In other words, they don’t fluctuate too much dependent on sales, insurance, debt service. So these are expenses. Again, they don’t change much from month to month, and they’re typically easier to predict or to budget. So the estimate for fixed expenses can be fairly accurate for the year, but we do want to consider contracts that might be expiring or a lease that might have a bump in rent halfway through the year or some other rate increases that might well impact these fixed expenses even if they’re not impacted by revenues. Your fixed expenses typically amount for the bulk of what’s called the burn rate, which is how much money you’ll spend on these expenses regardless of sales.

Henry Lopez (12:48):

In other words, if you had zero sales for the month, how much working capital would you need to cover these fixed expenses? And budgeting in part helps you determine how much working capital you do need. Now, I mentioned a moment ago about forecasting for cashflow, and so if you’re tied on working capital, if you don’t have or last year didn’t have enough in some tight months, then certainly I want to encourage you to do some forecasting, some cashflow forecasting, and perhaps do that type of budgeting first or in addition to your overall operating budget. Step number four is estimate your variable costs. So variable costs, which are the ones that fluctuate depending on your sales volumes. These include things like your raw materials, of course, your cost of goods sold, shipping commissions maintenance might be variable marketing expenses, although marketing expenses is a tough one and often one that people do not manage very well, and you do want to set a goal based on a percentage of your projected revenues across industries.

Henry Lopez (13:53):

Typically for marketing, that’s anywhere between five and 10% of your projected revenues for the year, and then that’s a particular expense category that you want to budget and manage and track very carefully throughout the year. Step number five is to plan for any one-time expenses. I mentioned this when I was talking about cashflow forecasting, and you’ll consider it there as well, but are there any one-time expenses that are coming up this year that you need to budget for maybe a remodel, maybe equipment purchases or renovations or a special marketing campaign? What are those things that you need to budget for as well? That could be one-time expenses. Number six I mentioned already is working capital. So identifying how much you need to set aside or add to whatever. Hopefully you came into this year in the way of working capital. Maybe you’re good there, maybe you’re set.

Henry Lopez (14:42):

That’s fantastic. For most small business owners, I find that you’re a little tight on working capital or very tight on working capital. So budgeting could also include setting aside a portion of your money of your projected revenues for working capital. Generally speaking, this is just a rule of thumb. We should look at having a working capital anywhere between one and two months of our fixed expenses, but it also, of course needs to cover any planned large purchases like periodic large inventory purchases or other capital investments. Step number seven is to put this all together. Once you’ve done that analysis and determined what your goals are and calculated based on your p and l, what those variable and fixed expenses are, then it’s actually put it all together in a budget. Now, you can use different tools that exist. You could use QuickBooks for example, or whatever you use for your financials.

Henry Lopez (15:34):

They all typically have some sort of a budgeting module, and that might be the way to go, especially if you’re comfortable with that or if perhaps your bookkeeper or CPA is going to help you with the technical aspects of constructing the budget you and your management team will have to make these decisions, but then actually how you’re going to implement the budget, meaning track it and plug in the numbers. It depends on your situation. The simplest thing is to use the spreadsheet that you can download that I mentioned and use that spreadsheet to put together a budget. Step number eight is to review and adjust. So critically, review your budget, ensure that it’s realistic and that it aligns with your business goals and adjust it as necessary. Of course, always keeping in mind that you want to achieve a certain profit margin. You may want to of course get a reviewed by your partners, your leadership team, your CPA, get that input so that you can finalize your budget.

Henry Lopez (16:28):

And then step number nine is continuous monitoring and adjustment, but actually using it as a tool. I would say that you want to look at your budget and update the actuals because what you’ll see in the spreadsheet tool that you can download from the show notes page is you’ll lay out your budget for all of the different categories that you decide on. It breaks it down by month and then by a quarter, and then you will plug in on a monthly basis the actual numbers so that you can see how you are tracking. It’s one of the reasons it’s good to look at it on a quarterly basis, and that’s the way the spreadsheet is broken down because you might have a fluctuation in a particular month that then might smooth out over a quarter period of time, especially if it’s a seasonal business and you have normal fluctuations anyway.

Henry Lopez (17:13):

If you do have a seasonal business, you definitely want to probably adjust the budget for that, or if not, if it’s fairly smooth throughout the year, then you’ll leave it straight line all the way across the 12 months. So you want to review it monthly at worst case, on a quarterly basis so that you are actually using it as a tool, not just a goal that you set at the beginning of the year and then it’s gathering dust somewhere. You also want to be prepared to adjust your budget depending on changing circumstances. Let’s say that the year isn’t going or ramping up as quickly as you had hoped. You may need to adjust your budget down, particularly in marketing or let’s hope it’s the reverse. You’re having a greater year than you thought, so you may need to adjust some things there. It needs to be a working tool so that it serves you just like your other financial tools as you’re managing your business throughout the year.

Henry Lopez (18:03):

So I’ve highlighted a couple times the focus on profit, and you may have heard of maybe some of you are following the Profit First approach. Profit First is a book written by Mike Michalowicz , and in this book he offers a very unique perspective, but a very effective perspective on financial management for small businesses, and in particular, a quote from that book that I think applies here very simply as he says, profit is not an event. Profit is a habit. So think about that. This is a habit that you’re developing now to budget and to continuously monitor where the money is going because you’ve got accurate and up-to-date financials that you’re reviewing on a monthly basis and a budget at least for those key expense categories that you’re also measuring and monitoring on a monthly basis. So the Profit First methodology, and I would encourage you to read that book and apply if not all of it, then key components of the methodology.

Henry Lopez (19:05):

It emphasizes the importance of prioritizing profit in every financial decision. That’s why I said that establishing your profit goal is critical, and then in essence, we work backwards from there. So what Mike Michalowicz challenges is the traditional way of looking at finances, which is sales minus expenses equals profit, which is true, but what he’s saying is to change your focus to a different formula, which is sales minus profit equals expenses. So you get the subtle difference there. In other words, what is your sales goal that’s realistic? What is the target profit margin that’s realistic? If your business model has historically or in the industry generates let’s say on average a 10% net operating profit margin and all of a sudden you set a goal for 50%, that’s not going to happen no matter how much you tighten your belt on the expenses, right? So it has to be realistic.

Henry Lopez (20:01):

But when you set that, you then take sales minus what you’re planning for profit and the rest gets allocated in a budget to the rest of your expenses. So it’s a different way of looking at your financials. Now, the challenge there though that I do want to share is that if you’ve got a business model, and you’ve heard me talk perhaps many times on this podcast about the difference between a business idea and a profitable business model, if you’ve got a business model that simply isn’t profitable, well, you’ve got a bigger problem. And budgeting highlights that because it shows you that no matter what, no matter how much you wrangle in the expenses, no matter how much you tighten the budget, it’s still not going to give you enough of a profit for it to be worthwhile, and that’s when we have to start to make very tough decisions about adjusting or pivoting that business model.

Henry Lopez (20:52):

But let’s come back from that. That’s not what this episode is about. It is though, one of the side benefits of budgeting is that it’s a way to validate the profitability of your business model. But going back to profit first, this approach in this mindset of starting with your profit goal and then backwards, if you will, on determining what you can allocate to all of your different expenses is a great way to budget and to manage your business financially. So at a high level, those are the nine steps to creating an operating budget. So where do you start? So it depends on where you’re at and what you’ve done prior. Certainly, first you have to finalize your financials for last year. So that is where you start first and foremost. Then you need to determine, do I need a comprehensive budget or do I start with just certain expense categories that I want to measure this year, like marketing and maintenance?

Henry Lopez (21:44):

If you want to just focus on marketing, then I’ve got the marketing budget tool, which is essentially a budgeting tool just for your marketing expenses. Now, you could do both. You could do the more comprehensive budget that has multiple categories, but then for marketing, you do a more detailed breakdown in the marketing budget tool. I know that sounds like a lot, but what the marketing budget tool allows you also is to put together essentially a plan for how and where you’re going to spend your money on marketing this year. So it’s much more than just a dollar amount. It’s the different activities and how much budget you’re allocating to those individual activities within the marketing expense. Then take the small business expense budgeting tool that you can download at the show notes page for this episode at the how a business.com, and put together your budget.

Henry Lopez (22:33):

The spreadsheet is just a template, modify it however you want. So take out rows, add rows. You’re going to see that it has some of the more typical expense categories, but you don’t have to use all of those, or you may have one or two that I don’t have on that template. You’ll simply change the spreadsheet. It’s not a very complex spreadsheet. And remember, you don’t have to start with a comprehensive budget for every single expense category. So you could just start, I recommend with those two to maybe five expense categories that are the most critical for you to monitor this year and to manage so that they don’t get out of hand. You can be proactive about managing it so that it doesn’t affect your net operating margin goal for the year. To summarize then my key takeaways, you need a budget, but you can’t create a budget until you’ve got your financials completed for last year.

Henry Lopez (23:24):

So that comes first. Budgeting is a great way now, if you haven’t done it before, to take that next step up and how you manage your business, that next level of rigor in your financial management in particular, to help you manage and control those variable expenses that you have to keep a close eye on, and if you focus on them and if you incentivize and give your team transparency on, you’re more likely to achieve your goal for those expense categories. And then it’s all about being able to achieve your profit margin goal. Remember to think about starting with your profit in mind first, and then you calculate what you can allocate to each of your variable expenses. Every small business needs some level of expense budgeting so that you can establish and maintain some goals and provide you that additional financial control. As I mentioned earlier, if your challenge in particular is a cashflow challenge, and maybe that’s where you start is by creating that cashflow forecast.

Henry Lopez (24:24):

And in that sense, you’re managing where the money is going and what you’ll need looking forward two or three months in a way of expenses. But a budget really takes it a step further with a budget, you’re putting a stake in the ground that says, realistically, based on what we did last year, maybe the year before as well, this expense category should be no more than X percentage of my targeted revenues. You allocate that, you manage it, you monitor it, and that’s how you’ll achieve or more likely to achieve sticking to those percentages and achieving your target profit margin. I wish you the best as you either launch or continue to grow your successful and profitable small business.