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It is not just income that has to be carefully planned. Costs are just as important. Budgeting means making your best guess possible of what sales and expenditure you will need to achieve those sales.
Budgets are usually set for a twelve-month period. This is the length of time for which governments usually require businesses to prepare statutory accounts for legal and taxation purposes.
Key steps in the budgeting process
Key steps can be summarized in four questions. Where is the business going in its market? Can we get there? How much will it cost? And, how will it be paid for? Or, in a little more detail, as follows.
1. Assess the market situation
- Can the business make the same sales as last year?
- Can it increase sales?
- Is there a target sales figure that you would like to reach?
- Can the market cope with your sales target?
2. Once you have the sales target, assess whether the business currently has the capacity to meet it
- Are current equipment levels sufficient to produce the right quantity of goods or services?
- Is there enough storage space for raw materials, finished products, and additional equipment?
- Are staff numbers and skills appropriate?
- Can additional staff with the right skills, at the right price be found in time?
- Should I invest in training for existing staff rather than hiring new ones?
- Is there a need for more management capacity with higher sales?
- Am I ready to hand over management control to someone else?
3. Once you know the answers to these questions, consider how much it will cost to achieve the sales target
- Will wage costs rise? By how much?
- How much are raw materials likely to cost?
- How much will additional storage cost?
- How much will additional machinery cost?
- Will other costs stay the same as last year?
4. Now that you have a good idea of what your sales target will cost to achieve, think about how it’s going to be funded
- Does the business have sufficient cash to pay for higher costs?
- Should sales prices increase? By how much?
- Can the price of raw materials or storage be reduced? By how much?
- Can the business save money by doing things smarter?
- Will the bank provide an overdraft? At what cost?
- Can the business get a loan? At what cost and for how long?
See an example of budget exercise with Amira’s business story here.
Using the budget to control expenditure.
You will understand from your own business that there are certain costs that change depending on the amount of sales activity, and others that stay the same during the year. A great example to demonstrate this is with purchases of raw materials and wages. The purchase of raw materials is directly related to the amount of goods sold. If sales go down, a business can reduce the amount of materials purchased, as less will be needed.
When it comes to labour, on the other hand, many businesses choose to use full time staff in their business, each of whom has a contract of employment. Those contracts, combined with national labour laws often make it difficult to reduce staff numbers even when sales are down. The result is that costs tend to remain fixed where activity is the same as budget or less. Of course, new staff can always be brought in or overtime offered, if sales are higher than expected.
Purchases of raw materials is an example of what are called variable costs (costs that vary depending on sales volume). Wages is an example of what are called fixed costs (costs that tend to stay fixed whatever the sales volume).
Understanding fixed and variable costs
There are key things to keep in mind about each type.
- Variable costs
- Try to buy only what is needed for immediate production
- Try to produce only what you are sure to sell
- Keep stocks as low as possible
- Stocks cost money and carry risks
- Retail businesses should have a quick supply chain
- Stocks cost money and carry risks
- Buy on credit wherever possible
- If possible arrange to pay for purchases only after the goods are sold and the cash received
- Fixed Costs
- Carefully set an amount to spend each month and stick to it
- Consider hiring staff on part-time contracts and increasing their hours as sales grow, or hiring daily contractors instead.
- Make savings on expenditures wherever possible
- Make expenditure control a key performance factor for senior employees
- Consider outsourcing some functions
- Quality control
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