What a Budget Is and Why Your Business Needs One?

A budget is an essential planning tool for estimating your business’s future revenue, expenses and profits. It helps control spending and identify potential problem areas where revenue might not cover spending and potential growth opportunities when you may have extra cash that could be invested in new opportunities. A detailed, realistic budget can also help the company secure funding from banks and investors.

What Is a Budget?

What is a business budget? It’s an overall view of your business’s finances. It lists information about the current state of your financial situation, as well as estimates for future spending and income. It includes regular revenue, expenses, capital expenditures and commitments such as loans. Your budget helps guide the decision making of your business. Budgets are usually made for a fiscal year and monitored on a regular basis—at least monthly.

What Makes a Good Budget?

Comparing estimated and actual revenue and expenses will help you know if you’ve got enough money to stay afloat, if you need to make cuts and if you’re turning a profit. A good budget provides enough detail and lays out a plan so you don’t spend more money than you take in, but at the same time you spend enough to strategically grow your business and keep it competitive. A business budget should include the following four key components:

• Income: This is usually sales revenue. Some businesses may also have income from other sources, such as grants, investments and fees.
• Operating expenses: Your business’s day-to-day running expenses. These are divided into fixed and variable expenses. Fixed expenses are usually the same from month to month and are paid on a regular basis, like rent or employee salaries and wages. Variable expenses are expected but may change depending on usage, production and sales, and other market influences. They can include the price of raw materials, labor and the cost of distribution for your goods and services.
• One-time expenses: These include capital expenditures and acquisitions.
• Profit: The most important profit measure is usually net income, also known as the bottom line.

Key Takeaways

• A budget sets targets for your business’s revenue, expenses and profits.
• Budgets typically forecast performance over a twelve-month period but can also be produced semiannually, quarterly or monthly.
• Monitoring the variance between budget forecasts and actual business performance can provide insights into business conditions and the overall financial health of your company, as well as different departments and areas. Creating budget estimates for different scenarios can help you make strategic decisions for your business.
• Using a budget as a management tool can rein in spending and motivate staff.
• A well-managed budget can help your business obtain loans at affordable interest rates.

Business Budgets Explained

A business budget maps out your financial landscape and lays out the path that you want to follow. To build a budget, start by documenting your business’s current financial situation. List all revenue, expenses and profit. Then use the budget to forecast future scenarios with planned revenue and expenses. Use the budget to set goals and better understand what revenue you’ll need to generate in order to cover expected costs. Monitor your progress regularly and track actual spending and revenue versus projections.

Typically, business budgets cover a 12-month accounting period. It can also be helpful to break down the budget into semiannual, quarter and month segments. Most budgets correspond with the fiscal year, or the time period used for financial and tax reporting purposes.

What are the three types of budgets?

The different kinds end with a surplus, deficit or are balanced. Although those terms are more commonly used to describe government budgets than corporate budgets. In government, the terms generally describe whether there’s enough tax revenue to cover costs.

1. Surplus: Revenue exceeds expenses, and the company turns a profit.
2. Deficit: Expenses exceed revenue. The business loses money—at least temporarily. Sometimes, it’s reasonable for a budget to be in deficit at the end of the period. For example, suppose you want to invest in new machinery to increase production and boost revenue potential. The cost of that machinery may exceed your revenue for that period, but increased production should result in higher income and profits in the future.
3. Balanced: Income equals expenditure. The business breaks even.

Your budget tells you where your finances should be heading. It’s also important to monitor actual income and spending against your budget. Some variance is normal, but if actual income is consistently below budget or actual expenditure is consistently above, it can be a warning that your businesses is facing unexpected financial difficulties.

Variances in actual income and expenditure can also give you information about the business environment. For example, you might find that your income increases more than expected in the run-up to Christmas or declines more than you had expected in August. This information can help you plan supplies and manage cash flow to carry the business through future seasonal fluctuations.

Why Is a Budget Important in Business?

Creating and monitoring a budget can seem like a lot of work, especially if your business is simple and you have no immediate plans to expand or make significant changes. But using a budget to manage your business confers three important benefits:

1. It can prevent overspending. Spending can easily run amok, so measure it regularly against your planned expenses in your budget. By comparing planned versus actuals in your budget, you can see when spending creeps up or income is not keeping pace with expenses. You can make adjustments and corrective actions to prevent a deficit.
2. It can help motivate employees. Use your budget to share business objectives with your staff. It can also be an insightful tool to set goals for revenue and cost cutting. In some cases, connecting bonuses and commissions to performance can help motivate your employees. If you have staff with spending authority, encouraging them to collectively monitor expenditure against budget can foster teamwork and cooperation to help the company hit its targets.
3. It can help you get business funding. When seeking outside funding, investors and banks will review various aspects of your business from different financial statements. A detailed operating budget shows them what it will cost to operate the business in terms of expected future revenue and expenses. A well-managed and thought-out budget can give banks and investors confidence in your strategy and company.

Benefits of a business plan: A business plan sets your strategic goals, establishes priorities, outlines short- and long-term targets, identifies funding needs and sources and lists key stakeholders. Business plans typically encompass a long-term view—usually five years or more. They’re essential for new businesses, as well as established companies.

Budgets and business plans: A detailed budget is a key element in any business plan. The budget sets your short-term financial goals and feeds into your business plan’s longer-term targets. The role of accountants and the way planning and budgeting is incorporated into broader business goals is growing. Accountants aren’t just reporting information, managerial accounting analyzes data to project trends and monitor business performance.

How Business Budgets Work

Business budgets look at how much cash you have and how much you’ll need. A budget is a tool for you to predict if you’ll have more funds coming in than you pay out. You should be realistic with your financial projections. And you may want to underestimate your financial performance, or create separate conservative, middle-of-the-road and ambitious budgets. Budgeting can be especially tough if you’re just getting started and you don’t have historical data to examine. In that case, try to create financial forecasts based off sales figures and information you can glean from peer companies. Financial planning software can help with this step.

Each month you should check your forecasts against actuals. This can help you make decisions and forecasting scenarios with budgets attached can be a useful exercise.

For example, if you are considering taking on additional staff, you can examine the budget impact of adding a permanent employee compared to using temporary contractors or asking current staff to work overtime. If you are thinking about investing in more equipment to increase production, you can experiment with different income estimates to see how much you would have to increase output to justify the capital expenditure.

Budgets help you make wiser business decisions. By removing emotion from purchase decisions, and instead focusing on staying within a budget that reflects strategic priorities, your business can more easily achieve goals and turn a profit.

Your business budget should be detailed enough to give you a clear picture of income and expenses. But too much detail can weigh down your budget. For example, you may include office supplies in your budget. But you don’t need to write out the specific amount for paper clips, highlighters and pens separately. A general category will suffice in most cases.

You can use your budget to set sales and operating profit targets for your business. Your budget can help you identify challenges such as high costs or poor cash flow. A well-thought-out budget can help your business qualify for a bank loan at reasonable interest rates or attract funding from investors.

Types of Corporate Budgets

Different circumstances might warrant different approaches to your budget processes. Depending on things like external market forces, the maturity of your business and the reliability of your historic data, you may choose either a static or flexible budget.

Static vs flexible

Static budget: A static budget is more straightforward and easier to manage than a flexible budget. You create the budget at the start of an accounting period using the best available information at the time. Start by considering historical data and expected revenue and expenses to create a budget for the fiscal year or other accounting period. List out expected revenue and spending by category. Then as the year progresses, monitor actual business performance against the budget. Typically, static budgets are established a year in advance and broken down into quarterly or monthly sections for monitoring purposes.

The advantage of a static budget is that you can see variances between the budget and actual business performance. This tells you how accurate your estimates are, and it provides insight into business conditions. For example, if your start-of-year estimates assumed no adverse weather conditions, but in August your business suffered a sudden interruption because of a hurricane, the effect on every item of income and expenditure would show up as variances against your original estimates. With a sufficiently detailed budget, you’d know not only the impact on your bottom line, but also which aspects of your business were most affected.

However, a static budget also has downsides. When the outlook is uncertain or your business is changing, you may find a large variance between estimated and actual income and spending. Also, with static budgeting, you’re making assumptions based on historical and predicted information. Your estimates may prove to be off.

Flexible budget: If you have a dynamic business or you operate in uncertain business conditions, you might opt for a flexible budget that you can update with new information. Unlike a static budget, a flexible budget is designed to adjust based on the activities of the business. One mechanism for doing this is to express costs as ratios instead of fixed values; for example, a company may budget 40% of revenue for staff salaries.

Fast-growing businesses might opt for a flexible budget. You can examine different scenarios, such as investment opportunities and monitor their effects on the budget more easily. For example, if a manufacturing company has to use more machine hours in March vs February, then its budget should logically increase in March. Conversely, if it uses them for few hours, its budget should reflect that decline. Therefore, most companies that have variable business costs each month or even quarterly have flexible budgets.

Flexible budgets are also useful when the business outlook is uncertain, since income and expenditure can vary significantly under these circumstances. For example, if sales unexpectedly increase significantly, you’ll need to order more supplies than you originally budgeted for. With a flexible budget, you can set up a relationship between sales revenue and cost of supplies so that the money budgeted for supplies automatically adjusts in line with sales revenue.

However, to manage a flexible budget, you’ll need a good grasp on the relationship between your revenue and spending. And don’t forget to set aside time to keep your budget up to date, as it’s more labor-intensive than a static budget.

How to Build a Budget

When building a budget for your business, start by deciding on a static or flexible budget. If you’ve never prepared one before, a static budget might be a good place to start. However, if you are an experienced business manager facing a period of uncertainty, you might consider creating a flexible budget. The decision will affect the way you develop your budget.

Next, set the accounting period for your budget. Common lengths are three months and one year. Set up a regular schedule to review and monitor spending and revenue. This is usually done at least monthly.

Components of a budget: Gather information and set expectations for each of the primary components of the budget—sales revenue, fixed and variable operating expenses and capital expenditures. Use that to calculate expected profits—or the difference between revenue and spending.

Examine financial statements to gather much of the information and to help you understand where your business sits financially. Looking back at historical data—whether you’ve kept a detailed budget or not—can inform your forecasts.

Income: Your principal income is most likely from sales, and sales are usually variable. Take a look at patterns of previous sales and use those to inform your budget. If you’re just getting started, take a look at other similar companies in your industry to set realistic expectations and aspirational but obtainable goals.

Operating costs: Operating costs include fixed and variable costs. Fixed costs include

• Rent
• Regular salaries for employees
• Insurance
• Interest payments and principal repayments on business loans

This information should be found on your income statement, balance sheet and other financial statements. Business accounting software for small businesses and startups can help you keep tabs on your financial situation.

However, even fixed costs can increase over time, so allow some room in your budget to account for things like:

• Rent increases
• Cost-of-living salary increases and other raises
• Performance incentives
• Additional staff for planned expansion
• Interest and principal repayments on planned new debt

Variable costs depend on your business’s activity. Some examples include:

• Raw materials
• Wages for workers paid by the hour or by piece of work completed
• Commissions
• Packaging
• Credit card interest payments, bank fees and overdraft charges

Estimate costs for raw materials and packaging based on historical data. Be sure to account for any planned expansion or expected growth in sales. Using production estimates and historical trends, you can also calculate estimates for your hourly staff. Don’t forget to include any cost-of-living raises, promotions and commissions.

Some items have both fixed and variable components. For example, you may pay a fixed monthly charge for your water service, plus an additional cost for the amount you use.

One-time expenses: You might also be planning some one-time expenses, such as new office equipment or production machinery. Include estimates for these costs.

Now you have your income and spending estimates, you can start to understand the profitability of your business. It can help you stay on track and make new goals. For example, if your budget is in the red, you may need find new areas to cut spending and new ways to bring in new clients or sell more goods and services.

Four Key Steps to Creating a Business Budget

Here’s an example of setting up a static budget using a standard budget template, which you can download in the next section.

1. List your income sources and the estimated revenue of each in the budget column. You’ll list actuals next to it as the financial period progresses.
2. Under operating expenses, list your variable expenses and an estimate for each. Use expected income and historical data to make predictions. For example, if you plan to sell 50 units each month, account for the cost of raw materials, the labor to produce the items, and the cost to sell and distribute them.
3. Also under operating expenses, list all your fixed expenses and an expected amount in the budget column. Don’t forget to include estimates for raises, new hires and other things like interest payments on debt.
4. List one-time expenditures, such as new office equipment, with cost estimates. These will be listed under non-operating expenses in your budget.

These steps can be done manually, but most companies use software for these functions. It helps produce more accurate and complete data to aid in your forecasting, as well as when you compare actual spending. And robust financial planning software include training and certificate programs to help you and your finance team take full advantage of its features.

What is an example of a budget? For a budget example, we’re going to use a hypothetical small company called Michigan Widgets. Here’s how Michigan Widgets’ static budget looked after completing steps 1-4.

As you can see, Michigan Widgets had quite a healthy-looking budget for 2019/20. Now let’s feed in some actual figures.

Unfortunately, Michigan Widgets’ business didn’t fare as well as expected in 2019/20 because revenue was less than the budget forecast. Expenses fell too, but not nearly as much. As a result, net income was about 45% lower than expected. The owner isn’t too happy but thinks this was a short-term downturn and that the business will recover in 2021/20. So, the company went ahead with new equipment purchases and didn’t make any staff reductions.

Free Budget Template

You can build a static budget for your business with this free downloadable template(opens in new tab).

Managing Budgets with Software

You can set up and maintain a simple static business budget like the one above using a standard spreadsheet. However, the process of gathering and entering information can be cumbersome and time-consuming. And if you want more advanced capabilities, such as the ability to create a flexible budget, a spreadsheet may not meet your needs.

For a more powerful and faster approach, use financial planning software for your ledgers, invoices and receipts. Software can make the budgeting and planning process less labor-intensive and keep all financial data in one central location. You and your finance teams can easily access up-to-date information to create budgets and forecasts for what-if scenarios. It can be a collaborative process while also providing simple-to-understand reports and dashboards.

A business budget is an essential management tool. Business managers can use it to monitor day-to-day performance, and it can inform decisions about investment and development for the future. Using a budget to set business targets and monitor performance against those targets can motivate staff and encourage teamwork, while helping keep spending under control. Comprehensive accounting software makes creating, tracking and adjusting your budget easier and more accurate.