How do I create a budget?

There are three concepts you need to understand: variable costs, fixed costs and break-even point.

1 VARIABLE COSTS -

Variable costs are those expenses in your business that increase or decrease with the level of your sales. For instance, if you sell hamburgers, your variable costs would include the cost of the meat, the buns, condiments as well as packaging.

As a general rule, your variable costs can always be expressed as a percentage of your sales. For instance, if the cost of buns, meat, etc. for a hamburger that sells for $1 is $ .60 or 60%, then you can assume that if you sell ten hamburgers or $10 in sales that your variable costs will be 60% of that or $6. With this data you can figure your gross profit and gross profit percentage.

Sales - Variable Costs = Gross Profit $1 - $ . 60 = $. 40 Gross Profit ÷ Sales = Gross Profit Percentage $ .40 ÷ $1 = .40 or 40%

This is a very important concept because it allows us to determine the net effect of increases and decreases in sales. As you can see, if hamburger sales increase by $10, we are not better off by $10, but only by $4 which is the net of the sales less the variable costs of $6.

2 FIXED COSTS -

Fixed costs are those which you will incur whether you have any sales or not. These would include such items as rent, utilities, certain labor, insurance, etc. Unlike variable costs, fixed costs do not increase or decrease with changes in sales. Therefore, the greater your sales, the less of an effect your fixed costs will have on your net profits. Here's how to determine net profit: Gross Profit - Fixed Costs = Net Profit

Fixed costs are only valid within a certain range of sales or activity. If sales exceed that range, fixed costs will jump to a new level. For example, you may be able to produce 100 hamburgers per hour with one employee, however, to produce more than that you would have to hire more help.

3 BREAK-EVEN POINT -

The break-even point is, as the name implies, the level of sales where you neither make money nor lose money. It is the level of sales where the gross profit is the same as the fixed costs. Using our hamburger example, we will assume fixed costs are $400, we have $1,000 in sales and our gross profit percentage is still 40%. Here are two formulas for determining your break-even point:

Fixed Costs ÷ Gross Profit % = Break-Even Point $400 ÷ 40% = $ 1,000 Fixed Costs ÷ (Price - Variable Costs) = Break-Even Point per unit in Units $400 ÷ ( $1.00 - $ .60) = 1000 units

Since we sell hamburgers for a $1.00 each, we must sell 1000 hamburgers to break even.

The break-even point is important for two reasons: one, it lets us know what volume we must sell to keep from losing money. And two, with a little modification, it will also tell us how much we must sell to produce a given amount of net profit.

Using the same information above, let's assume that instead of breaking even, we want to make a profit of $40. We simply add it to our fixed costs and then divide it by the gross profit percentage. When we do this we find that sales of $1,100 (1100 hamburgers) will give us a profit of $40.

Creating Your Own Budget-

While these figures are fictitious (I have no idea what it costs to make a hamburger), the same formulas will work for you.

To create your own budget, you must first determine what your variable and fixed costs will be or are. Next determine the level of profit you wish to attain and plug the numbers into the formula to determine the required level of sales.

After the sales level is calculated, you may find that it is not reasonable. If that is the case, take another look at your selling price, variable costs and fixed costs. Remember that changing your selling price and variable costs will create the greatest effect because they will change with volume. By "working" the numbers, you either come up with a winning game plan or realize that this game just cannot be won.

Using Your Budget-

Once you've created your budget and proudly shared it with your family and business associates, don't just stick it in a drawer. If you do that, you've wasted your time. Remember this is a map which will need to be consulted from time to time to insure you are still on the right road.

For example, you have calculated that you need to have sales of $500 per day to reach your desired net profit. If at the end of your first five-day week, you find that sales are only $2,100, you know that in the next week you will need to make up the difference by selling $2,900. By breaking your sales goals into bite-size pieces, you will have a much easier time meeting your total budget goals.

Costs must be monitored in the same way- both variable and fixed costs. Fixed costs do not tend to stray as easily as variable costs do and are easier to control. For instance, if the landlord raises the rent, you usually have time to react and adjust your strategy within your budget.

When variable costs get out of hand that can be devastating. This is because they are smaller individually, and therefore harder to notice, however they compound for every sale you make. By comparing your actual gross profit percentage with that in your budget on a frequent and regular basis, you can keep variable costs under control.

Conclusion-

Remember, a budget is a dynamic tool and will have to be adjusted from time to time to reflect changes in your goals and the economic environment. Be creative with your use of the budget; there is not only one way to use it.

Whatever you do, create a budget based on your goals and use it consistently and you will find that getting where you want to go is a lot easier than ever before.

At Jeffrey L. Sailor, CPA we can assist you in setting up a business budget and show you how to use it to reach your goals.