An annual budget is a month-by-month plan of the sales, costs, profit and cash you expect over the coming year. Building one takes a few hours. Its real value comes afterwards, when you use it to test decisions before you make them and to spot early when the year is drifting off course.
This guide covers how to put one together and how to use it.
Start with sales
Sales drive everything else, so build them first and build them from the bottom up. Instead of taking last year's total and adding 10 percent, work out what produces your income.
- For a service business: number of clients or jobs multiplied by average fee.
- For a retailer or online seller: orders multiplied by average order value.
- For a contractor: known contracts, plus a realistic estimate of new work.
Then spread the annual figure across the months, allowing for seasonality, holidays and when known contracts start and finish.
Add direct costs and overheads
Next, set out the costs that move with sales, such as materials, subcontractors and stock. These are usually best budgeted as a percentage of sales, based on your actual gross margin.
Then list overheads line by line: salaries and employer's National Insurance, rent, insurance, software, vehicles, marketing and professional fees. Use known figures wherever you can, and build in any price rises or pay reviews in the month they take effect.
The result is a monthly budgeted profit and loss account for the year.
Turn profit into cash
Profit and cash are not the same. A budget becomes far more useful once you add a cash view alongside it. That means allowing for:
- when customers actually pay, based on your typical debtor days
- VAT payments each quarter
- corporation tax, usually due nine months and one day after the year end
- loan repayments, equipment purchases and dividends
The cash budget shows the lowest point in the bank balance during the year. That is the number to discuss with your bank before you need it.
Use it to test decisions
Once the budget exists, it becomes a model you can change. Here is an example.
A business budgets for sales of £600,000, a gross margin of 40 percent and overheads of £180,000. Budgeted profit is £240,000 less £180,000, which is £60,000.
The owners are considering a new hire at a salary of £35,000. Employer's National Insurance is 15 percent of the salary above £5,000, which is £4,500, giving a cost of £39,500 a year before pension and any employment allowance. To cover that cost at a 40 percent margin, the business needs an extra £98,750 of sales. The question to answer is whether the new person can realistically help bring in or deliver that much extra work, and how quickly.
Price rises can be tested the same way. A 5 percent increase on £600,000 of sales adds £30,000 to profit if volumes hold. Even if volumes fell by 5 percent, the business would still be better off. Seeing that in figures often makes the decision easier.
Review it every month
A budget left in a drawer achieves nothing. Each month, compare actual results with the budget and look at the differences that matter. Sales below budget, a slipping margin or an overhead running ahead of plan are all signals to act.
Keep the original budget as your benchmark, but update a forecast for the rest of the year every quarter, so that decisions are based on where you are now heading.
What to do
- Build next year's sales budget from what drives your income, month by month.
- Add direct costs as a margin and list overheads line by line.
- Prepare a cash budget alongside the profit budget.
- Use the budget to model any significant decision before committing to it.
- Compare actuals with budget every month and reforecast quarterly.
If you would like help building a budget in Xero or a spreadsheet, book a free call.
