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How to Create a Budget

Digital Library > Acquiring and Managing Finances > Budgeting “How to Create a Budget”

Preparing a budget is a necessary evil for the success of any business. Learn how to create different kinds of budgets for all your company’s needs in this Quick-Read.

OVERVIEW [top]

Keeping a budget is key to your company’s success. It facilitates planning, improves communication of objectives and provides the basis for evaluating managers’ performance. Two types of budgets can be used — capital or cash. The budget should be updated at least yearly (if not monthly or quarterly). Budgets fall into two categories — flexible and static — and the pros and cons of each should be considered before deciding how to arrange your budget.

In this Quick-Read you will find:

  • The various types of budgets and their applications.
  • How to set up a budget.

SOLUTION [top]

Capital budgets

A capital budget analyzes potential capital expenditures and helps determine where your firm should invest resources. This is vital for success because a company’s growth as well as its ability to stay competitive depends on its ideas for new products, new equipment and new or improved facilities. The capital budget not only totals expenditures for each type of investment it also looks at the return or income generated by each.

Several expenditures can be analyzed using a capital budget. These include:

  • Replacing old equipment.
  • Expanding a current product line or expanding in current markets.
  • Expanding into new product lines or entering new markets.
  • Safety and/or environmental projects to meet government standards.
  • Research and development projects.
  • Projects that improve the facility or operations of the company.

Follow these four steps to create a capital budget for a project: For example, suppose you want to purchase a new $10,000 large-format color printer for your graphic design firm.

  1. Estimate the cost of the capital asset or project. Get bids from several vendors and come up with a likely total cost for the hardware, software, installation and maintenance.
  2. Estimate the cash flow for the project, including the cost of the asset, working costs for supplies and maintenance, tax deductions for depreciation, a disposal date and a salvage value. How much extra cash flow will come from the increased capacity of the new printer? A five-year cash flow table should look like this:

    Year Income Tax gain from depreciation Working costs Capital cost Cash flow
    1 0 0 0 (10,000) (10,000)
    2 4000 30% of 2500=$750 (1000) 0 3750
    3 6000 30% of 2500=$750 (1200) 0 5550
    4 5000 30% of 2500=$750 (1200) 0 4550
    5 4000 30% of 2500=$750 (1500) 0 3250
    Total         7100

  3. You should mentally factor the likelihood that your cash flow projections will turn out as you have predicted. What’s the chance that the new large format color printer will not generate an additional $6,000 in revenue in year 3? You should take that into account as you make your decision and recognize the risk inherent in your assumptions.
  4. Determine the present value of the cash flow for the asset or the project’s value to the company. Present value tables for adjusting future income estimates can be found in many reference books and on many Web sites, e.g., Quicken.com and the CCH Business Owner’s Toolkit. Assuming your annual cost of capital is 10%, a typical return for investing in stocks and bonds, your Net Present Value table should look like this:

    Year Cash flow PV multiplier @ 10 % Net Present Value
    1 (10,000) 1 (10,000)
    2 3750 .9091 3409
    3 5550 .8264 4587
    4 4550 .7513 3418
    5 3250 .6830 2220
    Total 7100   3634

    In other words, the $7,100 dollars that you see as a total is really only worth $3,634 in today’s dollars. Anything above zero would theoretically be a project worth pursuing. The positive NPV means a project is a better prospect than investing in securities and should be pursued unless there is a still more lucrative project to invest in. If you have multiple capital projects to choose from, you would want to choose the one with the highest Net Present Value.

Cash budgets

A cash budget provides one of the best tools for effective cash management. This format estimates all expected cash receipts and disbursements based on past experiences along with anticipated conditions for future cash flows. It allows you to predict the company’s future cash balance.

The time period covered by cash budgets is ordinarily one year, but it can be monthly or quarterly.

Classify anticipated cash receipts and disbursements by category, and forecast the cash balance at the end of each month during the year. If you see large fluctuations in cash from one month to another, a weekly or daily breakdown may be necessary.

Constructing a cash budget simply entails estimating cash receipts and disbursements. This can involve specific budgets for sales, purchases, salaries, wages, other expenses and revenue. Ordinarily, the cash budget contains the following five sections:

  1. Beginning cash balance plus cash receipts. This will equal the total cash available before financing. Cash receipts consist of collections from accounts receivables, cash sales and miscellaneous recurring cash sources, such as rental or royalty receipts.
  2. Cash disbursements. This consists of any cash paid on a regular basis. It does not include principal payments for the repayment of a loan because payments are not an operating expense.
  3. Cash financed. This is money received from loans or the principal payment of loans.

  4. Cash invested. This section states how the company will be investing the cash in asset purchases and/or how the comp any will be receiving cash from asset sales.

  5. The cash balance at the end of the period is always added to each succeeding month to start the process for the month being budgeted.

For more detailed instruction on cash budget preparation, see the Edward Lowe Foundation Business Builder "How to Create a Cash Budget."

Static budgets

The static (or fixed) budget provides only one level of output. It is not altered after it is set, regardless of the differences in actual numbers compared to budgeted numbers.

Sort budget items into either discretionary or mandatory expenses. A discretionary expense can be adjusted to meet other budgeting needs (e.g., advertising costs). Mandatory expenses are those that already have been contracted, such as utilities or rent.

On a 12-column worksheet (one column for each month), write in the budgeted amounts. Compare these to the actual amounts spent to track how close to the budgeted forecast the expenses are.

This format is easy to establish and allows you to anticipate individual expenses over the budget’s time period. However, a static budget doesn’t compensate for variables outside the company’s control. This may pose problems because there is no room to correct figures once the year commences and the business is operating with the static budget.

Flexible budgets

With a flexible budget, each month’s actual totals are compared to the budgeted figures after they are compiled. Each future month’s budgeted figures change as confirmed numbers for the current month are entered and affect the remaining months’ totals.

The advantage to using a flexible budget is that it shows revenues and expenses that occur at the actual activity level. It also corrects the variances resulting from good or bad cost controls. It can provide a better indicator of performance than a static budget because it can adjust for changes outside the company’s control. But it is more labor-intensive, requiring more inputting and maintenance.

REAL-LIFE EXAMPLE [top]

Brenda Ballard is founder and owner of Ballard Realty Inc. in Newport, N.C. When she was just starting, she created both static and flexible budgets, estimating her costs and including formulas available through the National Association of Realtors (NAR) for the amount typically required in her area to keep a business profitable on an annual basis.

The static budget covered fixed expenses, such as rent, phones and utilities. It also included monthly usage costs for equipment and supplies, such as stationery. Budgeting these one-time costs shows when equipment and supplies will need to be replaced. This kind of budget typically includes depreciation and amortization for capital expenditures.

The flexible budget covered such areas as advertising, which can be substantial to help a business become visible. "Ideally, after the business is established, the advertising budget will remain steady as you continue to invest in yourself, rather than letting it drop off," she says. "But keeping it flexible allows you to find a comfortable level based on your own financial position." It also lets you raise or lower it based on the season because real-estate sales tend to be most active in the spring and fall.

Her initial budgeting, in conjunction with her sales projections based on past sales rates, gained her funding from an investor to open and operate the business for two years — at which time it continued operating on its own financing.

DO IT [top]

  1. Create both a static and flexible budget for your rent, utility or telephone bills from last year’s totals and compare those budgets to actual expenses to see which format works best in each case.
  2. Organize all of your expenses into distinct categories to create a budget for each area. Separate mandatory expenses from flexible ones to best provide a projection and monitoring system.
  3. Create a capital budget for the last piece of equipment you bought, plugging in known numbers to see what return you have achieved.

RESOURCES [top]

Books

Budgeting A La Carte: Essential Tools for Harried Business Managers by John A. Tracy (Wiley, 1996).

Budgeting Basics & Beyond: A Complete Step-By-Step Guide for Nonfinancial Managers by Jae K. Shim and Joel G. Siegel (Prentice Hall, 1994).

Financial Decisionmaking: A CPA/Attorney’s Perspective by David L. Fraley (Oasis/PSI Research, 1998).

Articles

"How can I create a reliable cash flow budget?" by Stephen King, Inc.com, August 2000.

"Building A Financial Budget," excerpted from Start Your Own Business: The Only Start-Up Book You’ll Ever Need by Rieva Lesonsky (Entrepreneur Media, 1998).

"Capital Budgeting and Investment Analysis" by Tasha Marlena Ahmed Akbar Merican, Michigan State University (1999).

Article Contributors

Writer: Craig A. Shutt

Craig A. Shutt interviewed Dr. Bart A. Basi and William Bailey of the Center for Financial, Legal & Tax Planning Inc. in Marion, Ill., for this Quick-Read as well as Brenda Ballard, owner of Ballard Realty Inc. in Newport, N.C.

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