Let’s take a look at the revenue side of the monthly budget report first. Okay, so now you know what you did last year. How does it impact what you are going to sell next year? If you’re in a stable business, you should be able to expect that you will at least sell the same amount as you did last year. So that’s a start. However, it makes sense to always have your sales trending upwards. If you have planned special advertising and promotional events in the upcoming year, you should expect your sales to increase.
If you are a young and rapidly expanding business, look at your rate of growth over the past two or three years. If you are growing at an average of 20 percent per year, for example, budget a 20 percent increase in sales for the upcoming year. To measure your rate of growth from one year to the next, take the difference between the sales figures for both years and divide that difference by the total sales for the first year. For example, if your 2002 sales are $50,000 and your 2003 sales are $67,000, your rate of growth is ($67,000 – $50,000) ÷ 50,000 or 34 percent.
Once you have mapped out your revenues, it’s time to look at your expenses.
Expenses
Again, looking over your business’s monthly income statement for the past year will yield important information about your expenses. You will find certain expenses that never fluctuate, like equipment lease payments and office rent. There will also be expenses that vary, either in step with sales levels or because of other factors. Examples would be office supplies and postage.
Start mapping those expenses that you know for certain. If you are locked into a three-year office lease, you know exactly what your payments will be for the next year. Then start filling in the other expenses. You will need to think about each one as you map it out. For example, if you know that you will be sending out 5,000 flyers in May, make sure that the projected cost is in youradvertising budget figure for May. If you are projecting a 20 percent increase in sales, you will probably want to increase your office supply budget.
Your wage cost deserves special attention. It’s important to make sure that you are including the full cost of your employees, not just the net checks paid to them. Depending on the regulatory environment in which you operate, you would also have to pay out things for your employee like pension, employment insurance, or health care premiums. These are all costs of having employees and should be included as a projected expense. Also, if you are projecting a big jump in sales, make sure that you can do it with the employees you have. If not, include the wage costs of new employees in your plan.
Chapter Summary
• Budgeting is a critical process for all businesses that want to last.
• Review your monthly performance from last year and make sure that you can tell the story of the numbers.
• Make sure your budget numbers are consistent with your operating strategy.
• Review your 12-month budget every month, dropping off the old month and adding one on at the end.
3
Variable versus Fixed Costs: Why You Need to Know the Difference
In this chapter, you will learn —
• How to classify your business’s expenses into fixed or variable expenses
• How costs behave when your production volume changes
• Why “losing money on every unit but making it up on volume” doesn’t work
• How to determine your business’s capacity
Let’s take a look at cost behavior, that is, finding out how particular costs are affected by events such as changing sales levels, increases or decreases in other costs, and the purchase of new assets.
At first glance, it may appear that this kind of analysis of your financials is time consuming and boring, but all successful and long-lasting businesses understand cost behavior. This will help you better understand the mechanics of your business and will allow you to plan for growth with confidence.
Case Study
Becky frowned and rubbed her temples. “Vivian, how can I tell when we need to hire an employee? Shouldn’t I be able to see how much work the new employee has to bill out to be able to afford him?”
Vivian smiled. “Absolutely. Do you know what your break-even point and capacity are right now in the company?”
“Not only don’t I know those things, I don’t even know what they mean!”
“Your break-even point is the amount of revenue you need to bring in to keep the doors open. In other words, it is the amount of billings that covers the fixed expenses of the business. Your new employee, for example, would be a fixed cost,” Vivian said. “Capacity is the total amount of work that you can do with the resources you have. When Joe is working by himself, he can only bill out so many hours. With a new employee, that capacity doubles. Understanding these two key concepts allows you to analyze any changes you might want to make in your cost structure.”
Fixed versus Variable Expenses
Your business’s expenses can all be categorized by their behavior, that is, by whether or not they vary with the level of your business’s revenues. The expenses on your income statement are either fixed or variable.
Variable expenses
These expenses vary directly with the sales revenue of the business. The most common examples of variable costs are cost of goods sold (in the case of a retailer) and cost of goods produced (in the case of a manufacturer).
Let’s say you sell a product for $10 a unit and your cost to purchase that unit is $8. Your variable cost is $8 a unit. (The cost is variable because it depends on how many products you sell.) Therefore, if you have $1,000 in sales, your cost of goods sold is $800. If you have $100,000 in sales, your cost is $80,000. The cost of goods sold will always vary in a direct relationship with sales volume.
The only way to change variable costs is to do one of the following:
• Renegotiate your purchase contracts with your goods or materials suppliers
• Purchase cheaper product (although, that may very well have an impact on how much you can sell the product for)
• Purchase in greater volume to get higher purchase discounts (although, you may also have a higher cost of warehousing your inventory)
Fixed expenses
These are expenses that are independent of the sales volume. This means that even if you do not sell $1 worth of your product or service, you will still incur these costs.
Rent, utilities, and office wages are some examples of fixed expenses. Whether or not you are selling anything, you still need a place to run your business, to have lights on, and to pay someone to answer the telephones.
It’s important to note that fixed expenses are only fixed in the short run. Eventually, when your sales volumes increase, you will need a larger warehouse, more power for the equipment, and more office staff. However, for the time being, we will only look at the range of sales volume in which the fixed expenses remain constant.
Why is Cost Behavior Important to My Business?
So, why do you need to know how your costs behave? Because, armed with that information, you can analyze your income statement and plan for business growth. Two critical concepts fall out of cost behavior analysis: break-even point and capacity.