Budgeting is the financial compass that guides a company’s spending. However, there are different types of budgeting methods that a small business can adopt. Each type is suitable for different kinds of small businesses.
Is your business established in a stable business environment? Or is the business landscape chaotic? Do you want to slash costs drastically and start on a clean slate each new year?
There is no one-size-fits-all all. The key to budgeting success lies in choosing the right approach for your specific needs.
In this blog post, we’ll explore different types of budgeting methods suitable for a small business and how to apply them.
Budgeting for Small Business
Simply put, budgeting is the process of planning, organizing, and controlling the financial resources of -in this case- your small business. It is more or less a spending plan for your business. You budget your finances by estimating future income and expenses. Then, allocate funds to different categories or purposes, and monitor actual financial performance against the planned budget.
To achieve effectiveness in budgeting, you need an idea of your estimated income, your spending pattern, and your financial needs. The information regarding your income and expenses can not be based on guesswork. So, you need to know how to prepare a financial statement for your small business.
The primary objective of budgeting is to ensure that resources are used both efficiently and effectively. If you do it well, your business can achieve set goals or objectives. It could be maximizing profits, minimizing costs, saving for future investments, or paying off debts. So, budgeting provides a framework for making informed financial decisions and managing cash flow. Ultimately, it is a business activity that contributes to financial success.
Tips for Small-Business Budgeting
Know Your Numbers: Before you make a plan, get to know your financial landscape. Understand your income and expenses. How much money is coming in, and where is it going? Start by listing your sources of income and categorizing your expenses. This could include rent, utilities, salaries, and any other regular costs. Once you have a grasp on your financial picture, you’re ready to start budgeting.
Set Clear Goals: What are you aiming for? Setting clear financial goals helps you stay focused and motivated. The business goals also determine the suitable budget method for your business. Your goal may be expanding your product line, saving more money, cutting costs, or paying off debts. Having specific objectives will guide your budgeting decisions. These goals should be SMART – specific, measurable, achievable, relevant, and time-bound. Learning how to set SMART goals is the difference between proactive and reactive companies.
Break down your goals into short-term and long-term targets. This will make it easier to allocate resources and track your progress. Remember, your goals are unique to your business, so make them tailored to your aspirations.
The Best Budgeting Methods for Any Small Business
Traditional Budgeting
Traditional budgeting involves creating a detailed plan for income and expenses based on historical data. If you run a small business with stable income streams and a consistent operating environment, then this method is beneficial. It allows for precise allocation of resources and helps in identifying areas where costs can be controlled.
Imagine you own a small bakery that has been operating for several years. Your bakery has stable income streams from daily sales of bread, cakes, and pastries. You decide to use traditional budgeting to plan your finances for the upcoming year.
Gathering Historical Data: You start by looking at your financial records from the previous years. You analyze your sales figures and profit margins to understand your business’s financial performance.
Creating a Detailed Plan: Based on the historical data, you create a detailed budget for the upcoming year. You estimate your expected income from daily sales, wholesale orders, and special events. You also list all your expenses, including rent, utilities, ingredients, employee salaries, and marketing costs.
Precise Resource Allocation: With your budget in hand, you allocate resources to different categories according to your plan. For example, you set aside a specific amount for ingredient purchases, employee wages, and marketing campaigns.
Identifying Cost Control Opportunities: Traditional budgeting allows you to identify areas where costs can be controlled. For instance, you may notice that ingredient costs have been rising steadily. To control costs, you explore alternative suppliers or negotiate better prices with your current suppliers.
Regular Reviews and Adjustments: Despite your careful planning, unforeseen changes can occur in the business environment. For example, a sudden increase in flour prices or a new competitor opening nearby could impact your budget. Therefore, you schedule regular reviews of your budget to assess its accuracy and relevance.
However, one drawback of traditional budgeting is its rigidity. In a chaotic business environment, unforeseen changes may render the budget obsolete.
Missed Opportunities: The rigidity of traditional budgeting may also lead to missed opportunities. For instance, if a small business identifies a new market opportunity or a cost-saving measure mid-year, it may not be able to capitalize on it because it wasn’t accounted for in the initial budget. So periodic review is crucial.
Zero-Based Budgeting
Zero-based budgeting (ZBB) starts at zero-base. What this means is every expense (not just a new expense) must be justified. It starts with ‘zero’ each budgeting period as if there is no historical data. This approach encourages a thorough examination of all costs, eliminating unnecessary expenditures and promoting a culture of efficiency. It is very useful for small businesses facing uncertainty or those in need of cost-cutting measures.
Again let’s illustrate using the bakery business where you want to implement zero-based budgeting for the upcoming year.
Start from Zero: With zero-based budgeting, you begin with a clean slate and justify every expense, regardless of whether it was incurred in the past. This means you won’t simply base your budget on previous spending levels.
Identify Activities and Costs: Identify all the activities and expenses associated with running the bakery. This could include ingredients, labor, rent, utilities, marketing, equipment maintenance, and packaging materials.
Estimate Costs for Each Activity: Estimate the costs associated with each activity or expense category. For example, you may discover that the manufacturing costs keep rising. Instead of adjusting to a new amount, the ZBB encourages ways to maybe produce some ingredients in-house and not buy from suppliers.
Rank Activities by Priority: Prioritize the activities based on their importance to the bakery’s success. For example, ensuring high-quality ingredients for your products and maintaining equipment in good condition may be top priorities. Also, revenue-generating departments may have bigger budgets.
Allocate Resources: Allocate resources to each activity based on its priority and estimated costs. Start with the most critical activities and allocate funds accordingly. Ensure that the total budget does not exceed your available funds.
Review and Justify Expenses: Review and justify every expense to ensure it is necessary and contributes to achieving your bakery’s objectives.
Monitor and Adjust: Throughout the year, monitor your actual expenses against the budget and make adjustments as needed. If you find that certain expenses are over or under budget, investigate the reasons why and make adjustments accordingly.
Zero-based budgeting can ensure that every expense in your bakery is justified and contributes to achieving your business goals. It encourages careful consideration of spending. Thus, this method promotes accountability and efficiency within your small business.
The downside is that zero-based budgeting requires meticulous record-keeping and can be time-consuming. Also, the principle of prioritizing top revenue departments may lead to mistakes. If this business is deep into product research, they may downplay such a department. However, the long-term benefits of improved cost control and resource optimization often outweigh the initial challenges.
Incremental Budgeting
Incremental budgeting involves making adjustments to the previous budget based on changes in the business environment. This method is suitable if your small business is in a relatively stable marketplace. It allows for minor modifications to account for inflation, growth, or changes in market conditions.
Starting Point: With incremental budgeting, you begin with the previous year’s budget as a starting point. This means that you use the budget from the current year as a baseline for making adjustments for the upcoming year.
Identify Changes: Next, you identify any changes or adjustments that need to be made to the budget for the upcoming year. This could include factors such as inflation, changes in ingredient costs, increases in rent, or plans for expanding your product line.
Incremental Adjustments: Based on the changes identified, you make incremental adjustments to the budget for the upcoming year. For example: suppose you run our hypothetical bakery…
Ingredient Costs: If you anticipate a 5% increase in ingredient costs due to inflation or changes in supplier prices, you adjust the budget accordingly.
Labor Costs: If you plan to hire additional staff to handle increased demand or expand your product line, you allocate funds for increased labor costs.
Rent and Utilities: If your lease is up for renewal and you anticipate a rent increase, or if utility rates are expected to rise, you adjust the budget to account for these changes.
Marketing and Advertising: If you plan to invest more in marketing and advertising to attract new customers or promote new products, you allocate additional funds to these areas.
You review, approve, and implement. Throughout the year, you monitor actual expenses against the budget and make adjustments as needed to stay on track.
Year-End Evaluation: At the end of the year, you evaluate the budget’s performance and use the insights gained to inform future budgeting decisions. This may include identifying areas where actual expenses deviated significantly from the budget and analyzing the reasons behind these variances.
Incremental budgeting and traditional budgeting are similar in that they both use past budgets as a starting point. However, they differ in their approach to how those adjustments are made and the level of flexibility.
Activity-Based Budgeting
Activity-based budgeting (ABB) ties financial planning to specific business activities. This method is ideal for small businesses with diverse operations. It allows such a business to have a better understanding of the costs associated with each activity.
The challenge with ABB lies in accurately assigning costs to various activities. It requires a thorough analysis of processes and resource consumption. However, the insights gained can lead to more informed decision-making and resource allocation.
For better understanding, this is how we apply it to the bakery:
Identify Activities: Begin by identifying the key activities or processes that contribute to the bakery’s operations and financial performance. These activities could include baking, sales, marketing, customer service, and administrative tasks.
Assign Costs to Activities: Once you’ve identified the activities, allocate costs to each activity based on the resources required to perform them. For example:
Baking: Costs associated with ingredients, equipment maintenance, and labor.
Sales: Costs related to staffing the front counter, packaging materials, and point-of-sale systems.
Marketing: Costs for advertising, promotional materials, and online marketing campaigns.
Customer Service: Costs for staffing, training, and customer feedback mechanisms.
Administrative Tasks: Costs for accounting, payroll, and other administrative functions.
Allocate Resources: Based on the costs assigned to each activity, allocate resources (such as funds, personnel, and time) to ensure that each activity receives adequate support. For example:
Allocate more resources to baking activities during peak production times to meet demand.
Set aside additional funds for marketing activities during seasonal promotions or product launches.
Allocate sufficient staffing to customer service activities during busy periods to ensure excellent customer experience.
Monitor Performance and Make Adjustments When Necessary: Throughout the year, monitor the performance of each activity against its budgeted resources and objectives. Track key performance indicators (KPIs) related to each activity to assess efficiency and effectiveness.
As you can see, this approach allows for greater transparency, accountability, and resource optimization. It also leads to improved financial performance and operational efficiency.
Conclusion:
Selecting the right budgeting method for a small business is a critical decision that impacts financial stability and growth.
Regularly reassessing and adjusting the budgeting approach ensures adaptability to changing circumstances, which ultimately contributes to the business’s long-term success.
Align the chosen method with your business’s unique characteristics, such as its size, industry, and operating environment.