Keeping Your Business In Balance
Chances are that you’ve heard someone use the terms “Budget” and “Forecast” before but you may not know they are different and best used together. Business owners can monitor and make adjustments to their business operations by implementing accurate monthly financial statements, annual budgets and monthly or quarterly forecasts.
First and foremost, it is important to produce monthly financial statements. This is the historical record of where your money came from and where it was spent. Many clients think it is only necessary to gather this information annually to prepare income tax returns, but you need this data to run your business operations. Ideally, you’ll want to view this information on an accrual basis for operational needs. Accrual basis is recognizing revenue when it is earned and the related expenses to produce the product or service in the same period in which it is earned. This enables you to determine exactly how much it costs to perform the service or produce the product. You can learn a lot about trends by studying this monthly historical data. However, it is also useful in alerting you to problems and providing clues about your strengths. If you zero in on troublesome trends, you can make an immediate operational decision that counters a growing problem. If you notice which customers or revenue streams are driving your highest profits, you can fine tune your marketing and sales teams to focus on these areas.
A business should prepare an annual budget to understand what they are trying to accomplish in the coming year. Resources will be needed to achieve goals, and it is important to earmark funds that will be needed to hire additional labor, purchase capital equipment, and provide the infrastructure needed to support new growth. Budgets can be a “top down” or a “bottoms up” approach. In a top down approach, the senior management may provide a total budget that aligns with the corporate goals and assign the department to develop how it will best utilize those funds. In a bottoms up approach, each department would build their budget from scratch to accumulate the total needed to provide all goods/services for the year. Whichever method you use, the most important lesson is that the senior management team should align the final budget with the overall corporate strategy for the year so there are no conflicting goals. For example, the IT department could be concerned about replacing employees computers every 3 years so there are no data failures. The company may be struggling with cash flow and need to trim this budget. The senior management would then communicate to the IT department during the budget process that they should repair as many PCs as possible rather than immediately replacing at the 3-year mark.
A forecast is a monthly or quarterly estimate of how the business will perform. It usually starts as the budget and then is updated each month with the actual historical data. The remaining months of the year are then adjusted to reflect estimates that are more in line with the current business performance. Forecasts are fluid and always changing. This is because every month, we know more data points about what will happen in the near future. The further out the forecast is projected, the less reliable the data. This is due to unknown factors that cannot be predicted. For instance, if my business is to manufacture and sell widgets, I have a pretty good understanding of the next 1-3 months of sales because I have already acquired orders that need to be fulfilled for my customers. If in month 4 of my forecast, there is a natural catastrophe that wipes out my most economical supply of widget parts, my costs would go up or manufacturing could be delayed until a replacement supplier if found. This would require many changes to the forecast—for costs as well as new pricing for customers.
Businesses run on information. We need to understand the information available and use it to plan and predict what comes next. We also have to validate the data we are using to make sure we are getting accurate data. If we’re not keeping our eyes on the road, we could become victims of our own success. If we are keeping our eyes on our growth, we’ll be building out our infrastructure as we go so grand success doesn’t end in grand failure. If we can’t get products or services out to customers in a timely and organized fashion, we could miss our chance at our best future. This is why it is so important to utilize financial statements, budgets and forecasts in order to keep your business in balance.