For the next few weeks - we’re producing a series of blog posts and podcasts to get your business ready for next year. Business planning is something that too often takes a back seat to the “day to day” of running a business - particularly in small businesses. In this series we’re going to touch on budgeting, key performance indicators (or KPIs), business growth, succession planning, and more.
Today, we’re going to start with budgeting. If you already have a process in place to budget for the upcoming year - feel free to skim this blog or go back and re-read your favorite blog from this year. But, if you’re like most small businesses and you don’t have a process in place - I’m going to give you some solid reasons to develop a budget and two easy to follow processes to get started.
Like Simon Sinek - let’s start with why.
Taking the time to plan a budget forces you to think strategically about your business. If you have trouble getting out of the “day to day” of running your business, I encourage you to step back and take a day this month to focus on the future. You’ll thank me in a year!
Setting a budget is like setting a target. Imagine running a marathon that has no finish line. That’s what it feels like if you don’t have a budget. Budgets help you set goals for revenue and expenses, and will give you a measuring stick to monitor your progress.
If you’re planning to grow your business - and you should be, because a growing business is ALWAYS worth more than a flat or declining business - it may come with some challenges. If you can grow your business by 20%, 50% or more - do you have the capacity you’ll need to handle that growth? Is your business scalable or do you need to add resources to handle the growth? We’ll talk about growth in the coming weeks.
The most common investments needed for growth are human capital and CapX. CapX is short for capital expenses - the kinds of things you’ll invest in to be able to handle more business. Things like new equipment, perhaps vehicles, or more space. It might be software needed to drive higher efficiencies. Whatever those capital investments are, you’ll need access to cash to make the investments - and that’s just easier if you have a plan and budget for them.
Human capital, of course, is about your people. Most business owners, when asked what their most important asset is, would say their people. So if your people are, in fact, your most important assets, then you also need to plan not only for business growth, but also growing your people and their skills - a topic we’ll also cover in the coming weeks.
OK - so let’s recap on the reasons to step back and budget for next year:
You’ll set a target or a goal
You’ll think strategically about your business
You’ll consider your growth initiatives
You’ll think about your capacity for growth
And, you’ll think about the investments you’ll need to make in your people or your physical assets
Now that you understand the “why” - let’s talk about the “how.”
If you’ve never budgeted before - here are two simple methods you can use to get started. First let’s talk about the “Easy Button” method.
The Easy Method
The Easy Button Method takes a very broad view, but does not consider the specifics of your plan. While it’s OK to use this method if you’ve never budgeted before - only to this the first time. Once you’re more comfortable with the numbers - I urge you to consider diving a little deeper.
The easy button method sets a budget in 4 specific areas:
Revenue
Gross Profit
Expenses
Operating Profit
Step 1: Start with Revenue. What are your growth expectations for next year? Take your current revenue projection for this year, and add a factor for your growth target. You’ll need to consider your historical growth rates, because that will give you some clues regarding your potential growth. If your business has been flat, I suggest that you consider at least a 10% growth rate. If, however, your business has been growing, you’ll need to match at least your historical growth rate, but try to exceed it. Remember, a growing business is always more valuable than a flat or declining business.
Step 2: Use your historical gross profit percentage, and apply that for your gross profit target. Gross profit margin is usually dependent on revenue, but perhaps you can find ways to shave a percent or two off the cost of goods sold. If your historical gross profit margin has been, say 70% - can you try to shave your cost of goods sold to achieve a 72% or 75% gross profit. You see what’s happening here? You’re starting to think strategically about your financials and ways to reduce costs.
Step 3: Break down your expenses into major categories, perhaps by department or category. Think sales, marketing, operations, administrative, perhaps product development or support, and figure out the percentage of each category as compared to your revenue. This is easy to do if your financial statements are aligned in these categories already. For example, if your revenue is $1M, and your sales expenses are $100K, then your sales expenses are running at 10%. In the same example, if your administrative costs are 500K, then your admin costs are 5%. It really pays to look back at more than one year so you can plot your expenses by revenue and spot the trends. Are your expenses growing at the same rate as your revenue, or are they declining or increasing as a percentage. The optimum is for the expenses to decline as a percentage of revenue, or at least remain flat. If your expenses are growing faster than your revenue, you may have a problem brewing.
Step 4: Now that you’ve got the target for each category, add them up and now you can see your total operating expenses, which you’ll also want to express as a percentage of revenue. Again, optimally, you want this percentage to decline slightly, showing that you’re managing the business well, and that you have some synergies as you “scale” the business.
Step 5: Finally - we get to net profitability. Take your gross profit, subtract your total expenses, and now you have your net profitability goal. Be sure to express that as a percentage of revenue as well. Again here, we want that percentage to grow - so think about ways to improve your profitability. Don’t forget that 97% of all business transactions are based on earnings - so the value of your business is very likely tied directly to your profitability. It’s definitely worth thinking about!
The Harder Path
If you’re up to the challenge of taking the slightly harder path, I strongly encourage you to do that! Here’s how that works.
We’re going to follow the same process we did with the easy path, but we’re going to get more granular, and we’re going to add a twist at the end.
The harder path has a few more things to do. In addition to revenue, gross profit, expenses and operating profit, we’re going to add cost of goods sold and EBITDA - earnings before interest, taxes, depreciation and amortization.
Step 1: Let’s start with revenue. Rather than looking at revenue as a lump sum, here we’re going to break it into smaller sections by category. Whatever your revenue sources, we want to break out your revenue by source. For example, if you charge your customers for products or services or support - you’ll want to break those out so you can have visibility into each category. You’ll also want to segregate your recurring revenue. Make sure you break any recurring revenue out, because that is the golden ticket when it comes to business value. Recurring revenue is long-term and predictable - something every buyer wants to have.
Step 2: Now that you’ve broken your revenue down by category - consider your growth plan for each one. You may have higher growth in one category than the others. One or more of your categories may stay flat or decline, depending on your business. Again, take the historical data into consideration when planning your growth. You might also think about your VCR or value creation revenue. If you don’t know what that is, I recommend you go back and listen to the Maximize Business Value Podcast episode 71 - with David Wible - or read his blog post on it from August 17th.
Step 3: Once you have your growth by category, add them up, and determine if you’re satisfied with the overall growth. If not, go back and work on the categories.
Step 4: Next, we’re going to insert the cost of goods sold here, and we’re going to treat it just like the revenue categories. Break down your cost of goods sold by category, which are almost always tied to your revenue categories. For example, if you sell hardware, you’re going to have a hardware revenue line and a hardware cost of goods line. The percentage of cost of goods sold is also tied to the revenue, but take scalability into account. For example, if you sell cloud based software, do you need to increase the cost of goods for the cloud infrastructure, or can you achieve growth without increasing your cost? That’s the best possible outcome.
Step 5: Once you have your cost of goods broken down by category, add them up and that’s your total cost of goods sold. Subtract that from your revenue, and now you have your gross profit. Does it hit your target? Remember that your gross profit percentage should be the same or higher than your revenue growth.
Now let’s get into the expenses. In the harder path, you’re going to want to look at expenses by line item, not just by category. Here you can get very granular and think specifically about each line item and whether you can shave some costs or if they will need to increase to achieve your growth targets.
Step 6: For this, I like to take the historical data by month for at least one year so I can see the trends. It’s better if you look at 18 months or two years. I’d be willing to bet that if you haven’t done that before, you’re in for some surprises. I’d be surprised if you don’t start questioning some of the expenses to determine if they’re needed - and that’s a good thing.
Step 7: There’s one more nuance in the expense review. Think about taking all of the expenses related to owner compensation and discretionary expenses and moving them below the operating profit line. We do this exercise with our clients to make it easier to see the true operating expenses of the business, as well as understanding the EBITDA. Discretionary expenses, by the way, are those personal expenses that most business owners run through their businesses, but which are not tied to the operation of the business. For example, personal cell phone, home office expenses, personal cars, country club dues, personal travel, etc - that any future buyer will eliminate right off the bat. You might also think about minimizing those expenses to improve profitability - but that’s a discussion for another day.
Step 8: Now you can add up your operating expenses so you can see the true operating profitability. Add depreciation or amortization below the operating expenses, as well as your owner expenses, and then you’ll have your net profit.
You see - that’s not so hard, is it? Breaking these things down will force you into thinking strategically and that will lead to maximizing your business value!
Call to Action:
Whichever method you choose - the easy button or the harder path - take the time to budget for next year. Start Right Now!! I promise, you’ll thank me later!
If you need any help on these things - just go to our website and click the button to schedule a call with me. I love talking about this stuff with business owners.
What are you going to do today - to Maximize Business Value?
And remember, we’re here to help. If we can help you in any way don’t hesitate to reach out!
Want to learn more? Check out our podcast:
ABOUT THE AUTHOR
Tom Bronson is the founder and President of Mastery Partners, a company that helps business owners maximize business value, design exit strategy, and transition their business on their terms. Mastery utilizes proven techniques and strategies that dramatically improve business value that was developed during Tom’s career 100 business transactions as either a business buyer or seller. As a business owner himself, he has been in your situation a hundred times, and he knows what it takes to craft the right strategy. Bronson is passionate about helping business owners and has the experience to do it. Want to chat more or think Tom can help you? Reach out at tom@masterypartners.com or check out his book, Maximize Business Value, Begin with The Exit in Mind (2020).
Mastery Partners, where our mission is to equip business owners to Maximize Business Value so they can transition their business on their terms. Our mission was born from the lessons we’ve learned from over 100 business transactions, which fuels our desire to share our experiences and wisdom so you can succeed.
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