By Guest Contributor Jack Harwell, Business Adviser, Kansas Small Business Development Center
Will your company be profitable and can it stay profitable? Do you have the budgets in place that’ll let you grow the business?
These are some big questions you should answer before you start your business or take that next step toward growth because if you don’t, that could be a VERY expensive mistake. Lucky for you, we’ve got the answers and tools that’ll show you how to dissect and analyze your numbers so you can make sure your plans are actually viable in the real world (and to keep you on track to reach those ever important benchmarks so you can stay in business).
See, with a little simple math (trust us, a fifth grader could do it), you can rest easier knowing that you tested and measured the feasibility of your concept or plan BEFORE you sunk thousands or tens of thousands or hundreds of thousands of dollars into something that never would’ve worked … or something that just needed a few tweaks to be profitable. This strategy will also help existing businesses wring out more from their bottom dollar. And who doesn’t want to do that?
> > > Are you looking an in-person human mentor, like the smart and savvy folks at the Kansas Small Business Development Center at Johnson County Community College? We here at KCSourceLink can connect you to the right help at the right time, no matter where you are with your business or where you live in the metro. Just give us a ring at 816-235-6500 or tell us a bit about what you need here, and we’ll get you moving in the right direction.
The knowledge is in the numbers
This piece on managing your finances is the last of a three-part series on how to build a profitable business. In our first post, “Margins Matter: Get a Literal Formula for Success for Your Small Business,” we revealed that margin is the most important word in business and how you can identify cost of goods sold, or COGS, and calculate your gross profit. (All really important stuff if you want your business to succeed.)
In our second post, “Are You Watching Your COGS? If not, It Could Cost Your Small Business,” we explored how to manage, control and reduce COGS to maintain and grow your profits. (Yeah, you definitely want your business to do that.)
And this third post reveals how you can strategically manage the capital (cash) your business generates by having a budget process. You’ll learn to use a valuable tool called break-even so you can analyze overhead expenses and capital decisions.
Disclaimer: Some of the tools in this post are great for existing businesses, but if you’re just getting started, you’ll have to estimate most of these numbers. Instead of pulling figures out of thin air, helpful organizations in the KCSourceLink Resource Partner network (like the Kansas SBDC at Johnson County Community College) can show you how to take the best educated guess using databases and other tools to help you see if your concept is feasible. Get connected here.
Big decisions about capital need planning
Gross profit is a measure of the cash that’s generated after paying for cost of goods sold. What to do with this cash (capital) is a strategic decision that determines your future profitability and growth of your company. You can use the cash for day-to-day expenses to operate the business, pocket it as a reward for your hard work or funnel the cash back into your business. Purchasing equipment, adding staff or spending more on systems and process improvements are some of the ways you can invest in your business.
Rather than deciding on the fly how to use your capital, a more strategic approach would be to have an annual budget process. This will force you to plan thoughtfully and periodically for cash the business generates and how it will further your objectives. Once you have that in place, the budget becomes a guideline for how much your business can spend and on what. While forecasts seldom predict the outcome accurately, the budget will define and communicate your intent and can alert you when spending deviates from your plan.
Here’s a quick overview of what we’ll cover: The first step in the budget process is to establish a baseline of current sales and spending. The next step is to project future sales and the resulting gross profit. This gross profit plan predicts the cash your business will generate. You can then review the baseline and decide where the capital should go throughout the budget period.
If you’re a little lost, don’t worry. We’ll break down all of that:
So, what’s your baseline?
The budget process begins a few months before the new fiscal year. The starting point for building a budget is a baseline profit and loss, or P&L, that predicts the current year’s total sales, COGS and expenses. This baseline combines actual results for the year so far and what you expect to happen for the rest of the year. Because the year hasn’t yet ended at that point, estimate the numbers for the remaining part of the year.
Why do this? Because you need a clear picture of your business so you can calculate your profit margin and create that ever-important budget.
Here’s how you do it: Record year-to-date sales for each month in the past and use those figures to predict sales for the remaining months of the year. You then multiply your sales (actual and predicted sales) by your current gross margin percent to figure out the gross profit by month.
To set a baseline for the year’s overhead expenses, review spending to date and then see if the trend will continue or if you will end up spending more or less. Do this for each line item of the P&L. Record your estimate of future spending to complete the current year baseline P&L.
Forecast your sales and gross profit
Now that you have a good idea of your actual and expected sales by month for the current year, you can forecast what your sales might be next year. If your sales have trended higher every year in the past, you may expect that to happen again. You might also have a strategy to increase sales through additional sales and marketing efforts, expanding your territory or adding a new product to your portfolio. Whatever your strategy, estimate the impact on your sales and record the increased sales in the budget, month by month.
COGS (cost of goods sold) is proportional to sales, so you can predict future gross profits by multiplying your projected sales by the percent gross profit. Make sure the gross profit margin you use reflects plans to reduce COGS through process improvements or negotiations with your suppliers.
Review those expenses (and get your team involved)
The next step is to review all expenses, line-by-line, to understand what happened in the past and decide what you need to spend going forward. Start with a “do-nothing” approach to build your expense budget, which predicts next year’s expenses without any change in direction. For example, you can expect your electric bill to be about the same unless you have changed your rate of consumption by installing a new piece of equipment or implementing an aggressive effort to reduce energy costs.
Once the “do-nothing” budget is complete, go back and review each line item to look for opportunities to improve. This is a great time to engage your employees. Challenge them to come up with their own plans for reduced spending. You are more likely to reach your goals if you involve everyone in the budget process.
During this review, think if any strategic plans for next year will boost or cut your expenses. Then, adjust the expense budget to reflect those strategic decisions, whether you are adding staff or spending more on marketing. Reducing overhead costs will increase your net profit, so a thorough review of past spending may uncover ways to reduce these costs next year. Note these opportunities so you can remember why you reduced the expenses and to create an action-item list to make sure you follow up and stick to the budget.
Don't forget those capital expenses
The final component of your budget is the capital budget. This is where you plan large capital purchases that aren’t in the expense budget. After considering the long-term benefits and the amount of cash you can invest, record the cost and timing of all capital purchases you expect.
The effect on sales and gross profits from the new capital will need to be reflected in the budget. If a new piece of equipment lets you to expand your product portfolio and increase sales, revise the budget to reflect those new sales. You might notice creating a budget can be a circular process because you may have to go back and forth between spending and increasing sales to find an acceptable balance between optimizing profits, growth and your pocketbook. It is a lot of work, but the value you get from the process makes it worthwhile.
When deciding to spend capital, ask yourself how many additional sales you will need to make the purchase worthwhile. The break-even formula is a useful tool that provides the answer.
Do you know your break-even?
Besides predicting cash generated by sales, your gross margin percent can tell you how many sales you need to cover your overhead expenses. The formula for break-even is overhead divided by percent gross margin.
For example, if your overhead is $1,000, and your gross margin is 50 percent, you need sales to be at least $2,000 (that’s $1,000 / 0.50) to break-even.
You probably didn’t start your business to earn zero profits, but it is important to know your lower boundary. The break-even formula can also calculate how much more sales you need to generate the profits you need from the business. Add the desired profits to the overhead cost to calculate required sales.
To generate a profit of $3,000 in the above example, you divide $5,000 (that’s $2,000 overhead + $3,000 profit) by the gross margin percent. The sales required is now $10,000. (You get number by this: $5,000 / 0.50).
So, why does all this matter again? A disciplined budget process defines where you want your business to go. It’s a set of guardrails that controls spending and alerts you when you get off track. Plus, managing your business with a budget in place will give you more control over the future of your business and make you a more strategic owner.