What we're talking about

The main purpose of budgeting is to stop your business from falling into the overspending trap. A budget is simply a record of the cash coming in and out of your business, but it can also be used as a tool for estimating how much money you'll need for the next month, quarter or year. In this way, a budget also allows you to set money aside to save for big expenses (eg, software, loan repayments, new machinery for your production facility or your company's annual tax bill). It's worth bearing in mind that budgets can be for individuals, businesses, governments or just about anything else that generates and spends cash.

Why it's important

The smaller your business, the less likely you are to have a budget. For companies with between one and 10 employees, nearly a fifth didn't have any kind of budget in 2020. That's according to US research firm Clutch, which suggests that simply having a budget in place makes you less likely to overspend. Even so, half of small businesses didn't create a formal budget in 2020, and only 54% planned to create one in 2021.

While it's impossible to completely protect your business from unfortunate financial headwinds (eg, recessions, market crashes, natural disasters), budgets can be used to get a business into a stable financial position – so that it's better able to deal with any potential shocks. A budget will also stop any potential upswings – like a peak in sales or a big order – throwing the business off course. For this reason, creating a formal budget is a key part of any business. 

Things to note

Don't overcomplicate. Although there's plenty of budgeting software and people explaining how to budget (including us) out there, the most important thing is to not feel overwhelmed. If you're just starting with your budget or are simply trying to formalize your budgeting process, it's better to get moving with a simple budget than to get stuck on a complicated one and end up throwing in the towel altogether. In practice, that means using budgeting tools that are connected to your sales or accounting software so that you don't have to spend hours each week manually inputting data.

Stay flexible. To ensure you can weather the ever-changing nature of business, use your budget to inform your strategy and decision-making. For example, if you've just had a great month of sales, it should mean that your budget for the next month (eg, your marketing budget) can increase. This way, you can continue to drive growth in your business – if that's what you want. On the other hand, if you've made less money this month than you were expecting, your budget for the next month will likely have to decrease. Keeping your budget flexible and adaptable will let you protect your business when times are tough and make the most of boom times.

Keep expenses to a minimum. In the early days, the fewer non-essential expenses your business incurs, the faster you can get to profitability. Putting meals and taxi rides on the business account might seem tempting, but this will just eat into your profit margin and affect how much money you'll be able to take out of the business – either in savings or to pay yourself with. Also, remember that financials should always be near the top of the agenda when it comes to any monthly management meetings.

How to make a budget

1. Consider your reasons for a budget. Before you begin, consider why you're taking the time to create a budget. Are you trying to add legitimacy to your business so that you can appeal for investment or debt financing? Or are you just trying to keep track of expenses to avoid overspending? If it's the former, you'll want to work with an accountant. If it's the latter, you should be able to handle it internally.

2. Set up two business accounts. To simplify the budgeting process, consider setting up a business checking account and a business savings account. These should both be separate from your personal bank account. The checking account is where all money that comes into your business should be deposited – this will enable you to calculate your total revenue. The savings account is where you'll save for big payments in the future – like taxes or machinery. Savings accounts typically benefit from higher interest rates, meaning your business can earn interest while saving for these payments.

3. Estimate your business' income. Add in all of the income streams for your business (eg, sales, advertising revenue, consulting fees or freelance work). For a young business, estimating future income can be difficult when you've got limited financial history. If you're struggling to get close to a monthly estimate, try doing a best- and worst-case scenario. The likely scenario will probably be somewhere in the middle.

4. Note down your initial costs. If you haven't started your business yet, begin by calculating your ‘day-one’ costs – the expenses needed for you to get your business up and running. These could be your facilities costs (eg, initial cost of leasing a workspace or setting up your home office), capital expenditure (eg, equipment, laptop, furniture, car hire) and other costs like paying for an accountant or lawyer when incorporating a company. 

5. Figure out your recurring expenses. You'll have some costs that are easier to track on an annual or monthly basis because they repeat. Some of these fixed costs might be your rent, wifi, electricity bills, phone bill, business insurance, web hosting or any loan payment fees. If you're employing people – whether full-time, part-time or freelancers – include those costs here, along with an estimate of payroll taxes associated with wages and salaries.

6. Predict your variable expenses. Your variable costs are the ones that are hard to predict because they change depending on the number of sales your business generates. For example, these variable costs could be your production costs, packaging costs or shipping costs. Bear in mind that if your business is based around selling a service, you may not have any variable costs.

7. Decide how much to save. Build savings into your budget so that you're always putting money aside. This can be a fixed sum every month (eg, $2,000) or a percentage of your total revenue (eg, 20% of revenue) that you transfer from your business checking account into your savings account.

8. Calculate your profit margin. Now that you have data on the revenue and expenses of your business, you'll be left with the net income or expense. This is calculated by total income - total expenses = net income or net expense. Don't be disheartened if you see a loss (a negative number). Now that you've made a budget, you should be able to spot areas in the business where you're overspending, so you can cut back, or the areas that generate the most income, which you can reinvest into.

9. Set your budget for future months. A good budget should be forward-looking. You could consider when any upcoming large purchases will occur based on your growth or history – and plan accordingly. Or think about upcoming trends and patterns. For example, if you run an ice cream business, you might want to put money aside prior to the summer so that you can afford a considerably bigger order.

10. Monitor regularly. Now that your budget is up and running, you'll need to set aside time each week to monitor how the business' income and expenses are performing against the budgeted figures. This will allow you to make adjustments where necessary. With the help of small business accounting software, this process can take as little as five minutes a week. If you want more expert input and support around how to save money for your tax bill, working with an accountant is also a sound investment for many small businesses. 

Key takeaways

- A budget can help you prevent overspending and plan where to allocate resources in the future.

- After the initial set-up, subsequent updates to a budget can take you as little as five minutes a week.

-   Allowing your decisions to be informed by your budget will let your business thrive in the good times and stay protected when there's a downturn.

Level up

Perspective.  If you're a freelancer looking to upskill the financial side of your operation, read this piece with certified public accountant Amy Northard.

Example. Here, the co-founder of footwear brand Sante + Wade explains why small businesses need to embrace budgets.

Tool. If you're already using small business accounting software, you can probably run your budget from there. If you're not using any accounting software, make your own copy of this annual budget spreadsheet. (Once you've opened the Google Sheet, click on File>Make a copy.)

A version of this article was published in the Courier Workshop newsletter. For more deep dives into essential business concepts, sign up here.