How to Develop a Small Business Budget

Very few of my small business clients have a budget for their business. There is something about the word "budget" that implies "limitation" and "external control" for them. Very few people see a budget as a management tool in their own arsenal which would help them steer their business better.
Developing a budget doesn't have to be hard, either, especially if you have accurate financials. There are basically two ways of approaching the budgeting process:
Zero-based budgeting and Incremental budgeting
There are advantages and disadvantages to both methods, so it will be up to you to decide which approach will be best for you.
Zero-based budgeting When using the zero-based approach you build your budget from the ground up. Every single item is questioned and needs to be justified. It is an approach in which you look at your operation and ask yourself: "What do I need to accomplish my goals"? You don't concern yourself much with what you spent in the past, but rather with what it is you need to operate your business now and going forward. You start with a blank slate and brainstorm about the infrastructure, marketing and support functions for your business.
You may want to have a list of expense categories as a structure, but perhaps leave them blank for the time being and not even look at any historical financial information.
Incremental budgeting In contrast, incremental budgeting starts with historical information and simply adds to it (or subtracts, if applicable). The justification is generally limited to the increases, not to the entire budgeted amounts. So, for example, let's assume you spent $35,000 last year on marketing. In an incremental budget you may say - "well, this year I will need to do more, because I'm starting a new product line. So I will add $10,000 for my new product". Not much time, if at all, is spent on looking at the $35,000 spent last year and whether it would be needed again.
Or, in even more general terms, you may say "I predict that inflation will be around 5% next year, so I will budget for a 5% increase in my expenses across the board".
In my own practice, I do a little of both. Since I have pretty good historical financial information for my business, that's always my starting point, but as I go through my prior spending, I examine every element of every line of expense. I always question what I'm spending my money on, even when I'm not making a budget, and I try to be very flexible so I can make changes in my financial commitments as soon as I see that I derive no benefit from the service or the product I'm buying.
So, for example, if my marketing expense last year totaled $5,000, I would look at all its components:
Chamber of Commerce memberships $1000
Brochures $1000
Website $1000
Business cards $500
Client gifts $1500
And then I would assess the benefits derived from my Chamber of Commerce memberships and decide whether I wanted to continue them. I would take an inventory of my brochures and my business cards and see if I needed any more. I would decide how much to spend on marketing my website this year. Perhaps it would be more, perhaps less, depending on the place my website plays in my overall business strategy. I would then also evaluate the amount set aside for client gifts. And then, I would ask myself: "Is there anything else I think I need to do this year with my marketing?"
Once I had all my numbers together, I would look at the result - my first draft of a Profit and Loss statement for the next year.
Fine-tuning Your Budget At this point I would take a step back and say to myself: "is this result reflecting the goals I have set for my business for next year?" I'm assuming of course that you have set those goals at the outset. If not, it's never too late. You can formulate them right now.
How much do you want to grow? Do you want to expand into any other areas? What are your profitability goals?
If your first budgeted Profit & Loss statement doesn't meet those goals, you will just have to go through a couple of rounds of budget adjustments until you have the picture you are looking for. Once you do, the next step will be regular (monthly) monitoring of your actual performance against your budget.
Happy Budgeting in 2010!
Lucy Rudnicka is a former Corporate Controller. She now owns her own Accounting Services firm - FINANCIALS for You - and specializes in outsourced bookkeeping, business plan preparation, part-time Controller services and professionally designed financial templates.