Welcome to Chapter 4! To this point, we have discussed historical data. Despite this business leaders must look ahead. A budget is simply a financial roadmap for the future. Let's explore how to construct one.
Envision organizing a road trip across the country. You will not start driving without knowing that you have enough gas money. Before you go, you would take an estimate at your mileage, hotel costs, and food expenses.
A business budget is exactly the same. It is an estimate of future revenue and expenses over a specific period (usually a year).
To build an accurate budget, a manager must understand the two main types of costs:
These are expenses that do not change, no matter how much you sell. Even if your sales drop to zero for the month, you still have to pay these bills.
Examples: Office rent, insurance premiums, and salaries of permanent headquarters staff.
These are expenses that go up or down directly with your sales volume. If you sell more products, these costs increase. If you sell nothing, these costs drop to zero.
Examples: Raw materials, shipping fees, credit card processing fees, and sales commissions.
Most companies use a "Bottom-Up" budgeting approach. This means the finance department doesn't just guess the numbers; they ask the department managers what they need.
\( \text{Total Budgeted Cost} = \text{Fixed Costs} + (\text{Variable Cost per Unit} \times \text{Number of Units}) \)
A budget aids in doing business with certainty. By distinguishing your costs into “fixed” and “variable,” you can determine your cash needs to survive for the year accurately. However, what happens when reality does not match your plan? We will discuss this in the next lesson. Let's practice first!