So you sit down with your financial adviser or consultant, prepare for the brain-numbing task of setting your budget and out comes the routine question - "How much money do you need to make this year?"
If only it were that simple.
Hummmmm...Let me see. You want to make $200,000. Said and done. All you have to do is fill out a bunch of numbers on this sheet and it will all come true? Isn't that how the typical budget is created? Figure out how much money you want to make at the end of the year, predict your margin, and calculate the sales you need to generate?
Now, I don't know about you, but that strikes me as an over simplification of the most difficult part of running a business: landing a bunch of profitable work. I've worked for multiple companies that tried to budget this way and it never came out right. We would have been much more successful by assuming last year's performance would repeat itself.
Before I share a simple and effective budgeting approach, a little ground work is in order.
What Role Does A Budget Perform?
The purpose of your budget is to operationalize your strategic plan. In other words, your budget is a financial projection of what you plan to do this year. Your strategic plan should have identified new sales opportunities and the efforts required to take advantage of them.
Assuming improvement from last year without constructing a strategic plan that uncovers profit opportunities is folly.
It's very hard to START the budgeting process at the net income level. Not saying it's impossible, just very, very difficult...and often very confusing.
The budgeting process should give you great clarity on performance targets and milestones. It should give you great clarity on how you are going to run your company this year. Starting with a goal that has no foundation destroys the process.
When you work the process right - which I am going to show you how to do just that in a few moments - you gain incredible clarity on how your business runs. Clarity of how the volume of leads, the number and size of jobs and your gross margins affect your bottom line.
It also gives you new insight into your business.
So, if starting at the bottom line is the wrong starting place, where should you start? Believe it or not, you should start your budgeting process by focusing on your field labor costs.
The Secret to a Successful Budget
We're going to do a little math here, probably not your favorite subject (but at least more fun than English Lit!).
Here's the business formula you know so well: S - DC - OH = P
S = sales revenue
DC = direct field costs
OH = overhead expense
P = profit
We need to break down DC further.
DC = L + M + E + Sb
L = field labor
M = material
E = equipment
Sb = subcontracted work
The secret to budgeting is to focus on your labor costs (L).
How Much Work Are You Going To Do This Year?
Start your budgeting process by estimating how many hours your crews are going to work this year. Yes, believe it or not, the key to budget accuracy is accurately predicting how many HOURS your crews will work this year. It may be easier than you think
Pull up your payroll reports from the last three years and look at the trend. Did it bounce around? Did it increase yearly? Did it go down yearly? What affect do you expect the economy to have on your work opportunities and work hours this year?
Make a decision. Actually, make two decisions. How many straight time hours will you be paying for and how many overtime hours will you be paying for?
Now, are your wage rates going up? Factor that in and land at a labor cost for the amount of work you're going to do this year.
Material, Equipment, and Subcontracted Costs
Now that you know how much work you plan on doing (think in number of work days) you should be able to estimate the amount of material and equipment you will need.
Adjust the material costs for price inflation. If you need help guessing that figure, call your suppliers. Determine whether you need to buy or lease additional equipment. Decide whether you will be outsourcing more work, staying the same, or bringing more back in-house.
Add it all together and you have your budgeted field costs (DC).
Now, and only now, Predict Your Sales Revenue
Now that you know how much work you are going to do (be confident you will achieve your goal) you need to figure out how much revenue that work effort is going to produce.
Look over your last three income statements. Calculate the year-end mark-ups you produced. It's a simple formula you should have burned into your memory.
MU = S / DC
MU = mark-up
S = sales revenue (or for a single job, it equals price) DC = direct costs
Now, ask yourself a few questions.
1. Are owners becoming more price conscious?
2. Will I be able to replace my bottom-feeder clients with better paying clients?
3. Have my selling skills improved?
4. Has a new, competent competitor started chasing my core market?
Your answers drive your decision on what mark-up to assume you will generate.
Let's assume you have averaged a 1.4 mark-up the last three years but are confident your new found selling skills will enable you to raise it to 1.6 this year. Multiply your budgeted direct costs (DC) by 1.6 and you have your budgeted sales!
Now, that's how you REALISTICALLY come up with a sales budget.
Time for Overhead
The last piece of the puzzle is overhead. We'll keep this brief and simple.
Look at the three year trend on each overhead expense line item. Think about what you need to do to land and support the amount of work you plan on doing. Think about the price trends (for example, health care costs go up each year). Pick a number for each expense item. Add up all of your overhead expenses.
You now have all of your line items budgeted and are ready to find out how much money you would make should these numbers come true.
Now We Get to the Bottom Line - Finally
Subtract your direct costs from your sales revenue to arrive at your gross profit (S - DC = GP). You might also be curious to divide your gross profit by your sales to see what your gross margin is (S/GP = GM).
Subtract your overhead expense from your gross profit. That's your budgeting net income (S - GP = NI).
Not happy with that bottom line?
You've got four ways of putting more money in the bank.
1. Do more work (more crews, longer hours)
2. Reduce field inefficiencies (eliminate the standing around)
3. Raise your prices (sell better)
4. Lower overhead (it can only go so low before it affects the field)
If you decide one of the above four is doable, go back to your line item budget and make the appropriate adjustments.
(SIDE NOTE: If you've read very many of my articles, you've noticed they frequently focus on selling skills. You probably get tired of it and wish I would devote more time to operations topics.
The reason I keep coming back to sales skills in the newsletters, reports, and blogs is because they are BY FAR the easiest way to increase your bottom line. Increasing mark-up almost always produces a far bigger boost to the bottom line than does improving operations.
Heck, I'm an engineer. I LOVE operational issues. But, I owe it to you to keep you focused on the parts of your business that will best help you achieve your financial goals.)
How Budgeting Puts Control Back Into Your Hands
Once you've built the budget in the manner described, you are now able to run your company by the numbers. You can focus on the key success factors and have confidence the money will be there in the end if you hit your detailed performance targets (mark-up, hours worked, etc.).
Key Point Revisited
Everyone gets the cart before the horse. Either it's "I want to do $1,000,000 in sales" (which is a horrible approach) or it's "I want to generate $100,000 net income" (which is a much better, but somewhat difficult, approach) and tries to build their budget from there.
Remember, start your budgeting process by asking yourself "How many hours (days) are we going to do this year?"
The Right Time Is Now
It's never too late to run your budget. The vast majority of contractors struggle with this part of their business and they really can't afford to allow pride to keep them from seeking professional assistance.
Ron Roberts, The Contractor's Business Coach, teaches contractors how to turn their business into a profit spewing machine. To receive Ron's FREE Contractor Best Practices Newsletter visit www.FilthyRichContractor.com.