Many small businesses operate without budgets. Others have budgets but don’t get enough out of them.
These are problems. They can’t be fixed with a “How To” guide—if they could, we wouldn’t be writing about them. There are plenty of software programs and professionals out there devoted solely to making the budget process as painless as can be. We don’t need to add another set of instructions to the mix.
We’re writing about budgeting because knowing how to budget isn’t the real issue. The real issue is knowingwhy businesses create budgets in the first place. We’ve found that many small-business owners just don’t see the point of putting a budget together. It looks to them like a pro forma exercise with little real use. The benefits aren’t clear.
However, thanks to our practice, we’ve seen the way budgets help small businesses weather storms and seize opportunities. There are benefits. Major ones. We’re not saying a small business can’t survive without a budget. It probably can, at least for a while. We’re saying that if you, a small-business owner, look at budgets the right way, then you can use them to amplify your competitive advantages—namely, creativity and adaptability.
If you don’t think you need a budget, or don’t think a budget gives you useful information, then you might be overlooking some important questions about your future. That’s what we’ll be discussing here.
Budgets’ Unfortunate Reputation
You probably didn’t become an entrepreneur because you’ve got a burning love of spreadsheets. That’s fine. Being an entrepreneur isn’t supposed to be about paging through endless columns of variable costs or putting caps on spending. It’s supposed to be about having the freedom to blend innovation and risk-taking with passion and expertise. It’s supposed to be about removing barriers, not building them.
That being the case, some small-business owners see budgets as antithetical to the very spirit of entrepreneurship. Budgets impose stifling limitations. They’re artifacts of mega-corporate culture devised by clammy-handed people in windowless rooms with poor lighting. They may be necessary evils for sprawling, inhuman conglomerates, but when it comes to organizations that rely on individual personalities and individual decision-making, budgets are more burdensome than helpful. Indeed, the constraints imposed by budgeting make small businesses less nimble. Since nimbleness is one of their main advantages over larger rivals, budgets actually decrease small businesses’ ability to compete.
Or so the story goes.
Some of it is accurate. It’s true that passion and innovation go hand in hand with entrepreneurship. It’s true that small businesses should strive to turn their size into a competitive advantage. And it’s true that budgeting for small businesses is much different from budgeting for colossal corporations.
What’s not true is that budgets impose constraints. Budgets don’t actually impose anything. They merely describe constraints that are already present. Perhaps more importantly, they describe a business’s ability tocope with and even manipulate constraints placed on it by forces internal and external.
Constraints and Entrepreneurial Creativity
When you start a small business, you’re going to be hemmed in by laws, regulations, and a number of unavoidable economic realities. That’s a plain fact. No small business starts out in a position of unfettered freedom: the conditions that allow small businesses to exist in the first place also put them under all kinds of constraints. Working capital, interest rates, the minimum wage, the minimum competitive salary for professional employees—there are countless factors that limit what you can do and how much money it takes to do it.
So as an entrepreneur, there’s no point in trying to avoid constraints. You can’t. What you can do is become an expert in those that affect you most. Which unique constraints does a business in your industry have to deal with? Are there some that have a disproportionate impact on you because of the way your business functions? Can you make changes to reduce their impact? Are there constraints that you handle in an especially productive way? Can you turn this productivity into an advantage over your competitors? Do you approach some constraints the way everyone else does, even though you could be doing a better job with them?
A budget will help you answer these questions. It won’t create limitations that weren’t there before. Rather, it will give you a way to assess the pre-existing limitations that every small business in your industry has to deal with. The more you know about those limitations, the greater your ability to work within them, work around them, or in some cases, make them work for you.
Making limitations work for you is where entrepreneurial creativity comes into play. A budget helps you marshal your creative energies and find the opportunities for profit embedded in the market’s constraints. It tells you exactly what assets you have to work with, and helps you map out how those assets can be put to the most productive use, given the rules of the industry. If you have enough details on your business’s limitations, then you may discover new openings for innovation.
Most of the market-based constraints you experience will be shared by your competitors, who also have limited amounts of money and freedom. Which of you comes out on top won’t be determined by who has the fewest constraints, but by who does the best job of manipulating common constraints to find the possibilities they hide.
Speed, Spontaneity, and Profit
Small businesses, precisely because they’re small, tend to be better than their larger competitors at taking quick, decisive action. It’s one of their vital advantages. As an entrepreneur, you’ll be forced to react on a moment’s notice to emerging opportunities or perils in the market—that’s a given.
What’s not a given is the profitability of your reactions. Obviously, acting or adapting fast doesn’t do much good if it yields a loss.
So what information will you use to make your quick decisions? Do you have a detailed, practical breakdown of your business’s strengths and weaknesses? Do you know exactly how many resources you can afford to redeploy at a moment’s notice? Do you know how efficiently different aspects of your business tend to use the resources you devote to them? Are certain aspects of your business already strained? Are certain aspects flush with the potential for expansion?
The budgeting process gives you a diagnostic readout of your organization. It tells you how much stress the business can handle and which areas can handle it. In that way, it helps you decide whether you should act conservatively or aggressively in the short term. Without a budget, you’ll find yourself relying on guesswork, and many of your quick decisions will be needlessly risky.
A budget not only helps you assess yourself, but also helps you manage your relationships with other entities, like vendors and subcontractors. This will be especially important when the market is in flux.
Market fluctuations put people on edge. They’re stressful. Consequently, they can lead to unpleasant conversations with your business partners. A budget often serves as a counterbalance to stressed-out emotions. It grounds you by providing solid facts and figures to talk about. This helps quite a bit when you’re planning your next move, and makes it much easier to coordinate with your vendors and subcontractors.
Coordinating with your vendors and subcontractors is key to taking advantage of new opportunities. Let’s say you experience a sharp increase in demand for your product. It’s good news, but of course, it brings up questions: Do you have enough working capital to provide your product to a large number of new customers/clients? What are the current resources of each division of your business? How many more resources does each division need if it’s going to ramp up its activities? How efficiently does each division tend to use its resources? Will your gross margin increase because of the volume or decrease because of inefficiency?
These are all internal questions, but they’ll probably lead to others, such as: What do your vendor accounts look like? How much new inventory can you afford to purchase? What type of sales will you need if you’re going to pay off the new purchases on time? Can you afford to hire subcontractors to help with the push?
And, of equal or greater importance: What’s your plan for a downturn in demand? Will you find yourself in a precarious position with your vendors? Will you be able to keep promises to new customers if your vendor relationships are on rocky ground? Will you be able to pay your subcontractors for the hours they’ve put in?
Budgeting will cut down on nasty shocks for everyone involved. “Your suppliers are in all likelihood mapping out their expectations for the year,” says Inc.com, “and you can help them do so by providing your outlook. As a best practice, you should share your budget and the variety of scenarios you might face to see whether they can handle each level of demand” (Field 2010).
Since your business is one element in a network of other businesses, you have to be able to communicate both your capacities and your expectations to the people you rely on. A budget serves as a tool for facilitating such communication. It gives you a concrete way of describing not only where you stand, but also where you willstand in a given scenario. Thus, it helps foster strong partnerships and avoid uncomfortable phone calls.
This doesn’t mean sharing every detail of your budget, nor does it mean sharing some details with everyone. It simply means that guarding your budget like a state secret takes away some of its efficacy. You can use select portions of it to assist you in negotiating with critical partners—that is, you can be prudent about the information you divulge without being obscure. How much do your current business partners know about your budget? Is it enough for them to understand your capacities and your needs?
Speaking of business relationships: you’ll certainly want a budget if you plan on getting along with your bank. There’s little alternative. Banks don’t see budgets as optional—in the words of the American Bankers Association (ABA), “You are flying in the dark financially if you don’t have a budget for all income and expenses.”
If you show up without a budget, bankers are going to feel you’re wasting their time. They’re certainly not going to be interested in loaning you money (or more money). “Prepare for your financial review with your banker,” says ABA. “Have current inventories, cash flows and balance sheets ready.”
When your banker asks you how your debt is structured, and whether you have an imbalance between long- and short-term debt, what will you answer? Putting it a different way, how long will it take you to answer? Will you hesitate, waffle, or bluff? Or will you respond confidently and point out the relevant figures in your paperwork?
Just as the market’s unpredictability makes budgets useful, it also makes them fallible. A budget is like any plan: it will contain inaccurate predictions and require ongoing revision. That’s simply a condition of commerce. Businesspeople don’t have perfect foresight, not even the most celebrated businesspeople in the world.
However, a lack of perfect foresight doesn’t render planning completely useless. Even if your plans don’t entirely match the way reality unfolds, they serve as benchmarks against which you can assess your progress. They record where you wanted to go, where you actually went, and why the two don’t coincide. In that way, they indicate which areas of your business are performing well and which need to be modified in order to meet next quarter’s goals.
Certainty is off the table. Budgets aren’t guarantees. But setting expectations and monitoring progress are indispensible to small businesses’ long-term survival, and budgets help with that. They give small-business owners a way to (1) determine whether they’re drifting off course, (2) analyze the reasons, and (3) formulate corrective measures.
Most small-business owners hire a bookkeeper. A bookkeeper collects and organizes your financial information, which is time-consuming and requires close attention to detail. Too much time and too much attention for you to sacrifice. But even if you’re not involved with gathering and sorting your financial information, you needn’t remain aloof from it. To get the most benefit from budgeting, you’ll want to be accustomed to reading your financial statements and locating important data in your financial system.
When you meet with your bookkeeper, are you talking about his or her methods? Is he or she showing you how your financial information is organized? Are you able to navigate your bookkeeping software on your own, so as to pull up specific items without your bookkeeper’s assistance?
Proper bookkeeping is important, but it rarely goes far enough in the analysis department. You’ll notice that the bulk of our discussion has revolved around using budgets to orient yourself in the market—i.e., using them to take advantage of opportunities and minimize risks. That requires more than tabulating numbers; it requires interpreting them.
You don’t want to be the only person interpreting your finances any more than you want to be the only person organizing them. There’s too much time and energy involved. Is there anyone in your organization besides you who (1) monitors your finances on the close-in, detailed level, and (2) relates the details of your finances to your big-picture performance? Most bookkeepers don’t do the latter. Therefore, it’s a good idea to involve at least one other person in the budgeting process. Someone who looks at the same numbers as you and tries to fit them into your overall strategy.
In many small businesses, this advisory role is filled by either the management team, an outside consultant, or both. There are definite benefits to keeping your management team involved. If you do, your managers will take a hand in answering difficult questions and will buy into the direction of the company, including its financial commitments. They’ll know what’s expected of their departments and will see how those expectations fit into the company’s overall plan. Moreover, the budgeting process will provide a forum for discussions on pricing, margins, capacity, markets to pursue, headcount, and various other topics that affect everyone’s performance.
The value of a budget doesn’t rest on the accuracy of its predictions or the stringency of its cost-cutting. Instead, the value of a budget rests on how well it articulates your business’s financial direction, including its strengths and weaknesses. A budget sets goals against which you can measure your performance on a monthly basis. It helps you balance risk against opportunity. It helps you determine whether aggressive or conservative action is the right thing for the moment. It helps you communicate with your business partners in times of uncertainty.
Above all, a budget de-mystifies the limitations imposed on your business by the market. Thorough budgeting, especially when undertaken with the right personnel, can enhance your creative initiatives and merge adaptability and accountability with profit. In short, it’s a way to sharpen, not blunt, your small business’s advantages.
American Bankers Association. Ten tips for small business owners during tough financial times. http://www.aba.com/Press+Room/PR_Small_Business_troubledtimestips.htm.
Field, Anne. 2010. How to budget and manage inventory for 2011. Inc. http://www.inc.com/guides/2010/10/how-to-budget-and-manage-inventory-for-2011.html.