As I continue with my standard business plan financials series, I turn now to developing the spending budget. True, nobody likes budgets, but the budgeting function is one of the most important to management to keep cash in the bank; and we all know it. In standard business plan budgeting, you look for realism and credibility, with educated guesses. And the point of it is setting it down as a standard so you can track it, review it, and revise as needed.
The spending budget is also vital to projected profit and loss and projected cash flow. In the diagram here below of full financials (repeated here from three essential projections posted previously in this series) the spending budget includes both the expenses portion of profit and loss and additional spending that doesn’t show up in profit and loss but does impact the cash flow and balance sheet.
By the way, the word budget, as I use it here, is exactly the same as forecast. The difference between the two is just custom. I could just as easily refer to revenue and spending budgets, or revenue and spending forecasts, as revenue forecast and spending budget. Most people are used to them the way I’m using them, with forecast for revenue and budget for spending.
Also, the difference between Costs and Expenses is significant. In finance and accounting, costs are the direct costs you have in your sales forecast, and expenses are operating expenses like rent, advertising, and payroll. They are not the same thing.
Finally, a special note to our LivePlan users – LivePlan has its own interface to guide you through your spending budget. That’s for a different post. All the concepts you see here are valid, and included with LivePlan – but you don’t have to build them in your spreadsheet.
Three types of spending
There are three common types of spending in a normal business. These are the things you write checks for.
- The first is costs, direct costs, what you spend on what you sell. Those are the costs you have already estimated in your sales forecast.
- The second is your expenses. They are mostly operating expenses, like rent, utilities, advertising, and payroll.
- The third is what you spend to repay debts and purchase assets. I call that “other spending.” These are important financial terms that you have to use correctly; so if you have any doubt, investigate what assets are and how debt repayment is different from interest expense, not an expense, but something that absorbs cash and affects the cash available to the business.
Let’s look first at the most common kind of spending, the operating expenses.
The Expense Budget
Make sure you understand expenses as a technical financial term. Expenses are spending like payroll and rent that aren’t part of direct costs and reduce profits and taxable income. You need to understand that difference if you are going to run a business and manage cash flow. If you have any doubts, please read up on that.
Just as you did for sales forecast and direct costs, try to always project expenses in the same categories you have in your chart of accounts. If your accounting divides marketing expenses into personnel, advertising, and PR, don’t project marketing expenses in your business plan as print, online, and social media. This is important.
Summary of Operating Expenses
Forecasting your operating expenses is a matter of experience, educated guessing, a bit of research, and common sense. Let’s look at a sample expense budget from the same bicycle business plan I used in the sales forecast section above (with middle columns cut out):
All the numbers are educated guesses. Garrett, the bicycle storeowner, knows the business. As he develops his first lean plan, he has a good idea of what he pays for rent, marketing expenses, leased equipment, and so on. And if you don’t know these numbers, for your business, find out. If you don’t know rents, talk to a broker, see some locations, and estimate what you’ll end up paying. Do the same for utilities, insurance, and leased equipment: Make a good list, call people, and take a good educated guess.
Payroll and Payroll Taxes are Operating Expenses
Payroll, or wages and salaries, or compensation, are worth a list of their own. In the case of the bike shop owner, for payroll, he does a separate list so he can keep track. Payroll is a serious fixed cost and an obligation. Garrett’s summary budget (above) has the one line for payroll but it comes from a separate list. He just takes the total into the budget. Here’s the list:
Notice that the totals from the Personnel Plan show up in the expense budget. And if you look closely (it may take a calculator) at the expense row “Payroll Taxes” and compare that amount to the total payroll, you’ll see that it’s an estimate based on 25 percent of payroll. Garrett uses “Payroll Taxes” as a blanket term; it includes what he spends on health insurance and other benefits.
This is tricky: standard accounting and financial analysis include only sales, costs, and expenses in the calculation of Profit and Loss. However, in the real world, some of what you spend isn’t included in either costs or expenses. For example, repaying a loan takes money, but doesn’t show up anywhere in the profit and loss. And if you have a product-based business and proper accrual accounting, the money you spend buying inventory doesn’t show up in the profit and loss until that inventory sells. Buying a vehicle or production equipment isn’t tax deductible and isn’t an expense; but it costs money. The rule of thumb is that all expenses are tax deductible, but not all spending is an expense.
What to do? Plan and track your operating expenses for sure. And if you need to handle loan repayments, purchasing assets, distributing profits, owners’ draw, or other spending outside of profit and loss, keep those in your spending budget. Keep track of them. Plan for them.
Understand Starting Costs
Startup costs are a special case that applies to startup businesses only. They are the sum of the assets you need to purchase before you start, plus the expenses you incur before you start. My advice on how to estimate starting costs is coming later, in a separate post.