Have you ever heard of starting your budget from the bottom up? The traditional way of setting your budget usually starts with a fixed set of expenses and then calculates the resulting net profit. With profit-driven budgeting, you begin with the desired net profit as the goal and work backward to determine what expenses and revenues are needed to achieve that goal.
A Valuable Mindset Shift
Profit-driven budgeting sounds unorthodox, but with the simple shift from our goals to our costs, we enter abundance, not scarcity. An abundant mindset is invaluable when fostering a productive team and work environment, as it keeps your team focused on profitability. This article will give you a step-by-step guide on how to accomplish this bottom-up or profit-driven budgeting and provide answers to some of your burning questions.
Step-by-Step Profit-Driven Budgeting
The first thing you must do in profit-driven budgeting is set your desired net profit. What kind of money do you want to have at the end of the year to put into your retained earnings, and how much do you want as a distribution to yourself as company owner? Start by determining the level of net profit you want to achieve within a set amount of time. That set amount of time is usually a year, but it could be broken down into quarters based on your preference. Stick with a yearly budget if it is your first time building this type of budget.
Your next task is estimating revenues. Using your knowledge of your business and current market conditions, estimate the total revenues required to reach your desired net profit. This could be your sales income from all sources, among other things. After that, determine the associated variable costs that generated those revenues. The variable costs are expenses that fluctuate with the level of production or sales, such as the costs of goods sold or direct labor. Then determine your fixed costs, which are costs that do not vary with production or sales. These are items like your rent, salaries, and utilities, which are fixed or independent of production and don’t change often.
Now you are ready to calculate the total expenses for your budget. Allocate resources and expenses to different categories or departments within your organization based on your specific business needs and goals. It’s best practice to review your allocations with the department lead or director so that expectations and needs are adequately met. Don’t simply assign a budget or determine your needs in a silo unless you know all the ins and outs.
Implementing Your New Budget
At this stage you have a solid budget to monitor against your actual performance. Your teams should review the numbers in regular meetings in the middle and at the end of each month to catch any variances with the expected budget. Differences in the red that are caught early can help adjust your strategy to ensure you meet the expectations by the end of the month. On the other hand, if you have an uptick and are performing better than your expected budget, you can analyze what you did well and work to recreate it.
Using this approach keeps the focus on profitability as the primary goal and makes sure that your budget aligns with your financial objectives. It requires your team to understand your business’s cost structure, revenue drivers, and market dynamics, enabling you to set realistic targets. Doubling your target net profit is unrealistic in almost all cases. Instead, start by increasing your target net profit by 20-25% in the first year. Profit-driven budgeting applies to various types of businesses, including manufacturing, service, retail, and many others. It’s a versatile budgeting strategy, but it requires knowing your financial dynamics.
Avoiding Profit-Driven Pitfalls
As with any budgeting process, this method comes with a few challenges. One of the major challenges is estimating revenue projections. If you don’t have historical data on your performance, it’s hard to set proper objectives. The rest of the budget will not be accurate if your revenue estimates are out of proportion. Incorrect revenue projections often come from setting unrealistic expectations on the set net profit. Be reasonable and remember that you should be basing that net profit number on historical data or average expectation for a company of your size and capacity level.
Another common pitfall that will throw off any budget is the inability to adjust to the changes in the business environment. Stay versatile and monitor your budget versus actual frequently, as recommended above, to stay ahead of problems and manage your business and budget effectively. Action-based metrics should also be measured from the bottom to the top. This way, you can find the areas in which your business is lacking and focus your efforts there.
Use Tools to Better Your Business
As you can tell, proper prior and future data collection is essential to executing and maintaining a profit-driven budget. If you do not perform sound metrics captures regularly and do not have a handle on your financial drivers, cost structure, and market dynamics, the profit-driven budget strategy is not for you. Make sure those items are in order before implementing profit-driven budgeting and you will have success. There are also various profit planning software tools available that can help you streamline the profit-driven budgeting process. Reputable budgeting software will enable you to set targets, monitor progress, and analyze variances with ease. With the outline in this article and the right software in place, your budget will become a tool to help you drive profitability.