Every successful business needs a budget. Janice Meyer, Housing First Minnesota’s vice president of finance, breaks down budgeting approaches as you head into 2021.
If you’re wondering how to prepare a 2021 budget amid unprecedented uncertainty, join the club, it’s crowded! Some industries have fared better than others during the pandemic, construction being one of them. But there are still pressures facing the industry such as supply chain disruptions and related price fluctuations. These pressures are not likely to see relief anytime soon and should be considered when budgeting for 2021. Other budgeting factors to consider are increased wages. This could be either for lost time wages, as staff may not be working while waiting for COVID-19 test results, or simply the need to stay competitive in the marketplace to retain talented workers. On a positive note, with interest rates at historic lows, financing expenses should be lower which can offset some of the other increased expenses, and this is also good news for consumers wanting to purchase a new home or remodel an existing home.
So, why do you need a budget? A budget is a basic ‘roadmap’ to get you where you want to go. Along with defining your vision, mission statement, and goals, it is an integral part of business planning. Creating a budget does not have to be a difficult task, and it is enormously beneficial to enable you to measure whether you are on track for your annual revenue, salary, and profit goals. Half the work of budgeting for the following year is done by preparing accrual and detailed financial reports, such as the income statement, in the current year. While past performance does not always predict the future, looking at trends in your revenue and expense line items from the past few years and then considering factors of the current environment can give you a good starting point.
There are two budgeting approaches: Approach 1 – Anticipate revenue for the year; Approach 2 – Anticipate operating expenses and profit for the year.
The approach that starts by anticipating revenue works better for those industries whose prices are market driven because it is easier for them to anticipate revenue. There are three steps to this approach:
- Project your anticipated goal for revenue. Base this on current or last year’s results as a starting point.
- Project your gross profit goal. This is calculated by multiplying annual revenue by the margin percentage to get gross profit dollars created. Industry ranges for gross profit margins are 20-30% for new homes, 33-40% for remodeling.
Example: $1,000,000 revenue x 30% = $300,000 gross profit.
The difference between the revenue and gross profit is the budgeted cost of goods sold (COGS), $700,000 in the example. COGS includes material, labor, labor burden, trade contractors, and all other construction-related expenditures. For suppliers, this would be the wholesale cost of the product you are selling.
- Calculate your net profit. From the gross profit, subtract the overhead expenses that are needed to run the business—this will leave you with net profit. The gross profit needs to cover expenses such as rent, business insurance, vehicle expenses, software, consulting, office expenses, taxes, and owner’s salary. When evaluating overhead expenses, it is useful to look at the past year and then adjust for inflation and any anticipated new expenses for the coming year.
ANTICIPATE OPERATING EXPENSES AND PROFIT
This approach works well for those who have more latitude to negotiate prices and scope of work, such as custom builders, remodelers, and service providers. This approach is preferable because it creates a concrete goal and also tells you how much you must sell, not just what it might be nice to sell. There are six steps in this approach:
- Project salary. Define a legitimate goal for owner’s salary.
- Determine what level of net profit your company needs for future growth. A suggested goal would be 10% of revenue.
- Categorize expenses. Go through your business expenses and categorize the operating expenses you incur regardless of your sales volume (rent, insurance, utilities, financing costs, marketing expenses).
- Set pricing. Set realistic levels of pricing for your product and determine your gross profit margin percentage.
- Calculate Revenue. Divide the total of owner’s compensation, net profit, and operating expenses by the gross margin percentage to get the amount of revenue you must produce to make your plan work.
Here’s an example:
Owners’ comp: $100,000
Net profit: 100,000
Operating expenses: 200,000
400,000 / 30% (gross profit margin) = $1,333,333 (revenue)
- Perform a reality check to see if the sales volume is realistic. If not, you will need to look at reducing some overhead expenses or finding ways to lower your cost of goods sold.
At some point, you will also want to prepare quarterly and, ideally, monthly budgets that reflect seasonal trends in the business or certain events that occur only periodically throughout the year (think Parade of Homes!). Remember that initially you do not need to go into that level of detail to gain tremendous benefits from planning a simple budget for your business.