Steps for Creating a Budget

1. Analyze your company's overall strategy. What's the forecast for the global and national economy? What are current industry trends and forecasts? What are your company's strengths, weaknesses, opportunities, and threats? How do your company's culture and values affect its approach to specific financial decisions?

2. If your company does top-down budgeting, start with the targets given to you by senior management. If your company does bottom-up budgeting, create these targets yourself. What will best meet the needs of your unit? List the 3–5 most important goals for your unit—and put an expected completion date on each of them.

3. Articulate your assumptions. What ongoing and/or one-time "events" do you want to see happen during the upcoming budget period? Assess the revenue and cost implications of each event. Check the previous year's budget for ideas you can refine.

4. Quantify your assumptions. Assign specific revenue and cost numbers to each of the events you've planned for your unit. Get input from other team members about estimates for particular line items. Check trade publications for industry averages to use as benchmarks. Using a spreadsheet program, put the numbers in an abbreviated income statement template. Instead of including key assumptions and drivers in formulas, put them into separate cells so that they can be easily understood by others—and easily changed if the need arises. While you're at it, set up your spreadsheet so that you're ready for the tracking phase: create places for actuals, account numbers, charge codes. Present the numbers in the proper format. If the company has specific policies about presenting a budget, make sure your budget complies with the format. Include the level of detail that is appropriate to your position in the company.

5. Take a step back. Do the numbers add up? Does the budget meet the goals you and your senior management have established? What does the bottom line look like? How does it compare to last year? Can you provide documentation for your assumptions? Is the budget defensible? What questions are most likely to arise when senior management looks at your budget? How will you answer them? What adjustments or concessions would be easiest to make if your budget is not approved? Write an executive summary that includes key points and numbers, as well as a précis of the major initiatives planned for your unit in the coming year.

Breakeven Analysis

This kind of analysis is useful when considering an investment that will enable you to sell something new, or to sell more of something you already make. It tells you how much (or how much more) you need to sell in order to pay for the fixed investment—in other words, at what point you will break even. With that information in hand, you can look at market demand and competitors' market shares to determine whether it's realistic to expect to sell that much. In more precise terms, the breakeven calculation helps you determine the volume level at which total contribution from a product line or investment equals total fixed costs. But before you can perform the calculation, you need to understand the components that go into it. Contribution is defined as unit revenue minus variable costs per unit; it's the sum of money available to contribute to paying fixed costs. Fixed costs are items such as insurance, management salaries, rent, product development costs—they're items that stay pretty much the same no matter how many units of a product or service are sold. Variable costs are those expenses that change depending on how many units are produced and sold; examples would include labor, utility costs, and raw materials. With these concepts, we can understand the calculation: 1. Subtract the variable cost per unit from the selling price—this is the unit contribution. 2. Divide total fixed costs, or the amount of the investment, by the unit contribution. 3. The quotient is the breakeven volume, expressed as the number of units that must be sold in order for all fixed costs to be covered. Let's look again at that plastic extruder. Suppose each hat rack produced by the extruder sells for $75, and the variable cost per unit is $22. $ 75 (unit price) – 22 (variable cost per unit) $ 53 (unit contribution) $ 100,000 (total investment required) ÷ 53 (unit contribution) 1,887 hat racks (breakeven volume) At this point, Amalgamated must decide whether the breakeven volume is achievable: Is it realistic to expect to sell 1,887 additional hat racks, and if so, how quickly? Note that this volume must be incremental: because Amalgamated has been producing this type of hat rack all along, and the extruder simply represents a way to improve the production process, the compensating sales volume must be above and beyond current sales volume.

What Is Cost/Benefit Analysis?

Basically, this means evaluating whether, over a given time frame, the benefits of the new investment, or the new business opportunity, outweigh the associated costs. Before beginning any cost/benefit analysis, it's important to understand the cost of the status quo. You want to weigh the relative merits of each investment against the negative consequences, if any, of not proceeding with the investment. Don't assume that the costs of doing nothing are always high: in many cases, even when significant benefits could be gained from a new investment, the cost of doing nothing is relatively low. Cost/benefit analysis of a particular investment involves the following steps: 1. Identify the costs included in the new purchase/business opportunity. 2. Identify the benefits of additional revenues. 3. Identify the cost savings to be gained. 4. Map out the timeline for expected costs and anticipated revenues. 5. Evaluate the unquantifiable benefits and costs. The first three steps are fairly straightforward. Begin by identifying all the costs associated with the venture—this year's up-front costs as well as ones you anticipate in subsequent years. Additional revenues could come from more customers or from increased purchases from existing customers. To understand the benefits of these revenues, make sure to factor in the new costs associated with them; ultimately, this means you'll be looking at profit. With cost savings, it's a little simpler, at least in the sense that they are incremental profit—they go straight to the bottom line. However, cost savings are sometimes a little more subtle, more difficult to recognize. They can arise from a variety of sources; for the ones listed below, it isn't hard to quantify the savings. More efficient processing. This could mean that fewer people are required to do the processing, or that the process requires fewer steps, or even that the time spent on each step decreases. More accurate processing. The time required to correct errors and the number of lost customers could both decrease. Next, map out these two elements—the costs and the revenues or cost savings—over the relevant period of time. When do you expect the costs to be incurred? In what increments? When do you expect to receive the benefits (additional revenues or cost savings)? In what increments? Once that's done, you're ready to begin the evaluation phase using one or more of the following analytical tools: return on investment (ROI) payback period breakeven analysis net present value (NPV) sensitivity analysis