The Basics Of Budgeting
It is virtually impossible to achieve big financial rewards without paying attention to the business of contracting. Too many of you never see the forest because you are too busy examining the trees. That is, you concentrate on the day-to-day production phase of your business and don’t have enough time left over to plan the future or engage in the numbers crunching that is the essence of being a businessman.
Ask the average PHC contractor what he does for a living, and most will respond, “I’m a plumber,” or “mechanic,” or those who want to impress the questioner might say, “I’m a technician.” All are wrong answers. Once you go into business for yourselves, you are first and foremost businessmen and businesswomen.
You might continue to work with the tools for awhile, but you must learn to look at that as temporary and a necessary evil. You’re fooling yourself if you think you’ll succeed in the long run being a full-time mechanic and part-time businessman. There is too much hard work and risk involved in running a business to devote less than full attention to it. So it has to be the other way around. A contractor, no matter how small, has to be a full-time businessman, and maybe a part-time mechanic until he can afford to throw down the tools. The sooner you do that, the better off you’ll be.
Let’s Get Crunching:I apologize for being repetitive, because I know many of you have heard this spiel from me before. But I want to make sure you understand where I’m coming from.
End of sermonizing. This month’s subject is budgeting. This consists of establishing the fiscal year before it ever starts by defining how much money should be allotted to various business expenses, and how much you expect to make in revenues and profit. It is a more detailed process than merely saying to oneself, “I think we’ll do $1 million this year.” — which I’m afraid is as far as budgeting ever goes with the majority of PHC contractors.
A business budget is a detailed accounting of plans and goals. Without it you are like a ship leaving port without charts or a navigator — you’re bound to get lost. A budget kicks off the new (fiscal) year two months before it starts. For instance, at Blau Plumbing & Heating, our fiscal year runs from Feb. 1 to Jan. 31, so our numbers crunchers start the budgeting process around Dec. 1.
The first place to start is by looking at the financial data for present and past fiscal years. It is a must to record this data in a comprehensive overhead format, as shown on pages 34 and 36. This is key to knowing where you’ve been, where you are and where you’re going. The overhead budget represents a ton of money that will be expended to operate the business in the next fiscal year, and it must be recovered in the selling prices of all jobs.
On this sample budget sheet I’ve left both left columns blank, except for the proprietor’s salary on the top line and the total overhead line at bottom. The expenditures for the 1987 fiscal year would have to be filled in before we could intelligently project numbers for 1988. This requires, of course, that you have a handle on all expenditures. If you don’t, the first thing to do is get your bookkeeping and accounting system in order so you know exactly how all that money you spent disappeared.
This sample sheet could represent a rather large firm engaged in repair, remodeling and DIY sales. Keep in mind, however, that a mix of market activities should be broken down into their individual components, with an overhead budget produced for every department or activity, i.e., service, new construction, remodeling, showroom merchandising, etc. This is important in order to determine what is and what is not profitable.
Let us assume we have filled in all the numbers for Fiscal Year 1987. Adding it all up, the final total overhead amount is $562,500, which is 45 percent of sales. Now turn your attention to the sample 1987 Annual Profit and Loss Statement on page 39. There we see that we needed $1.25 million in gross sales to support our overhead and direct costs, plus leave $125,000, 10 percent of sales, as net profit. (We should be so fortunate!)
Forecasting:This establishes the current state of our business finances. Now it is a matter of projecting what we expect to do next year, and here’s where you need to put on your thinking cap.
In the sample overhead budget, I’ve filled in $646,875 in expenditures for next fiscal year, still representing 45 percent of total sales. How do we arrive at that figure?
Well, it is largely guesswork, but educated guesswork. Some overhead increases can be figured with pretty good precision based on price increases announced by your suppliers. You know, for example, when things such as insurance policies, maintenance contracts, leases and rents come up for renewal. Talk to your agents to get an inkling of how much of an increase you can expect at renewal time, then factor that into next year’s budget. Where information about future price increases is unavailable, it behooves you to check out the budgets from the past several years and use the average as a guide.
This process requires a lot of reviewing, shuffling, reshuffling, crunching, checking and analyzing of financial data. It is not something you can do in one day or in your “spare” time — which illustrates the point I made earlier about the need to be a businessman first, mechanic second.
Anyway, for the sake of simplicity I’ve factored in an overall 15 percent increase in overhead expense for FY 1988 on our sample sheet. We arrived at this amount by observing past financial data and looking into the future with the most reliable crystal ball available. Our problem now is to determine what we need in the way of sales to support the increased overhead for next year, and set a net profit goal that is ambitious but doable.
The Arithmetic:I’ve tried to drive home the point that all costs, as well as profit, are a percentage of sales. On our 1987 P & L, we see that overhead of $562,500 is 45 percent of sales volume of $1.25 million and net profit of $125,000 is 10 percent.
Also below is a sample P & L for 1988 with the spaces left blank. I invite you to exercise your noggin by filling in the blanks before reading any further. All percentages will remain the same as 1987, and we already know that overhead dollars for FY 1988 are budgeted at $646,875.
Since we know that this amount of overhead still represents 45 percent of sales, it is simple to determine the amount of gross sales we need next year. Algebraically, $646,875 equals 45 percent of x, so we divide $646,875 by 45 percent (0.45) to come up with $1,437,500. That is the amount of gross sales we project, or budget, to cover our anticipated overhead, direct costs and profit.
Now we need to think about a profit target. Let’s shoot for a repeat performance of 1987, so 10 percent of $1.4375 million equals $143,750 net profit — hooray ... maybe!
Overhead and profit combined equals $790,625, which is 55 percent of sales. The difference between total sales which is allocated to direct costs of sales — material, labor, permits, etc. (Please don’t be confused by the fact that direct costs exactly equal overhead costs in this example. I constructed it that way just for the sake of simplicity. In the real world of business they would never be the same, at least not to the dollar.)
What’s It Mean?An astute businessman gleans all sorts of information from this kind of numbers crunching. For instance, how many journeymen would be needed to support approximately $1.44 million in sales?
The answer can’t be immediately determined from our oversimplified example, but a contractor involved in this kind of budgeting process would derive the answer along the following lines.
Let’s assume this is a budget strictly for service work, and the company employed 10 journeymen last year. They produced $1.25 million in revenues, an average gross sales per man of $125,000.
Looking at next year’s budget, the contractor sees that those 10 journeymen would have to average about $144,000 apiece in gross sales to meet the overall sales target, more than a 15 percent increase. Uh oh! We’re always looking to increase productivity, but that probably is too much to expect, so this contractor has a decision to make. Either he has to revise his budget, or else consider hiring at least one and probably two more journeymen if he wants to reach his sales goal. If he does decide to hire more people, he has to go back and revise his overhead projections to account for them. In this example, let’s assume that their added cost has already been factored in.
By reasoning along similar lines the contractor will be able to tell how many trucks he needs to operate, how much material he needs to buy, how much cash flow is needed and when it’s needed, and a multitude of other facts.
Also, going back to our $125,000 sales per man figure, more useful information comes into view. On an annual basis these 10 men would be expected to put in 20,000 hours of productive labor with another 2,000 hours logged to nonproductive tasks, which would be overhead expense. Dividing $646,875 worth of overhead by 20,000 productive hours of labor reveals overhead in a different light, namely a cost of $32.34 per productive manhour of labor. If we assume a 12–man labor force, we divide the overhead by 24,000 hours to arrive at a cost of $26.95 per productive manhour of labor.
It is important to know what gross sales per manhour, per week, per month must be. It is important to know how much it costs you the minute you unlock the door in the morning and lock it at night. It is important to know this and know that and know everything possible about your business if it is to reward you in a way that is commensurate with the hard work you put in and the risk you take.
Budgeting may sound complicated, but when one becomes truly involved with the numbers, it’s downright stimulating. I never look at it as a grind, but as a challenge that can even be fun. It’s something like playing blackjack in Las Vegas, except the odds are more in your favor.