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ing. Many people hate budgets; some to the point that they run their
businesses using their daily bank balances as their only financial tool.

You, too, might resist the notion that you can benefit from good budget-
ing”until you try it. You would learn that budgeting takes some of the
hazard out of business by minimizing the guesswork. Budgeting gives
you a blueprint for action. It tells you what to expect and alerts you to
trouble when the unexpected happens. Indeed, it is crucial to know how
your business will accomplish the goals you set for it, and your budget
measures your success; when your business outperforms your projec-
tions, you know you™re doing well.

To benchmark your success, you can calculate certain financial and oper-
ating ratios that look at both your income statement and balance sheet,
giving you an indication of your financial health over time. You will also
want to compare your numbers against your competitors™ and the indus-
try standard. For most industries, it is possible to compare your ratios to
the industry standard to get a sense of how financially competitive you
are as a business. You will certainly want to strive to be in the top half, or
better yet, the top quarter.


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32 Set High Standards



In this chapter, I take you through the basics of budgeting, showing how
to put together a bottom-up budget”that is, an overall budget that re-
flects the real needs of your business. I present case studies that show
the value of budgeting to a young business and to the business facing a
crisis. I also include a number of worksheets at the end of this chapter to
show you how to analyze your average selling prices, month-to-month
unit sales, sales projections, payroll, expenses, and overall performance.
First, I explain in more detail why the budget is so crucial and how to
keep your budget under control in even the most volatile industries.



THE BUDGET SETS PRIORITIES

You send a direct message about the priorities of the company with what
you spend your money on, as opposed to what you say with your vision
or mission statement. You might say your company is committed to cus-
tomer service, but if you spend little money training or staffing your cus-
tomer hotlines and a great deal on your corporate facility, employees will
know what your real commitment is.




PA RT IC I PAT I V E B U D GE T I NG

It™s an oddity of traditional businesses that budgets come down
from on high, from senior management, particularly from the fi-
nance department. The best budgets show the input of the people
making the expenditures and focus on each business function in
the company from the bottom up and starting with zero in each col-
umn of numbers. The best budgets reflect the thinking of the people
who know best where the company really spends its money. Get the
input of these people when you put your budgets and projections
together.

Senior managers must also understand and have input into the num-
bers in the budget. Good budgeting is a highly interactive process.
Whereas people may not argue for changes to the mission statement,
they will almost certainly argue for changes in allowable spending.
Budgets should be drafted, compared to the previous year™s actual
expenditures, debated for the best use of resources, and redrafted as
necessary.
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Creating a Budget Everyone Can Use and Understand



You should prepare budgets after you set direction with your vision and
mission statements and corporate objectives. The budget is the next step
in taking you from the generalities of your business plan to the specifics
of day-to-day operations.

By setting priorities, the budget makes clear what your finances permit
you to do to reach your goals. It translates the vision and mission state-
ments and corporate objectives into action.

Above all, the budget is a tool for all people who have responsibility for
spending money and making money, not just CEOs. The financial state-
ments you show your directors, investors, and lenders don™t tell man-
agers what you expect from them and which of their efforts you value
most; your budget does.


KNOW WHEN TO STOP

It is important to spend time creating your budget, but when you finish it,
get back to daily business. The most important point is to have something
to measure reality against, not to make the budget perfect. Budgeting be-
comes more realistic as time goes on. Budget 12 months in advance, and,
if possible, update quarter by quarter to create a rolling 12-month budget.
This enables you to make changes frequently enough to do reasonably ac-
curate budgeting. Don™t think too much about the budgeting process in
the meantime.

In addition, build some tolerance for variance into your numbers. Your
budget stops being accurate the moment you finish it, and when vari-
ances occur”and they will”make sure the numbers allow opportunity
for your managers to act creatively. Although budgets should be de-
signed to create accountability, accountability should be related to the
real issues behind the numbers, not the numbers alone.

Remember that finance plays both operational and analytic roles. Some
business owners become excessively enamored of quantitative analysis”
to the detriment of qualitative analysis, which can lead to problems. When
an overzealous finance department detects a companywide difficulty, it
can make matters worse by forcing its priorities on other units rather than
looking at the underlying problem.

One Illinois-based consultant offers a good example. When an internal
audit finds too many assets tied up in inventory, he says, “out goes a
34 Set High Standards



memo telling all unit managers to cut inventory 25 percent in six months.
Only the hot items move out fast. The rest sit there. When it™s all over, in-
ventories are down 10 percent, the CFO declares victory”and the only
items left are the ones nobody wants.”



PLAN FOR DEBT

Knowing where you stand can yield big benefits, as Andrea Totten dis-
covered in running her California-based quilt-making company, Rags to
Riches. She founded the company in 1971, selling quilts and comforters
at flea markets and art fairs, then used a small catalog to generate orders
from stores and designers. “[Business] started getting really busy and
that™s when I decided that I needed to find a direction,” she says. “I
guess then I didn™t think of the word business plan, but I guess now in
retrospect that™s what it was.”

Totten wrote proposals and went to a variety of lenders, only to find
most reluctant to lend to small businesses and some, it seemed, reluctant
to lend to women. “Even though I had a house and a car, they wouldn™t
take them [as collateral],” she says. “Each year they™d say, ˜Come back in
a year.™ Meanwhile, four or five years passed.”

Totten resorted to “asset based lending””high-interest loans made
against accounts receivable by fashion industry lenders called factors.
“You sell your receivables,” Totten says. “[The loans] were good at the
time because they were needed. But they turned out to be too expensive
to maintain.”

The factors charged 4.5 percent interest per month. “The only way to
beat it is to keep the money going. So once the business slows down, it™s
a killer,” she says.

She persuaded a bank to lend her working capital when her billings
passed half a million dollars. Still, Totten found herself devoting 20 per-
cent of her cash flow to servicing debt. In addition, she didn™t think her
bankers valued small-company business; among other things, they fre-
quently changed the terms of her credit line. She paid her loans down as
quickly as she could and eventually got out of debt.

“By the time I took classes on how to write [business plans, the instruc-
tors assumed that] you sell $20,000 and the next month you have $20,000
35
Creating a Budget Everyone Can Use and Understand



in because the people always pay on time. Not true. Receivables don™t
come in that smoothly, and vendors want money. Your labor, of course, is
COD,” she says. “I brought in $80,000 in cash, where was it? The business
plan was hard to keep to because of the fluctuations of our industry.”

In the late 1980s, a number of Totten™s competitors went out of business.
Trouble plagued the retail industry, too. Stores that had always paid
their bills on time now stalled her, stretching her receivables to $10,000
or $15,000 per store. Then suddenly they™d be gone, leaving her with lots
of bad debt.

All this led Totten to manage her receivables strictly. “I never let any-
body get high enough to ruin me if I lose,” she says. “It™s kind of like
gambling. Don™t ever gamble more than you can afford to lose. I look at
my receivables and [decide which] people I™ll put on COD. If they don™t
want to buy from me anymore, that™s okay because I™m losing money
[with them] anyway.”



FOLLOW THE MONEY

Totten developed a number of strategies for staying on budget in a tu-
multuous industry. First, she downsized by attrition”that is, she opted
not to replace employees who left. Once she had little or no short-term
debt to preoccupy her, she could reassess her market, too. “I said: ˜What
do I want to do? Do I want to go and look for new business or do I want
to better serve the business I have?™ And I chose to stay with the stores
that were loyal to me and not advertise.”

In addition, Totten was selling to almost 1,000 retailers throughout the
country. Whereas many entrepreneurs would look to add even more re-
tailers, Totten felt that she was stretching herself too thin. She looked at
the big customers who paid most reliably and cut back on doing business
with the rest. In the end, she trimmed her customer list by two-thirds but
maintained almost the same revenue. As she explains, “To me, there are
two ways to go out of business. One is to have too many orders and the
other is to have too few. I used to look at gross sales, but my accountant
showed me if I sell $900,000 a year and my profits are higher, that™s a suc-
cess, not if I sell a million a year and my profits are down.”

Totten also released her outside sales reps. They took 10 percent commis-
sions and often didn™t service the customer well, giving out the wrong
36 Set High Standards



information or not knowing the answers to key questions. “I [used to
pay] two people to do the same job. Now we have our [in-house] reps call
and customers fax the orders in. We call back and go over the order with
them,” she says.

Throughout this restructuring, she kept prices steady, protecting her
margins. Her strategy translated into stiff terms with her customers. Rags
to Riches doesn™t give retailers discounts beyond those in its price list”
and those only to retailers who display the company™s wares prominently.
“It™s one thing to get into a new store, but its another thing to get re-
orders,” she says. In fact, she uses reorder trends as her main diagnostic
test for how the company is doing. “If we don™t get reorders, then we
know that something™s wrong. Either the salespeople don™t know how to
sell [the product] or it™s not displayed correctly or it™s in the wrong store.”

Her final observation about taking control of her company™s finances was
that “Small business people have to keep up with what is happening just
as much as a CEO at a huge corporation. If you™re not on top of your fi-
nances on a real-time basis you™re not going to make it.” Thirty plus
years later, Rags to Riches produces bedding and upholstered furniture
along with hand-painted furniture in a 13,000-square foot facility and
employs a staff of 50.



CONTROL EXPENSES

Andrea Totten grew her business by remaining flexible and by keeping
an attentive eye on her market. She controlled expenses and reshaped her
finances to fit her needs. She learned the value of understanding the im-
pact of finances on her business.

Totten™s example holds some valuable lessons, including these:

• Evaluate your projections regularly, particularly when adding capi-
tal to your business (whether yours or somebody else™s).

• If you have a hunch about the future, follow it”but look for similar
surprises in the past and find out what impact they had. Don™t
simply adjust your financial projections on instinct. Instead, base
your new thinking on as much hard evidence as you can gather.
Your hunch may tell you that an upturn lies around the corner”
but that new market you pursue may trail the overall economy by
a year.
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Creating a Budget Everyone Can Use and Understand



The owners of new businesses often review every expense, but as things
progress, they back off. They control expenses with budgets and paper
trails”that is, invoices and purchase orders”and make sure that only a
few, accountable people handle cash.

Once your business is established, you should spend most of your budg-
eting time on the big numbers, where most of your money is spent. The
major categories are revenue, payroll, inventory costs, marketing and
sales, facility, insurance, computers, and others that may be related to
your particular business. Here are some simple reminders about holding
down expenses:

• Purchasing. In a small business, put one person”not five or six”in
charge of ordering merchandise and using overnight mail services.

• Supplies. Make your employees aware of the costs of office supplies;
some managers mark the individual cost of each item, such as
pens, on the box. Hold your managers responsible for expenses in
their departments. Keep an eye out for hard-to-budget costs such
as delivery fees. You may spend less to send an hourly worker to
pick up supplies.

• Travel and entertainment. Scrutinize expenses such as travel and
entertainment. Trips should be planned in advance when possible
to take advantage of travel discounts, especially some of those
now found on the Internet. Make sure that travel and entertain-
ment expenses pay off with increased business.

• Professional fees. Negotiate fees paid to lawyers, accountants, and
consultants by the project or the period of time, or even their
hourly rate. Set caps on what can be spent without specific
approval.

• Computers and related costs. A great deal of money has been spent
in the past few years on personal computers and software, most
of it necessary. Set a budget for computer hardware and a sepa-
rate budget for software and technical support.


PLAN FOR CASH

Unfortunately, in most businesses, cash coming in lags behind cash
going out. For instance, you may have to pay for inventory or raw mate-
rials months before you receive money on the products they produced.
This requires cash flow planning. Your budget may be right, but it may
38 Set High Standards



not take into consideration when the cash has to go out and when it will
come in. Many businesses use a line of credit to plan for this lag time.

Get a line of credit when your business is doing well”when you don™t
need it. When you do need it, you probably won™t qualify to get it.

Knowing how to slow down spending and collect what others owe you
are skills essential in any business. These skills give you access to the
cash you need to grow or to stay in the game.

Accounts payable are the bills from vendors. It is often possible to negoti-
ate terms that will allow you to hold on to your money longer. For in-
stance, you may be able to pay bills in 45 days instead of the customary
30 (this varies by industry) if you make arrangements beforehand.

When a company is facing a financial downturn, one of the first things
it does is slow down the paying of its bills. It may be unable to borrow
from a bank at that point, so it borrows from its vendors. It is important
to know how to do this well, as well as to know when it is being done to
you. If you find you need to pay bills late, the most important thing is
to maintain communications with your vendors. It would be expensive
for them to have to forcibly collect these monies from you, so they will
likely be willing to hang in there for some time, as long as you provide
them with a plan for repayment. This is particularly important if you
need to keep purchasing from them during your financial crisis.

Do not get in the habit of paying your vendors late unless necessary.
When it becomes necessary, you will need the track record of a good
payment history to convince them to give you extra time. Especially
in tight industry niches, word travels about who pays on time and
who doesn™t. The day may come when you need a favor from a vendor
who feels ill-used or when a credit agency downgrades your payment
rating.

Accounts receivable are monies that your customers owe you for product
already delivered. The object is to collect this money as quickly as
possible. Coming from the opposite perspective, it is important to
know the top (at least) 10 customers who owe you money and to track
their payment habits. You are more likely to be paid if you keep in reg-
ular communication with them and they need your services on an on-
going basis. You should specify a maximum amount of credit you are
willing to extend to each customer, and watch carefully any customers
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Creating a Budget Everyone Can Use and Understand



at the upper end of that limit. Don™t loan more than you can afford
to lose.


BUDGET FOR THE BIG ITEMS

Another kind of budgeting that companies must do is budgeting for the
big-ticket items that can be depreciated over time. Depreciation allows you
to take the expense of the big item into your records over time so that you
have a more even profit picture year to year. Real estate, a building, a
computer system, or other large equipment are examples of these big-
ticket items, called capital expenditures. You should budget for these ex-
penditures separately because they don™t go into your income statement.
Income statements are intended to represent your revenue and expenses
from regular operations, not extraordinary one-time purchases.


PLAN FOR PROFITS

Even if cash lags behind, always plan to make a profit. You may be able to
get through short periods where your expenses are higher than your rev-
enue, especially when you first start in business, but it will catch up with
you. However, in spite of your careful budgeting, the truth is that rev-
enue is often less than expected, and expenses are usually more than ex-
pected. Knowing this, budget enough of an excess to allow for a margin
of error to ensure a reasonable profit.

What makes for a reasonable profit varies by business, industry, and is
usually affected by the economy as well. Some years, survival itself is a
victory. In other years, building up a cash reserve to protect yourself in
the down years (and expect that there will be some if you are in business
long enough) is essential.

For the long run, it is essential to develop a business that prospers in
both an up and down economy”preferably with some products or ser-
vices that sell well when the economy is great and others that people
need when times are tough.


SET FINANCIAL CONTROLS

Budgeting and sharing financial information with employees doesn™t
mean loosening the reins on financial controls and checks and balances
40 Set High Standards



to prevent errors and theft. It is estimated that employee theft may cause

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