Putting together a budget? Check out this episode of “Mind Your Own Business.”

I sat down with a client last week to review their draft P&L budget for the new financial year. As I went through their figures with them, it was obvious to me that their budgeting had been more of a mathematical exercise than a thinking exercise. Their financial controller had just slapped on a 10% increase on all revenue streams. Some of their costs had been adjusted based on historical trends, and they had their draft P&L budget.

While this is an approach you can take to budgeting, in my view, it’s not the best approach. The approach you should take, in my opinion, is to treat your budget as a business plan in numbers. You want to be clear on what you’re trying to achieve and put some thought into how you are going to get there.

Let’s take revenue, for example. This particular client just had all revenue being reported into one sales nominal. That isn’t helpful. You need to look at all of your revenue streams because within some of those revenue streams, there will be more opportunity for growth than others. Some revenue streams will be more profitable. So for your business, which revenue streams does it make sense for you to pursue, or which products or service lines does it make sense for you to pursue?

This particular business didn’t have a true cost of sales. They had some costs hiding in their overheads that were proper cost of sales. What you need to do is make sure you’ve got all the right costs above the gross profit line. Equally, if there are some overheads in your cost of sales and direct cost, push them down. This way, you can understand what your true margins are. This is important. If you don’t have those costs in the right area, you’re not going to have a true gross margin, which means your pricing policy could be affected because you don’t have the right information to hand.

Understand what’s happened with those cost of sales. What’s likely to happen? Put some nuance into it. If you know that you are struggling for capacity in some areas, what are you going to do about it? Are you going to increase that capacity, or are you going to try and get a better yield for the capacity that you do have? If that’s the case, how does that affect your revenue and your cost of sales?

What are you going to do around trying to reduce some costs? It’s really tight at the moment while prices are going up all over the place. Is there some opportunity for you to be a little more prudent in some areas? Are all of your cost lines in your cost of sales at the right level?

A really good tool for this is to do something called a common size analysis, where you express every single number in your budget as a percentage of turnover. Over that, if you do that and compare it with previous years, it’s much easier to try and understand what a range of normal should be, or at least if something’s a bit out of whack.

Sometimes clients will give me a budget and say, “Oh, what do you think?” And it’s really difficult to try and understand if the numbers you’re looking at in isolation are good or bad. You need benchmarks; you need things to compare these numbers against. So a common size analysis is, in my view, one of the best tools you can put in place to understand how your budget compares to previous years.

Make sure that you’ve got that level of nuance in your cost of sales. Then, when it comes to your overheads, the common size analysis will really help. But what capital expenditure are you planning over the next 12 months? And what impact will that have on depreciation? Are all of your overheads divided into the right level of detail?

Often I’ll see businesses that have the right percentage of turnover when it comes to their overall overheads, but often they’re not spending money in the right places. So is there an opportunity to realign your investment in your overheads so you can get a bigger bang for your buck? These are important questions, and obviously, there are loads of others. But the mindset that I’d like you to adopt when you’re putting together your P&L budget is one of a business planning in numbers.

Using this approach, thinking through things, working with your teams to understand specifically what needs to change, and how likely those things are to change, that is going to give you so much better information. It’s going to give you a much better path forward for the next 12 months and will really bring your budgets to life.

One more thing: creating a P&L budget is one thing, but you absolutely need a 12-month cash flow budget. You need to know how much cash you’re going to end the financial year with because while profit and turnover are important, cash is king. And if you aren’t focused on what that cash balance needs to be at the end of the year, then you are likely to sleepwalk into problems.

So there we go. Think about the things that I’ve discussed in this video, watch this video with your team, and come up with your approach to creating a proper P&L budget and a proper cash flow budget that’s going to help you get brilliant results over the year ahead.

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