Colonel Savage, upon observing the workers of the Union Pacific RR in 1868, “Verily, men earn their money like horses and spend it like asses.”
What you can afford and when you can afford it
The owner cannot really tell me what they can afford or when they can afford it. A Company’s budget establishes what they can afford—their cash flow establishes when they will be able to afford it. The budget is merely the company’s financial plan to obtain their desired result. It is obviously central to a company’s success and a basic business tool yet the owner does not even have one. The budget is the financial model that the business must achieve in order to get your results.
A “budget” is a financial plan designed to produce a pre-determined result. It is the owner’s most important management tool.
Total COGS 70%
Gross Profit 30%
Net Profit 10%
Note that it is critical that the budget be in percentages and not dollars. Only the Federal Government can budget dollars because they are not restricted to what comes in—you are. Your job is to hit two numbers—the 70% Gross Profit and the 20% Overhead. If these two numbers hit, you will hit your profit.
What consulting can do for you is to tie down those numbers, create systems for the constant revision of those numbers and create focus throughout the entire organization on hitting those numbers.
Since the owner’s job is to hit those two numbers we start with the assumption that the owner is no good—that he will not hit those two numbers. Therefore we create a Profit Plan for the business assuming that he will only do half of his job. The company develops a budget for, in this case, 5% of sales and pre-determines how that will be spent on new assets, retirement of debt, retention of cash and taxes. This way the business knows what they are doing in these categories over then next twelve months and they can be relatively certain of achieving it since it is based only on half of the profit that they should be doing. If the owner does his job and produces the 10% profit that he should, then he is entitled to that difference as his bonus. In taking it he does not compromise the company as their needs have been accounted for in the first 5%. This is how a neopreneur business owner makes his money. You receive a salary for working in the company but your real money comes from doing your job—hitting those two numbers. You can do whatever you like with that money—you have already covered your cost of production, your overhead and have fully funded your Profit Plan.
To make your job easier, we delegate the responsibilities for hitting the numbers that are in this budget—fractionalization. We can have a production person responsible for production labor, a purchaser responsible for material costs, and an administration person responsible for overhead (although we generally have to take administrative—or at least owner’s compensation—out of the delegated overhead number). If the person who is responsible for holding the direct labor to 30% is able to do his job better and holds it to 28%, he has produced an additional 2% profit. This is beyond the budgeted profit and becomes the basis for an incentive. One-half percent is paid to the person who produced it; one-half percent to the owner for managing him so effectively and one percent is paid to the company for additional assets, debt retirement, cash retention and taxes. This formula is carried through to the other key profit variables.
In this example, the amount of the profit plan, when divided by .05 gives you the company’s required sales for break even. Not even a sales plan can be developed without a budget.