Here’s a question I get asked a lot: What’s the best way to start a budget, determine financial categories, and think about goal setting?
The best way to start a budget and to set goals is to “know your number.”
This is one of those cases where you want to start with the end in mind.
What’s your number?
Think about how much do you want your business to pay you total this year. Keep in mind that there are income taxes and self-employment taxes involved. So think of what would you like your NET income from your business to be.
Here’s a big caveat: This process that I’m going to outline for you applies only for those business models where the owner takes money out of the business via DRAWS; in other words they don’t pay themselves as employees. No payroll involved.
So here are the five steps: steps 1-4 cover the “starting a budget and goal setting” piece; step 5 discusses choosing financial categories.
Step #1: Pick your number
- How much does it cost to be you? For groceries, rent, mortgage, transportation, clothes, eating out, movies, trips? All the daily and weekly stuff you pay for. What is the total annual amount you spend for daily living expenses?
- Next, how much do you want to save each year for retirement, college for the kids, a new home, a new car, a vacation, cash reserves for those unexpected expenses, major repairs on the house and car, you name it?
- Add those two pieces together and that’s your number for the year: the annual amount that you need to meet all those obligations and choices. That’s the number that’s going to determine your business budget goals.
Step #2: Figure out your personal effective tax rate
- Pull out copies of your most recent federal and state tax returns.
- Total up all the tax you paid the state and the feds.
- Divide that into your total gross income (line 21 on the 1040 for 2017.) This is your effective tax rate.
Step #3: Figure out your Administrative Overhead
- Percentage method: if you know that you don’t want to spend more than 25% of your gross income on administrative OH, then use the “% Budget Builder” spreadsheet and plug that % in the yellow box. This method works best if your administrative overhead costs rise in proportion to your gross income.
- Dollar method: if you know an actual dollar amount of how much you want to spend, then use the “$ Budget Builder” spreadsheet. This method works best if your administrative costs are not so dependent on your sales, and more fixed.
One way is not better than the other. It’s just that one will be better suited to your situation. If you know how much your administrative overhead was in actual dollars for the last two years, and you think that that dollar amount will do you just fine for the next year, then use that number.
Step #4: Figure out your Cost of Sales (COS)
- Total up all the costs involved in putting together each product or service. These are what are called in accounting lingo “direct costs.” The are monies that you spend on making or providing the product or service. Things like:
- ingredients to make scones and cakes
- labor to bake the cakes
- subcontractors who work on providing client deliverables
- lumber and parts to build a house
- Put a sales price on the product or service. How much do you charge your client/customer for your product or service.
- Divide the total cost into the sales price to get your COS percentage.
Once you have gathered these 4 numbers, click on through here to download the “5 Ways Budget Builder Tool” that will calculate your gross income target based on the numbers you came up with here.
The amount your business needs to bring in based on those metrics and the accompanying “Budget Builder Tool” calculates what your gross income needs to be to get you to your number. Voila! Just input the numbers you generated above into the corresponding yellow boxes on the spreadsheet.
Step #5: Clarify your financial categories
- There are two types of costs: cost of sales and administrative overhead costs. Why it’s important to categorize correctly between these two is so that you can know how much it costs you to manufacture/distribute/provide your goods or services. This gets you to your Gross Profit number, a key metric.
- Your administrative expenses then get subtracted from the gross profit leaving you with your net operating profit, another key metric.
- Within each of these two “buckets” you have a lot of flexibility in the number and names of each category (called “accounts” in financial jargon.)
- The administrative overhead bucket is further sectioned into smaller buckets, such as sales, marketing, website, payroll, professional development. This is so you can track how much you are spending in different types of categories, compare them to each other year over year, and notice any trends or patterns. And each section is yet another metric.
- Within each section, you can get as detailed as you want. It’s up to you. You can have one account called “Website Expenses” or you can break that down into more detailed accounts like:
- Headshots
- Copyediting
- Domain Names
- Hosting Fees.
So there you have it. That’s how you build a budget starting with knowing your number.
“What gets measured gets managed.” Peter Drucker
“What gets measured grows.” Christine Kane
A budget is a vision. A financial vision. Creating a budget is akin to creating a vision board. Just as a vision board with pictures helps you visualize what you want and solidifies your intention to get them, so a budget acts as a financial vision board using numbers instead of pictures. In order to reach a goal, you have to know what your shooting for. Zig Ziglar put it well when he said, “You can’t hit a target you cannot see. You cannot see a target you do not have.”
Your business’ purpose is to support you, it’s how you make your living and provide for your family. Knowing your numbers is how you get from where you are to where you want to be. Knowing your numbers is the plan.
Want to go further and dive deeper with these steps? Let me know. I’d love to hear what you’re curious about. Just email me at monique@equitybydesign.com
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