Increase Profitability With Zero-Based Budgeting

INCREASE PROFITABILITY WITH ZERO-BASED BUDGETING

By Douglas E. Castle For GEI Consulting

Originally Published In the GEI Blog

In business, our basic financial objectives are to 1) increase the number of units sold; 2)increase profit margin per unit sold; and to 3) decrease fixed and semi-fixed expenses – all of this so that our company may consistently maximize profits [assuming, of course, that we do not sacrifice quality and service standards] as operations continue. While we have neither the space nor time to delve into the revenue and unit pricing objectives, we can tackle the expense reduction issue head on by utilizing zero-based budgeting.

Typically, budgets are mapped out or structured based upon existing expenses, which are looked at line by line, and where each expense line is multiplied, too often unquestioningly, by some increase factor (i.e., some percent per month or some percent increase per year). When the budget variance reports (actual versus budgeted expenses) are examined monthly or quarterly, the previously mentioned approach artifically inflates the quality of performance; if this budgeting approach is continued unchecked, actual expenses will be consistantly lower than their budgeted amounts (as if operations were running quite efficiently) even as the company is losing money by the boatload by overspending. This simplistic time-saving type of budgeting, while exceedingly common, leads to over-inflated budgeted expenses, poor variance feedback, and consequently, to poor expense controls and policies. Some real-life examples:

==+ In very large companies, I have actually seen cases where discontinued departments and functions were actually given budgetary expense allocations because nobody cared to check on whether or not those departments or functions were still in existence. And this error was compounded with each fiscal year. Governmental departments and divisions of Not-for-profit entities are notorious for doing this, as are some For-profit entities – especially the larger, more structurally complex ones.

==+ In other large companies, I have witnessed a managerial mentality where “If we don't spend every bit of what we were budgeted for this year, we'll lose our allocation for next year. We'd better use it before we lose it!” This type of thinking guarantees expense inflation and incredible waste. And once again, governmental departments and divisions of Not-for-profit entities are notorious for doing this, as are regular For-profit entities – especially the larger, more structurally complex ones.

Needless to say (but I'll say it anyway) the two above procedural and mindset errors create tremendous financial problems as well as a crass distortion in the evaluation of actual performance. The possible “cure” for this erroneous protocol and reasoning is to employ a zero-based budgeting session at least once per year. The process is actually simple, and I've distilled it into several straightforward steps which you can follow to do a zero-based budgeting at some regular intervals throughout the year:

Step 1: Create a Budget Review Group comprised of major stakeholders and other participants who will not be threatened by the results of the process and who have a substanital interest in the profitability of the enterprise;

Step 2: Access a line-by-line expense budget (like the type you would use to perform a variance analysis) as a worksheet;

Step 3: Examine each line of the expense budget in terms of its utility. What purpose does it serve? Is it necessary? Should it be discontinued or continued? Is its relevance increasing or declining? Does it directly serve the purpose of generating profits or of supporting profitable operations for the business?;

Step 4: Eliminate budgeted expense items as appropriate. Reduce other expense items to their appropriate level. Remember that the key question to ask in a zero-based budgeting scenario is “Does this expense support revenue growth or production of goods or services to support those revenues?” Reconstruct the budget based upon these crucial revisited assumptions;

Step 5: Take the reconstructed budget and make the necessary eliminations, cuts and reductions to the actual business, as if you were looking at the business as an outside “efficiency expert” or cost accountant. This is a politically perilous step, as it will likely undermine some free benefits to certain individuals, destroy some hidden agendas by starvation, and stop the methodical step-by-step process of internal fiefdom-building amongst certain power-mongers within your managerial infrastructure.

Despite the temporary discomfort caused by the reshuffling which invariably follows a zero-based budgeting “correction,” the results are almost always worth the investment of time and effort. In sum, zero-based budgeting can give your organization a refreshed and clear prospective that will enable you to more readily serve the purpose of profitability for all stakeholders.

Reduce your corporate waste footprint with zero-based budgeting. Be environmentally-friendly.

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Thank you, as always, for reading me.

Douglas Castle for Global Edge International Consulting Associates, Inc. and The Global Edge International Blog

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Creating A Winning Business Plan

Notice: Much of the above work below derives from information publicly available through the U.S. Small Business Administration (the SBA).

Your business plan is simply a written document that describes in detail how your new business is going to achieve its goals. A business plan will lay out a written framework from a marketing, financial and operational viewpoint. Sometimes a business plan is prepared for an established business that is moving in a new direction, or is in search of new capital. Your business plan is a compass to guide you, incrementally and categorically, to the achievement of your vision – And of course, in some cases, the document will be used as a selling tool to solicit the interest of prospective acquirors or financiers.

You've undoubtedly heard the truism that “If you fail to plan, then you should plan to fail”. And the best plans are the result of a group or team effort which is reduced to a writing.

A business plan includes a description of a company or small business, its services and/or products and how the business will achieve its goals. The plan includes the overall budget, current and projected financing, a market analysis and its marketing strategy approach. In a business plan, a business owner projects revenues and expenses for a certain period of time and describes operational activity and costs related to the business.

The idea behind putting together a business plan is to enable owners to have a more defined picture of potential costs and drawbacks to certain business decisions and to help them modify accordingly before implementing these ideas.

A business plan is also a road map that provides directions so that a business can plan its future and helps it avoid bumps in the road. The time you spend making your business plan thorough and accurate, and keeping it up-to-date, is an investment that pays big dividends in the long term.

Your business plan should conform to generally accepted guidelines regarding form and content. Each section should include specific elements and address relevant questions that the people who read your plan will most likely ask.

Generally, a business plan has the following components:

Title Page and Contents
A business plan should be presented in a binder with a cover listing the name of the business, the name(s) of the principal(s), address, phone number, e-mail and website addresses, and the date. You don't have to spend a lot of money on a fancy binder or cover. Your readers want a plan that looks professional, is easy to read and is well-put-together.

Include the same information on the title page. If you have a logo, you can use it, too. A table of contents follows the executive summary or statement of purpose, so that readers can quickly find the information or financial data they need.

Executive Summary
The executive summary, or statement of purpose, succinctly encapsulates your reason for writing the business plan. It tells the reader what you want and why, right up front. Are you looking for a $10,000 loan to remodel and refurbish your factory? A loan of $25,000 to expand your product line or buy new equipment? How will you repay your loan, and over what term? Would you like to find a partner to whom you'd sell 25 percent of the business? What's in it for him or her? The questions that pertain to your situation should be addressed here clearly and succinctly.
The summary or statement should be no more than half a page in length and should touch on the following key elements:

• Business concept describes the business, its product, the market it serves and the business' competitive advantage.
• Financial features include financial highlights, such as sales and profits.
• Financial requirements state how much capital is needed for startup or expansion, how it will be used and what collateral is available.
• Current business position furnishes relevant information about the company, its legal form of operation, when it was founded, the principal owners and key personnel.
• Major achievements points out anything noteworthy, such as patents, prototypes, important contracts regarding product development, or results from test marketing that have been conducted.
  

Description of the Business
The business description usually begins with a short explanation of the industry. When describing the industry, discuss what's going on now as well as the outlook for the future. Do the necessary research so you can provide information on all the various markets within the industry, including references to new products or developments that could benefit or hinder your business. Base your observations on reliable data and be sure to footnote and cite your sources of information when necessary. Remember that bankers and investors want to know hard facts--they won't risk money on assumptions or conjecture.

When describing your business, say which sector it falls into (wholesale, retail, food service, manufacturing, hospitality and so on), and whether the business is new or established. Then say whether the business is a sole proprietorship, partnership, C or Sub chapter S corporation. Next, list the business' principals and state what they bring to the business. Continue with information on who the business' customers are, how big the market is, and how the product or service is distributed and marketed.

Description of the Product or Service
The business description can be a few paragraphs to a few pages in length, depending on the complexity of your plan. If your plan isn't too complicated, keep your business description short, describing the industry in one paragraph, the product in another, and the business and its success factors in two or three more paragraphs.

When you describe your product or service, make sure your reader has a clear idea of what you're talking about. Explain how people use your product or service and talk about what makes your product or service different from others available in the market. Be specific about what sets your business apart from those of your competitors.

Then explain how your business will gain a competitive edge and why your business will be profitable. Describe the factors you think will make it successful. If your business plan will be used as a financing proposal, explain why the additional equity or debt will make your business more profitable. Give hard facts, such as "new equipment will create an income stream of $10,000 per year" and briefly describe how.

Other information to address here is a description of the experience of the other key people in the business. Whoever reads your business plan will want to know what suppliers or experts you've spoken to about your business and their response to your idea. They may even ask you to clarify your choice of location or reasons for selling this particular product.

Market Analysis
A thorough market analysis will help you define your prospects as well as help you establish pricing, distribution, and promotional strategies that will allow your company to be successful vis-à-vis your competition, both in the short and long term.

Begin your market analysis by defining the market in terms of size, demographics, structure, growth prospects, trends, and sales potential. Next, determine how often your product or service will be purchased by your target market. Then figure out the potential annual purchase. Then figure out what percentage of this annual sum you either have or can attain. Keep in mind that no one gets 100 percent market share, and that a something as small as 25 percent is considered a dominant share.

Your market share will be a benchmark that tells you how well you're doing in light of your market-planning projections.

You'll also have to describe your positioning strategy. How you differentiate your product or service from that of your competitors and then determine which market niche to fill is called "positioning." Positioning helps establish your product or service's identity within the eyes of the purchaser. A positioning statement for a business plan doesn't have to be long or elaborate, but it does need to point out who your target market is, how you'll reach them, what they're really buying from you, who your competitors are, and what your USP (unique selling proposition) is.

How you price your product or service is perhaps your most important marketing decision. It's also one of the most difficult to make for most small business owners, because there are no instant formulas. Many methods of establishing prices are available to you, but these are among the most common.

• Cost-plus pricing is used mainly by manufacturers to assure that all costs, both fixed and variable, are covered and the desired profit percentage is attained.
• Demand pricing is used by companies that sell their products through a variety of sources at differing prices based on demand.
• Competitive pricing is used by companies that are entering a market where there's already an established price and it's difficult to differentiate one product from another.
• Markup pricing is used mainly by retailers and is calculated by adding your desired profit to the cost of the product.
  

You'll also have to determine distribution, which includes the entire process of moving the product from the factory to the end user. Make sure to analyze your competitors' distribution channels before deciding whether to use the same type of channel or an alternative that may provide you with a strategic advantage.

Finally, your promotion strategy should include all the ways you communicate with your markets to make them aware of your products or services. To be successful, your promotion strategy should address advertising, packaging, public relations, sales promotions and personal sales.

Competitive Analysis
The purpose of the competitive analysis is to determine:

• the strengths and weaknesses of the competitors within your market.
• strategies that will provide you with a distinct advantage.
• barriers that can be developed to prevent competition from entering your market.
• any weaknesses that can be exploited in the product development cycle.
  

The first step in a competitor analysis is to identify both direct and indirect competition for your business, both now and in the future. Once you've grouped your competitors, start analyzing their marketing strategies and identifying their vulnerable areas by examining their strengths and weaknesses. This will help you determine your distinct competitive advantage.

Whoever reads your business plan should be very clear on who your target market is, what your market niche is, exactly how you'll stand apart from your competitors, and why you'll be successful doing so.

Operations and Management
The operations and management component of your plan is designed to describe how the business functions on a continuing basis. The operations plan highlights the logistics of the organization, such as the responsibilities of the management team, the tasks assigned to each division within the company, and capital and expense requirements related to the operations of the business.

Financial Components of Your Business Plan
After defining the product, market and operations, the next area to turn your attention to are the three financial statements that form the backbone of your business plan: the income statement, cash flow statement, and balance sheet.

The income statement is a simple and straightforward report on the business' cash-generating ability. It is a scorecard on the financial performance of your business that reflects when sales are made and when expenses are incurred. It draws information from the various financial models developed earlier such as revenue, expenses, capital (in the form of depreciation), and cost of goods. By combining these elements, the income statement illustrates just how much your company makes or loses during the year by subtracting cost of goods and expenses from revenue to arrive at a net result, which is either a profit or loss. In addition to the income statements, include a note analyzing the results. The analysis should be very short, emphasizing the key points of the income statement. Your CPA can help you craft this.

The cash flow statement is one of the most critical information tools for your business, since it shows how much cash you'll need to meet obligations, when you'll require it and where it will come from. The result is the profit or loss at the end of each month and year. The cash flow statement carries both profits and losses over to the next month to also show the cumulative amount. Running a loss on your cash flow statement is a major red flag that indicates not having enough cash to meet expenses-something that demands immediate attention and action.

The cash flow statement should be prepared on a monthly basis during the first year, on a quarterly basis for the second year, and annually for the third year. The following 17 items are listed in the order they need to appear on your cash flow statement. As with the income statement, you'll need to analyze the cash flow statement in a short summary in the business plan. Once again, the analysis doesn't have to be long and should cover highlights only. Ask your CPA for help.

The last financial statement you'll need is a balance sheet. Unlike the previous financial statements, the balance sheet is generated annually for the business plan and is, more or less, a summary of all the preceding financial information broken down into three areas: assets, liabilities and equity.

Balance sheets are used to calculate the net worth of a business or individual by measuring assets against liabilities. If your business plan is for an existing business, the balance sheet from your last reporting period should be included. If the business plan is for a new business, try to project what your assets and liabilities will be over the course of the business plan to determine what equity you may accumulate in the business. To obtain financing for a new business, you'll need to include a personal financial statement or balance sheet.

In the business plan, you'll need to create an analysis for the balance sheet just as you need to do for the income and cash flow statements. The analysis of the balance sheet should be kept short and cover key points.

Supporting Documents
In this section, include any other documents that are of interest to your reader, such as your resume; contracts with suppliers, customers, or clients, letters of reference, letters of intent, copy of your lease and any other legal documents, tax returns for the previous three years, and anything else relevant to your business plan.

Some people think you don't need a business plan unless you're trying to borrow money. Of course, it's true that you do need a good plan if you intend to approach a lender--whether a banker, a venture capitalist or any number of other sources--for startup capital. But a business plan is more than a pitch for financing; it's a guide to help you define and meet your business goals.

Just as you wouldn't start off on a cross-country drive without a road map, you should not embark on your new business without a business plan to guide you. A business plan won't automatically make you a success, but it will help you avoid some common causes of business failure, such as under-capitalization or lack of an adequate market.

As you research and prepare your business plan, you'll find weak spots in your business idea that you'll be able to repair. You'll also discover areas with potential you may not have thought about before--and ways to profit from them. Only by putting together a business plan can you decide whether your great idea is really worth your time and investment.

If yours is a startup business and you'd like to download a high-quality template and instructions to follow for the preparation of your own business plan, simply click HERE.

If yours is an existing and established business and you'd like to download a high-quality template and instructions to follow for the preparation of your own business plan, simply click HERE.

Notice: Much of the above work derives from information publicly available through the U.S. Small Business Administration (the SBA).

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Your Company's Burn Rate - Budget And Capitalize Successfully

It may well take money to make money, but it requires intelligence and vigilance not to lose it. Too many entrepreneurial enterprises and crowdfunded projects suffer from the initial "high" of newly-found capital, and spend quickly and unwisely. Having a detailed budget at the outset -- a budget that incorporates your enterprise's "Burn Rate" of capital per month -- is essential to enable your business to survive and thrive.

As a word (in advance) of advice, establish a realistic application of proceeds and a month-to-month budget prior to seeking any infusion of capital. For the well-being of your company, strategic and tactical budgeting are disciplinary tools to keep your company in proper operating condition.

The burn rate is that amount of funds which your company must spend per month (i.e., necessary fixed costs, without any allowance made for revenues -- a "zero revenue" assumption) in order to continue its operations.

Be certain that while you are calculating your monthly burn rate that you do not include sunk costs relating to pet projects. Sunk costs are those costs which tend to relate to pet projects which are being treated as investments, but which are really cases of "throwing good money after bad". Don't make a provision for sunk costs -- simply identify them and stop incurring them by accepting (although this may be difficult emotionally) that they are merely an accumulation of waste -- stop feeding failed projects and cut your losses as early in your company's evolution as is possible.

After you've calculated your monthly capital burn rate, divide it into the amount of available capital (cash from investors, credit lines and from accumulated earnings) and the result produced will be the number of months that your company can sustain itself without generating any revenues. This computation yields your company's estimated lifespan if it were to generate no revenues.

Before commencing any negotiations for capital (through debt, equity, or otherwise), know your company's anticipated burn rate and multiply it by the number of months forecasted to be required prior to your company's initiating an adequate contribution margin (this latter number can be obtained by taking your company's price per unit sold, reducing that number by direct variable costs [such as direct labor and direct materials, as applicable] and multiplying that result by the number of units sold in a month) and you will have produced a conservative estimate of how much capital your company will require to sustain its existence until the contribution margin is fully adequate to cover the burn rate amount.

Some other important considerations and distinctions about your company's capital burn rate:

1) Gross burn rate is the total amount of money you are spending per month. Net burn rate is the amount of money you are losing per month. So if your costs are $500,000 per month and you have $350,000 per month in revenue then your net burn (500-350) is equal to $150,000. The reason that most investors quickly zero in on net burn is that if you have $3 million in your bank account and have a net burn of $150,000 per month you have more than 18 months of cash left provided your net burn stays constant. Conversely if you’re burning $600,000 per month (yes, some companies do) then you only have 5 months of cash left.

2) The answer is more complex than just Gross Burn Rate vs. Net Burn Rate. There may well be a trade-off between growth & profits.

Gross margin (GM) is the amount of profit you make per sale of your product or service taking into account your total costs of selling that product or service. If you have a very low gross margin (10-30%) it can be very hard to build a large, scalable business because you need to make a lot of sales to cover your operating costs.

Some industries work well with players who have low gross margins but these tend to be industries with very large, well established players and hard for new entrants to compete. In startup world low GM almost always equals death which is why many Internet retailers have failed or are failing (many operated at 35% gross margins).

Many software companies have > 80% gross margins which is why they are more valuable than say traditional retailers or consumer product companies. But software companies often take longer to scale top-line revenue than retailers so it takes a while to cover your nut. It’s why some journalists enthusiastically declare, “Company X is doing $20 million in revenue” (when said company might be just selling somebody else’s physical product) and think that is necessarily good while in fact that might be much worse than a company doing $5 million in sales (but who might be selling software whose sales are extremely profitable).

3)  In doing your burn rate calculations, it may well be advisable to add a percentage-based "contingency" or "reserve" factor to the base burn rate. I typically take the burn rate as it is calculated, and multiply it by a factor of 1.10, which represents a contingency or reserve factor of 10%. While the burn rate will appear slightly higher, it is reasonable and responsible to provide for contingencies. If these surplus funds are not needed, they can be allowed to accumulate as cash or in some other liquid investment to be used when as and if necessary. I advise you to err on the side of caution.

Every fiscally responsible entrepreneur or executive should know his or her company's burn rate; further the burn rate should be recalculated every several months using a zero-based budgeting approach. This is because fixed cost structures and amounts expended per month do (despite their name) tend to change in a sort of stepped function at certain critical levels of revenue production.

Thank you, as always for reading me. Please visit our GEI website at the following address: http://GlobalEdgeInternational.com and visit our official blog as well at http://GlobalEdgeInternational.blogspot.com.


Douglas Castle

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