The financial term for planning is budgeting. It is 2014 but I am still staggered at hearing the following on my travels around the industry:
Your budget – if set up properly and used appropriately – is the most important ongoing management tool you can use in your business. It will help you generate greater profits and, more importantly, cash flow, the lifeblood of any operation.
In the past I have treated this subject with just a single article. But, considering the importance of this document to future success and for some operations simple survival I have put together a series of articles on this subject.
To start with there are two types of budgets: top line and bottom line.
WHAT’S THE BOTTOM LINE?
Bottom line budgeting is adopted by many corporate head offices. With this technique a profit is decided upon, on to this is added the planned overheads to calculate the $ Gross Profit required. This number is then divided by the % Gross Profit to calculate the Sales Target.
For example, Hardware Store Z has Assets (what the business owns) of $1,000,000 (eg debtors, stock and written down value of plant & equipment) and Liabilities (what the business owes) of $600,000 (eg creditors and bank borrowings).
This means that the store is operating on Shareholders’ Funds or Shareholders’ Capital of $400,000
Step1 – Set the Return on Capital: In bottom line budgeting, the first target set is the profit required. The profit we are talking about here is the Return on the Capital required by the shareholders.
In previous articles I have usually set this rate at 25% (for further information on this please visit my website). Therefore the profit required in this case study is:
$400,000 x 25% = $100,000
Step 2 – Calculate overheads: Budgeted overheads are calculated next. Last year’s overheads totalled $600,000 (wages, rent, power, fuel etc) The decision in this case is to increase them by 5%, mostly caused by inflation.
So the calculation is as follows:
$600,000 x 105% = $630,000
Step 3 – Target Gross Profit: Target $ Gross Profit is the addition of the profit required to meet the Shareholders’ profit ($100,000) plus target overheads ($600,000).
$100,000 + $600,000 = $715,000
Step 4 – Calculate Sales Target: We do this by taking the $ Gross Profit required ($715,000) and dividing it by the target % Gross Profit.
How do we set this percentage? There are a number of factors and these will be addressed in the next article. For now, say the case study store is in a mixed retail and trade market and the current Gross Profit Margin (after rebate) is 30%.
Using this as our target Gross Profit Margin, the Sales Target is:
$715,000 ÷ 30% = $2,383,333
NO BUDGET, NO MEASUREMENT!
The problem I have with this method of sales targeting is that it is driven by the bottom line number. What the shareholders require as a profit and the sales budget number could in no way bear any semblance to reality.
This method of budgeting could also restrict Hardware Store Z’s profitability in that the sales target could be lower than expectations.
I personally prefer to start the budget at the top line (sales) and filter down to the target profit return to the shareholders.
This will be the subject of my next article as well as how to set the target Gross Profit Margin and the factors that come into play in setting it.
But above all, do remember – if you don’t budget you cannot measure!
Peter Cox is a senior consultant for Macquarie Advisory Partnership based in Sydney. He has over a decade of experience training and consulting in the retail hardware industry. He conducts key-note addresses, and management and sales workshops, which are aimed at improving profitability and liquidity in one of Australasia’s most competitive retail environments. Phone 0061 438 712 200 or visit www.petermcox.com.au