I’m continually amazed at the number of contractors who don’t prepare annual budgets. You may have heard the saying, “If you plan a trip without a known destination, then any route will take you there, but you may not be happy with where you end up.” Budgeting is very much like planning a trip. It’s determining where you want to be and then planning the method to get there. We have found that budgeting is one of the most important functions we perform each year. It is our process of determining how much we need in sales in conjunction with what we feel we can realistically obtain in sales. We then have to work to make sure that our expenses are in line with our projected sales.
ExpensesWe start by looking at our expenses. We go over all expense items after we divide them into fixed and variable expenses. Our fixed expenses include such things as rent, utilities, office salaries, etc., while variable expenses are things like workers’ compensation insurance, gasoline expenses, etc.
Based on the three previous years, we “guestimate” what each expense item will be to establish our overall total expenses. We track gasoline prices and project depreciation numbers. We then look at what our historic gross profit margin has been and anticipate, using probable market changes, ability to obtain price increases, etc., what our gross profit margin will be in the upcoming year. Then we establish a goal as to how much net profit we want to make in percentage.
We believe you should never budget for less than 5 percent net profit before taxes. In fact, we recommend budgeting for more. Remember, the contracting business is a risky business.
Once we have determined the net profit we desire, we can determine what sales will be required to accomplish our profit goals.
Profit GoalsRemember this equation: Sales x Gross Profit Margin – Expenses = Net Profit.
Rework the equation to determine sales: Sales = Net Profit + Expenses divided by Gross Profit Margin. This calculation will then give you the sales necessary to accomplish your net profit margin goal, given your expenses.
However, you can’t stop at this point. You need to determine if that sales goal is a realistic number. We then go through an entirely different but parallel exercise. We review each of our major 40 to 50 customers’ purchases from us over the last three years.
Then, taking into account anticipated market conditions and each contractor’s position in the market and anticipated sales, we establish anticipated sales to each major contractor and apply an experience factor that reflects potential new customers, smaller customers, etc.
This gives us the sales figure we believe we can reasonably expect. At that point, we compare the sales we need vs. those that we can reasonably expect. We then sit down and make any necessary adjustments.
If we feel we need more sales and can probably obtain those sales at our needed gross profit margin, then we use that sales goal.
If we feel it’s not possible to obtain those sales at the necessary gross profit, then we go back and review expenses to determine where we can cut expenses to make our desired profit with an anticipated amount of sales.
While the process may seem complicated, once you’ve been through it, it’s not as difficult as it may sound.
In any case, complicated or not, if you want to be happy with your position at the end of the year, then you’re much better off to determine in advance what position will make you happy at the end of the year, as well as what route you will need to take to get there.
Guest columnist Butch Welsch operates Welsch Heating & Cooling in St. Louis. He can be reached by e-mail at Welsch1@primary.net.
Publication date: 01/13/2003