How to Establish and Stay on Budget
Most contractors I run across confess “I never have as much money at the end of the year as I expect to.” Do you suffer the same fate?
Do you arrive at year end wondering where your money went to? If so, I’d bet you’d like to learn how to avoid that ugly outcome.
Pay attention here, I’m going to let you in on a little secret that will help you end those unpleasant year-end surprises. Lean in close. Don’t tell anyone about this. It’s so secretive that few contractors do it. Are you ready?
Use a budget
That’s it. That’s all it takes. Create a budget, track the variances, and take corrective action when necessary. Class dismissed.
Oh, you want to hear more? Okay. Keep reading to learn how to put a stop to those nasty year-end surprises.
Annual budgets allow you to stay on top of your financial progress as your year unfolds. They arm you with the ability to reel in expenses before they kill your bottom line. They force you to think through your business’ strategy and its resource allocations.
When you don’t have a budget to monitor, or don’t monitor the one you have, you are destined to arrive at year-end thinking “Rats. Where’d my money go?”
Contractors’ aversion to budgeting has always struck me as funny (not in the ha-ha sense). On the one hand, contractors tend to be obsessive about planning field work. They know that letting their field crews sort out what to do from day to day is a recipe for disaster. But on the other hand, they don’t apply that reasoning to their business. Lack of business planning leads to poor financial performance; it’s as simple as that.
You need a budget, it needs to reflect the reality of your market, you need to keep a close eye on its progress, and you need to take corrective action when it’s called for. Anything short of this will leave you with that “What happened?” feeling.
Look at the Market
Before diving into the how-to budget details, let’s make sure you understand the connections between your budget, your business plan, and your market.
Your budget is a financial representation of your business plan. Your business plan’s purpose is to take advantage of profitable opportunities in the market. Budgeting should not be attempted until your business plan has been developed.
Your business plan should be aligned to the size of your market, the prices your market will pay, and the cost of serving its needs. You can only make as much money as your market will support and your business plan will deliver. Budget accordingly.
Contractors often put the cart before the horse. They set sales, overhead, and net income goals, put them into a budget, and then try to craft a strategy to fulfill them. That sequence totally ignores the market.
It’s foolhardy to create the financial model and then try to craft a business plan that fits it when the business plan hasn’t been tuned to the market. First strategy; then budget; then meet the budget; then build a bulging bank account.
Your budget will be developed through five stages: preparation, rough draft, refinement, reality check, and rollout.
Stage 1 – Preparation
Unless you implement a new sales and marketing plan, you improve labor productivity, or you reduce overhead, your financial performance will be controlled by the market and the economy. If they grow, you will make more money. If they shrink, you will make less, or even lose, money.
In this industry, past performance is the best predictor of future performance – unless you force change. Build your budget on the foundation of your recent three year financial performance. To do that, gather together the balance sheets, income statements, and cash flow statements for those years.
Next, tap as many information sources as possible to gain an informed view of upcoming market changes. Visit with your banker. Visit with your insurance and bond agent. Buy construction forecast data from McGraw-Hill or a similar provider. Search the census bureaus’ website for reports on economic projections. Call the Federal Reserve and see what reports they have available. Call your local economic development councils.
Eventually, you will discover the experts’ consensus opinion. Even they can be completely blindsided by turns in the economy, but they are the most informed group to listen to.
Go over the information with your executive team. Reach consensus on your upcoming market opportunities.
Here are the Stage 1 steps.
Grab the last three sets of annual statements.
Gather up construction forecasts.
Discuss market opportunities.
Stage 2 – Rough draft
The purpose of the rough draft is to give you a reasonable starting point. Your rough draft will not consider changes to your business plan nor changes in the economy. To create the rough draft, study the income statements from the last three years and determine:
Your sales trends
Your direct cost trends
Your administrative overhead trends
Your sales and marketing expense trends
Your operations support trends
Your labor burden trends
Your average gross margin
Take your most recent income statement and adjust each line item for the trend (up or down) or jot down the three year average, whichever you feel is most appropriate.
Here are the Stage 2 steps.
Determine trends and averages for each income statement line item.
Decide whether the average or the trend is the most appropriate assumption.v
Mark-up last year’s income statement accordingly.
Stage 3 – Refinement
Now, adjust the numbers for changes in the market and changes in your business plan.
If you expect the market to shrink, assume both your sales volume and your margins will shrink. If you expect your market to grow, assume either your sales volume or your margin will grow. Do not assume both will grow (we’re not going to go into this but it usually holds true).
Now estimate the cost impact of new business strategies. For example, you may decide to expand sales by pursuing the office building market. In order to land the work, you will authorize a ,000.00 advertising campaign consisting of magazine advertisements, direct mail, and client entertainment. This spending would be on top of the advertising you do to generate your current work load. Your advertising budget needs to reflect the additional ,000 investment.
When thinking through your business plan, look at closely the cost impacts of:
Increased advertising to pursue new market
Expansion of sales staff
Purchase of new equipment
Adding office staff
Implementing or altering management information system
Employee training and development
Changing the bonus plan
Entering a new geographic territory complete with local office
Pay raises
Rising health care premiums
Another budget impact you need to account for is improved selling performance. Assume your sales team persuaded another 20% of your clients to hand you negotiated contracts. You budget would need to reflect the higher mark-ups associated with negotiated contracts.
You are ready to finalize your first draft. Adjust the trended or average numbers for each line item by the impacts of your business plan. Re-type the document so that it is easy to ready.
Here are the Stage 3 steps.
Verify your labor pool and operations support staff team can handle the projected work load.
Verify the targets for sales volume and direct cost markup are reasonable
Verify increases in marketing and sales expenses.
Update equipment expense and depreciation to accommodate new equipment needs.
Update sales volume goal.
Update direct cost margin goal.
Calculate expected work load (labor, material, equipment costs).
Revise and re-type your budget.
Stage 4 – Reality Check
One of the primary reasons contractors fail to hit their profit goals is because they are overly optimistic about their gross margins. The time has arrived for everyone to join a no-holds-barred discussion on operations and sales.
You need to challenge all assumptions made that the crews will perform better than they have in the past. No baseless, pie-in-the-sky claims are allowed. Unless, there is a reason to believe turnover has been greatly reduced, more efficient equipment has been purchased, or the operations management team will be able reduce downtime and rework, do not assume your labor will be more productive than in the past.
The other claim that you must question strongly is the ability of the sales and marketing team to generate better quality leads and better paying jobs. Sales and marketing personnel are highly optimistic individuals by nature. Take their promises of greater glory with a grain of salt. Believe it when you see it, not before.
In other words, don’t take their word on gross margins at face value. You need to analyze it segment by segment. Discuss the real mark-ups each segments produces. Pull out your job costing reports to see what the real mark-ups ended up being.
Ask them why they believe the leads will be better and why the margins will improve. Segment by segment, forecast total sales and margins. Pull them together and compare to your budgeted direct cost and gross profit.
Adjust your budget accordingly. Now, you’ve finalized your budget.
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