Determining Expense Budgets

Determining Expense Budgets

Budgets for each expense must be established, considering both external and internal factors, as in sales forecasting.

In determining expense budgets, the following would be considered internal factors:

  •  Corrective actions planned to bring excessive expenses in line.
  • Policy changes such as new commission plans.
  • A commitment such as equipment purchases, leases on new facilities, or professional service contracts.
  • Planned salary increases.
  • Planned changes in benefit programs.
  • Additional personnel.
  • Promotional plans.

 External factors could include the following:

  •  Inflation and its effect on price increases from suppliers.
  • Tax rate increases including payroll taxes, local property taxes, inventory taxes, and so on.
  • Utility rate increases.

 Additionally, the interrelated effects of expense increases must be considered. For example, payroll increases will increase payroll taxes and, possibly, employee benefits. Rent on larger facilities can also involve additional utilities expense.

 Reevaluating the Plan

Once an initial plan has been established, it is often useful to review it in order to identify areas of further improvement.

Getting Started on Budgeting

Getting Started on Budgeting

Your first budget will be the most difficult to develop – but it will be worth the effort. The budget will help you analyze the results of your advertising. By your next business year you’ll have a more factual basis for budgeting than you did before. Your plans will become more effective with each budget you develop, don’t delay in getting started on budgeting.

 Developing Expenses Budgets

 After a realistic forecast has been developed for sales and gross profit, expenses for the coming year must be estimated in order to establish expense budgets and to determine expected operating profit.

 Comparisons

As with the forecast of sales and gross profit, expense estimating begins with a review of the current year’s performance based upon comparison with the following indicators:

  • Performance in prior periods
  • Industry averages
  • Objectives established for the current year

For purposes of comparison, it is often useful to express each expense as a percentage of total sales.

Comparing Variable Expenses

The use of percentages as a basis of comparison and forecasting is particularly applicable when analyzing variable expenses. Variable expenses are those that tend to change as a result of changes in sales volume. For example, if salesmen’s commissions are based upon a percentage of sales, the total dollar amount of commissions earned would increase as sales increase. If sales in a month were 20% higher than expected, commissions paid would also increase 20% as a direct result of the higher sales volume.

Comparing Fixed Expenses

On the other hand, fixed expenses are not directly affected by short-term variations in sales volume. Therefore, a 20% increase in the dollar amount of any fixed expense such as salaries or rent would normally be considered unacceptable even if sales for the period increased by 20%. When comparing fixed expense levels with objectives or from one period to another, it is more realistic to make comparisons in absolute dollars rather than in percentages.

A business has sales and rent expense in January, February, and March as follows:

 

                                               Rent expense

Month                 Sales                        $            % Sales

 

January            $100,000                 $1,000              1.00

February              80,000                   1,000              1.25

March                125,000                   1,000              0.80

 

As a percentage of sales, rent expense was high in February and low in March. However, this does not indicate that control of this expense was more or less effective in either month. It simply reflects the changes in sales volume. In all three cases, the actual rent expense was 1,000.

Long-Range Considerations

Despite the shortcomings of using percentages to evaluate fixed expense control within the business from month to month, they can be useful when making long-term comparisons or comparisons with industry averages. These averages normally express expenses as percentages of sales, regardless of whether they are fixed or variable.

For example, assume that a business found that its rent expense as a percentage of sales was 2% compared with an industry average of 1%. This differential would have to be offset by better than average performance in gross profit or other expense classifications if the business expects to realize net profit equal to its industry average. Perhaps the reason for the high percentage is due to an exorbitant rental expense, or it may be caused by inadequate sales. In either case, certain questions must be answered. These could include the following:

 

  • Are we renting more space than we need?
  • Is our space too expensive for our requirements?
  • Could a less elaborate facility be located that would be adequate for our needs?
  • Would a less costly location be sufficient?
  • Is our space utilization inefficient?
  • Will expected sales increases be handled without renting additional space? Will this bring our rent expense percentage in line with the industry?
  • Can the terms of our lease be re-negotiated?

 

Similarly, when comparing long-term performance with prior periods, the use of fixed expense percentages can be helpful. For example, if you found that warehouse salaries jumped from 2% of sales to 4%, a number of important questions would be raised. These could include the following:

 

Are we now using too many warehouse personnel?

Are warehouse personnel less efficient?

Has ineffectiveness crept into the warehouse layout or operating procedure?

Are warehouse workers overpaid?

Is warehouse supervision inadequate

A Flexible Budget

A Flexible Budget

Any combination of these methods may be employed in the formation and allocation of your advertising budget. All of them – or simply one – may be needed to meet your advertising objectives. However you decide to plan your budget, it should be a flexible budget, capable of being adjusted to changes in the marketplace.

 The duration of your planning and budgeting period depends upon the nature of your business. If you can use short budgeting periods, you’ll find that your advertising can be more flexible and that you can change tactics to meet immediate trends.

 To ensure advertising flexibility, you should have a contingency fund to deal with special circumstances – such as the introduction of a new product, specials available in local media, or unexpected competitive situations.

 Beware of your competitor’s activities at all times. Don’t blindly copy your competitors, but analyze how their actions may affect your business – and be prepared to act.

Getting Started

Your first budget will be the most difficult to develop – but it will be worth the effort. The budget will help you analyze the results of your advertising. By your next business year you’ll have a more factual basis for budgeting than you did before. Your plans will become more effective with each budget you develop.

How to Allocate Your Budget

How to Allocate Your Budget

Once you have determined your advertising budget, you must decide how tol allocate your budget. First, you’ll have to decide if you’ll do any institutional advertising or only promotional advertising.

 

After you set aside an amount to build your image (if that’s your plans for the year), you can then allocate your promotional advertising in a number of ways. Among the most common breakdowns are by:

 

1) departmental budgets

2) total budget

3) calendar periods

4) media

5) sales areas

 

Departmental Budgets

The most common method of allocating advertising dollars is percent of sales. Those departments or product categories with the greatest sales volume receive the biggest share of the budget.

In a small business or when the merchandise range is limited, the same percentage can be used throughout. Otherwise, a good rule is to use the average industry figure for each product.

 

By breaking down the budget by departments or products those goods that require more promotion to stimulate sales can get the required advertising dollars. Your budget can be further divided into individual merchandise lines.

 

Total Budget

Your total budget may be the result of integrated departmental or product budgets. If your business has set an upper limit for advertising expense percentage, then your departmental budgets, which are based on different percentages of sales in each area, might be pared down.

In smaller business the total budget may be the only one established. it too, should be divided into merchandise classification for scheduling.

 

Calendar Periods

Most executives of small businesses usually plan their advertising on a monthly, even a weekly, basis. Your budget, even if it’s for a longer planning period, ought to be calculated for these shorter periods. It will give you better control.

 

The percentage-of-sales methods is also useful here to determine how much money to allocate by time periods. The standard practice is to match sales with advertising dollars. Thus, if February accounts for 5% of your sales, you might give it 5% of your budget.

 

Sometimes you might want to adjust advertising allocations downward in some of your heavier sales months, so you can boost the budget of some of your poorer periods. But this should be done only if you have reason (as when your competition’s sales trends differ markedly from yours) to believe that a change in your advertising timing could improve slow sales.

 

Media

The amount of advertising that you place in each advertising medium – such as direct mail, newspapers, click through or radio – should be determined by past experience, industry practice, and ideas from media specialists. Normally it’s wise to use the same sort of media your competitors use. That’s where, most likely, your potential customers look and listen.

 

Sales areas

You can spend your advertising dollars where your customers already come from, or you can use them to try to stimulate new sales areas. Just as in dividing your appropriation by time periods, it’s wise to continue to do the bulk of your advertising in familiar areas. Usually it’s more costly to develop new markets than to maintain established ones.

Objective and Task Budget Method

Objective and Task Budget Method

The most difficult (and least used) method for determining an advertising budget is the objective and task budget method. Yet, it’s the most accurate and best accomplishes what all budgets should:

  •  It relates the appropriation to the marketing task to be accomplished.
  • It relates the advertising appropriation under usual conditions and in the long run to the volume of sales, so that profits and reserves will not be drained.

 To establish your budget by this method, you need a coordinated marketing program with specific objectives based on a thorough survey of your markets and their potential.

 While the percentage-of-sales or profits method first determines how much you’ll spend without much consideration of what you want to accomplish, the task method establishes what you must do in order to meet your objectives. Only then do you calculate its cost.

 You should set specific objectives: not just “Increase sales,” but, for example, “Sell 25% more of product X or service Y by attracting the business of teenagers.” Then determine what media best reaches your target market and estimate how much it will cost to run the number and types of advertisement you think it’ll take to get that sales increase. You repeat this process for each of your objectives. When you total these costs, you have your projected budget.

 Of course, you may find that you can’t afford to advertise as you’d like to. It’s a good idea, therefore, to rank your objectives. As with the other methods, be prepared to change your plan to reflect reality and to fit the resources you have available.

Unit of Sales Budget Method

Unit of Sales Budget Method

 

In the unit of sales budget method for developing a marketing budget you set aside a fixed sum for each unit of product to be sold, based on your experience and trade knowledge of how much advertising it takes to sell each unit. That is, if it takes two cents’ worth of advertising to sell a case of canned vegetables and you want to move 100,000 cases, you’ll probably plan to spend $2,000 on advertising them. Does it cost X dollars to sell a refrigerator? Then you’ll probably have to budget 1,000 time X if you plan to sell a thousand refrigerators. You’re simply basing your budget on unit of sale rather than dollar amounts of sales.

 Some people consider this method just a variation of percentage-of-sales. Unit-of-sales does, however, probably let you make a closer estimate of what you should plan to spend for maximum effect, since it’s based on what experience tells you it takes to sell an actual unit, rather than an overall percentage of your gross sales estimate.

 The unit-of-sales method is particularly useful in fields where the amount of product available is limited by outside factors, such as the weather’s effect on crops. If that’s the situation for your business, you first estimate how many units or cases will be available to you. Then, you advertise only as much as experience tells you it takes to sell them. Thus, if you have a pretty good idea ahead of time how many units will be available, you should have minimal waste in your advertising costs.

 This method is also suited for specialty goods, such as washing machines and automobiles; however, it’s difficult to apply when you have many different kinds of products to advertise and must divide your advertising among these products. The unit-of-sales method is not very useful in sporadic or irregular markets or for style merchandise.

Budget Revenue Basis

Which Sales Method for establishing your budget revenue basis?

Your budget revenue basis can be determined as a percentage of past sales, of estimated future sales, or as a combination of the two:

 1. Past Sales. Your base can be last year’s sales or an average of a number of years in the immediate past. Consider, though, that changes in economic conditions can make your figure too high or too low.

 2. Estimated future sales. You can calculate your advertising budget as a percentage of your anticipated sales for next year. The most common pitfall of this method is an optimistic assumption that your business will continue to grow. You must keep general business trends always in mind, especially if there’s the chance of a slump, and hardheadedly assess the directions in your industry and your own operation.

 3. Past sales and estimated future sales. The middle ground between an often conservative appraisal based on last year’s sales and a usually too optimistic assessment of next years is to combine both. It’s a more realistic method during periods of changed economic conditions. It allows you to analyze trends and results thoughtfully and to predict with a little more assurance of accuracy.

 Unit of Sales

In the unit-of-sale method you set aside a fixed sum for each unit of product to be sold, based on your experience and trade knowledge of how much advertising it takes to sell each unit. That is, if it takes two cents’ worth of advertising to sell a case of canned vegetables and you want to move 100,000 cases, you’ll probably plan to spend $2,000 on advertising them. Does it cost X dollars to sell a refrigerator? Then you’ll probably have to budget 1,000 time X if you plan to sell a thousand refrigerators. You’re simply basing your budget on unit of sale rather than dollar amounts of sales.

 Some people consider this method just a variation of percentage-of-sales. Unit-of-sales does, however, probably let you make a closer estimate of what you should plan to spend for maximum effect, since it’s based on what experience tells you it takes to sell an actual unit, rather than an overall percentage of your gross sales estimate.

 The unit-of-sales method is particularly useful in fields where the amount of product available is limited by outside factors, such as the weather’s effect on crops. If that’s the situation for your business, you first estimate how many units or cases will be available to you. Then, you advertise only as much as experience tells you it takes to sell them. Thus, if you have a pretty good idea ahead of time how many units will be available, you should have minimal waste in your advertising costs.

 This method is also suited for specialty goods, such as washing machines and automobiles; however, it’s difficult to apply when you have many different kinds of products to advertise and must divide your advertising among these products. The unit-of-sales method is not very useful in sporadic or irregular markets or for style merchandise.