Budgeting for Next Year

Photo by ansik.

In my previous New Year’s Planning article, I talked about getting ready for tax time. Now that we have that fun subject out of the way, let’s look at your 2009 budget.

For many creatives, “budget” is one of “Don’t Go There” words. But we’re going there, and I promise that it will be a worthwhile experience.

In this article, we’re going to prepare a hypothetical income statement for your business. And the first question we’ll address is a fun one: How much revenue do you plan to generate next year? Write that number down. Now we’re going to give it a name: Projected Gross Income.

If you have your finger in more than one freelancing pie – say, you’re a designer, writer and consultant – then you have three income streams. The sum of those income streams should equal your Projected Gross Income.

Before we go any further, permit me to make three important points about budgeting:

1. In its simplest terms, budgeting is goal-setting with numbers. And those numbers are based on your projections. As you gain business experience, you’ll get better at projecting.
2. Whenever you make a projection, justify it. Pretend that your budget is part of a business plan that you’re going to present to venture capitalists. They’ll ask you about your assumptions – “What makes you think you can bill $75,000 next year, Mr. Freelancer?” Your answers should show that your assumptions are realistic.
3. Accounting software isn’t the right tool for budget planning. That’s because accounting software is the business equivalent of a rearview mirror – it’s great for generating reports on what you’ve already done. For budget planning, spreadsheet software like Microsoft Excel or Open Office Calc is much better choice. Spreadsheet software allows you to run your numbers over and over again. (Be forewarned: Running the numbers is the business equivalent of a highly addictive computer game. Don’t get carried away!)

Now that you’ve projected your Gross Income – and you can justify that figure – it’s time to start subtracting from it. The first deduction comes from your Cost of Sales. As a general rule, your Cost of Sales will include all of the direct costs that are needed to produce what you do for clients.

For example, let’s say that you’re in the Web design business. Your Cost of Sales may include the hiring of subcontractors for back-end programming on your clients’ websites. You might also be subcontracting to a copywriter who gets your clients’ written copy into tip-top shape.

Subtracting your Cost of Sales from your Income reveals your Gross Profit. Although there are no hard and fast rules, it’s a good idea to limit your Cost of Sales to 10 to 15 percent of your Gross Income. Reason: You need to have enough money left over to cover your Operating Expenses.

Operating Expenses are probably the easiest things to estimate. If you’ve been in business for a while, just pull out your income statements and see what you spent for this, that, and the other thing. If you’re a rookie freelancer with no previous years’ income statements, ask your accountant what businesses like yours lay out for operating expenses. You can also use industry standards as a guide. For example, there’s a much-hallowed rule that says that you should allocate 10 percent of your Gross Income for marketing expenditures. For many freelancers, marketing will be the biggest single Operating Expense.

While some of your Operating Expenses are undoubtedly going up – insurance and utility costs sure are! – you can also be a cost-cutter. Just this year, I reduced my telephone expenses by switching from a landline to VoIP. And I cut my paper and printer toner costs by taming that Control-P reflex.

In short, consider inevitable cost increases and things you can cut when you’re estimating your Operating Expenses. But don’t stop there. Be sure to account for those special projects coming up in the New Year. Call these the “Gotta Spend Money to Make Money” projects. Here are three examples:

1. You are planning to take a couple of classes to improve your design skills. This means that you’ll need to budget more for educational expenses than in years past.
2. Your proficiency as a programmer has led you into creating software applications for which you need intellectual property protection. Looks like you’re going to be spending much more than you usually do on legal fees.
3. After several years of hiding in your freelancing cave, you’ve decided that it’s time to attend a professional development conference in another city. In addition to incurring higher educational expenses, your travel expenses will also be much higher. Make sure that your 2009 projections reflect that.

Now that you’ve estimated your Gross Income, Cost of Sales, and Gross Profit, it’s time to total your Operating Expenses. Next, subtract the Operating Expenses from Gross Profit to get your Net Profit.

In addition to being a nice looking number, Net Profit has some important work to do for you. It’s the source of funds for…

1. Paying you a salary that rewards you for the risks of being a freelancer. Salaries also come in handy when it comes time to covering personal expenses like the mortgage, buying groceries, and keeping the house lights on. (Note that I referred to these things as personal expenses, not business expenses. If you work from home, some of your personal expenses may be deductible on your tax return, but check with your accountant for the official rules and regulations.)
2. Buying new equipment for your business. Face it, your computer isn’t going to last forever. Neither are any of your other office toys.
3. Paying your taxes. Believe me, having funds set aside for this purpose brings great peace of mind.
4. Funding long-term goals. For example, if you’re planning to retire, you have some saving to do. Or maybe you’d like to take a one-year sabbatical and travel overseas. That will require savings as well. Or maybe that new client has started an interesting company that you’d like to invest in. Or perhaps you’d like to try investing in some green energy stocks.

After you’ve projected your 2009 budget with spreadsheet software, it’s time to incorporate it into your business accounting. If your accounting software is like my MYOB, you may have to wait until you open your 2009 books to do this.

Since accounting software tends to be monthly report-centric, you’ll probably be asked to enter a monthly number for each item in your budget. For items that don’t vary much, simply divide your annual number by 12 and enter the result. For “lumpier” items – such as income that you realize in just two months out of 12 or an expense that you only incur in July – only enter figures for those months.

Once you’ve loaded your budget into your accounting software, you’re ready to measure actual business results vs. your projections. In my next article, I’ll talk about how you can make those projections come true.