How to Create a Budget for Your Business

Creating a budget is vital for the financial health and longevity of your small business. However, it can also be a daunting task.

Budgets are meant to be flexible and simple. The best budgets build in assumptions with wiggle room for when market conditions change or if you see a lucrative opportunity. A budget for your business will consider the prior three months, last month, and will then predict the month to come. You can then use that data to help make smart financial decisions.

From monthly spending to vendor choices, there are many elements to plan for and incorporate into your broader budget. Follow these simple steps to develop a strong business budget.

Step 1: Start with your revenue

Your revenue is the amount you expect to make through the sale of goods and services. This is the total income you expect to make over a certain period, usually one month. Existing businesses can estimate revenue by looking at historical sales figures. Use the last three months or the same month from a year ago to predict what you believe your revenue will be.

For instance, if you're running a restaurant, you might include sales from in-person dining, deliveries, and curbside pickup. If you also sell prepared foods, for example, include the sales from that revenue stream as well.

If you don't have revenue yet, Yvonne Cobb, a certified public accountant and Founder and CEO of TakeAway Tax, recommends taking a goal-oriented approach to financial planning.

"The key to effective budgeting is setting a specific financial goal — 'finding your number' — and working backward," Cobb explained. "This … offers a clear benchmark and ensures that all decisions contribute directly to the business's goal."

Step 2: Subtract your fixed costs

Fixed costs are recurring expenses that are essential to the operation of your business. Rent, taxes, insurance, supplies, and payroll are all examples of fixed costs. Tally up your total fixed costs for the same time period (e.g., one month) and subtract that amount from your total revenue.

It's likely your fixed costs are relatively stable month after month. Rent, for instance, doesn't change from one month to the next unless you're beginning a new lease. Estimating your fixed costs should be relatively straightforward when you base the calculation on the last month and three months prior.

Step 3: Estimate your variable expenses

Variable expenses are, as the name implies, costs that may change from month to month. "These can include things like usage-based utilities (like electricity or gas), shipping costs, sales commissions or travel costs," wrote Freshbooks.

As you estimate your variable expenses, be strategic about every expense. Variable costs are where smart decision-making comes into play. If you forecast that sales will be lower during the coming month, you need to find ways to lower your business’s variable costs.

According to Karla Dennis, an enrolled tax agent and Founder of KDA Inc., small business owners often spend money without an expectation or purpose for that expense. She advised asking yourself, "What will this expense get me in return?" before making any purchases.

"Ensure every dime being spent is going to get you to your goals," Dennis said. "This will help eliminate expenses that are not needed. Then, make sure you stay within the budget you set."

Step 4: Put money toward a contingency fund

A contingency fund is like an emergency fund for unexpected costs that arise for your business. If a piece of equipment breaks down or if you need to quickly replace damaged inventory, a contingency fund prevents the need to take out a small business loan to cover these costs.

It can also be considered a savings fund for one-off costs, such as a new computer, for instance. Setting aside money over time for a contingency fund makes it easier to save and helps you maintain financial stability when something happens unexpectedly.

Step 5: Put together a P&L statement

A profit and loss statement, known as a P&L statement, summarizes all the work you have done.

"Add up all of your income for the month and add up all of your expenses for the month. Then, subtract the expenses from the income and hope you get a positive number at the end," wrote NerdWallet.

If you don't end up with a positive number, that's necessary information. Many small businesses don't turn a profit until their second year of business. This information will help you go back through your budget and see where you can cut costs, especially variable costs. Or, you may consider raising your prices to increase revenue. No matter what strategy you take, a budget will help you see where there may be flexibility for you to plan for the future.

Step 6: Review and adjust your budget periodically

A good business budget isn't something you set and forget. Sofia Perez, Owner and Content Manager at Character Counter, says business budgets — whether yearly, quarterly, or monthly — should be reviewed often.

"You need to have your eyes on the dollars at all times," she said. "I recommend planning two months in advance, [including] expenses that could throw off estimated revenue as well as gross profit to ensure the company's money is accounted for."

Cash flow vs. budgeting: What's the difference?

Cash flow is a big issue for many small business owners, often forcing many new ventures to close. Cash flow is the amount of money coming into (inflow) and going out of (outflow) your business. Knowing your cash flow is essential for financial planning, pricing your products or services, and recruiting investors.

Cash flow and budgeting are closely linked. Traditional budgeting involves creating a detailed plan for your income and expenses. It's typically forward-looking, meaning you'll create a plan to ensure you have enough money to pay for your business's needs every month.

Cash flow gets more granular. It requires tracking your budget by measuring expenses and incomes on a day-to-day basis.

"The primary purpose of the cashflow forecast is to provide the status of the business' cash position at any point of time over that period, to support decisions during that time by identifying when there may be projected or expected shortages of cash so that payments can be managed and prioritised," wrote H&R Block.

Cash flow helps you monitor your variable expenses, invoice due dates, and accounts receivable to ensure your business stays solvent. It helps you manage your budget proactively. Remember, budgets are meant to be flexible; that's because you may need to adjust your budget to ensure your cash flow is positive.

[Read more: 5 Tools to Help You Manage Your Small Business Budget]

Tips for creating a small business budget

Creating and sticking to a business budget helps ensure you're using your cash most effectively. Ryan Carrigan, CEO and Founder of moveBuddha, recommends that small businesses start with short-term or activity-based budgeting before looking too far into the future. The process of tracking every cost-related activity can help you plan your future budget in whatever increment you choose.

"It can be beneficial to analyze all costs and profits in the beginning," Carrigan said. "Then create a monthly budget until you grow enough to create a sustainable budget that can last a quarter, six months, and eventually annually."

There are a few different techniques for creating a small business budget. Jason Manar, a former FBI agent and Chief Information Security Officer at Kaseya, recommends adopting a zero-based budget strategy.

"During my time in the FBI, I found most successful small businesses used a zero-based budget," Manar told CO—. "They built the budget from scratch, justifying every dollar spent that had to be directly correlated to necessities. Those businesses that were transparent and involved in all departments had a more comprehensive understanding of the needs and priorities of the company."

While a zero-based budget can be useful for tracking every dollar, keep in mind that your budget should be flexible. Rigid budgets that account for every dollar and cent aren't necessarily the best strategically, according to Jan Brandrup, CEO of Neurogan.

"Choosing a flexible budgeting strategy has been most beneficial for us, and it is helpful because it's adaptable and allows you to track the ups and downs of spending and revenue," Brandrup said.

Although it's great to have a budget that is planned every month, flexibility can help manage any unexpected expenses that pop up.

"Having a flexible budget that forecasts as opposed to structures your money will ultimately promote and drive profit," said Brandrup.

Finally, choose your vendors wisely. Before signing any contracts, Michael Sawyer, Operations Director at Ultimate Kilimanjaro, recommends taking the extra time to determine the quality and values of any prospective vendors to ensure they align with yours to make a positive impact on your business.

"Just because you have an opportunity doesn’t mean you should jump on it," Sawyer said. "You don't want to invest and waste money on a poor partnership."

[Read more: 5 Cost-Cutting Tools For Small Businesses]

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.