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The One Year, Thirty Minute Challenge :: Week 43 :: Finance :: Operating Budget

According to a survey by Clutch, 61% of small business owners did not create an annual operating budget. As the number of employees shrunk, the likelihood of a business creating an annual budget shrunk even more – 74% of businesses with 1-10 employees did not create a budget. Unsurprisingly, in another Clutch survey, 35% of small business owners listed unforeseen expenses as their top financial challenge.

An operating budget certainly doesn’t insulate you from unforeseen expenses, but it does force you to deliberately examine projected revenue and expense numbers for the upcoming financial period. The exercise, if done correctly, will make you prove, with real math, that your strategic and operational plans are going to deliver the financial results you desire.

Earlier in the One Year, Thirty Minute Challenge we looked at capital budgeting. Operating budgets differ radically from capital budgets. Capital budgets deal with large-ticket items that are depreciated over several years. Their purchase is not reflected in an operating budget. Operating budgets deal with income and expense projections for an upcoming fiscal period. Money that is typically both earned and spent in that period.

Operating budgets are based on assumptions – assumptions like “what we pay for utilities will stay the same”, “we will have no major customer defections”, “our health care premiums will go up 10%” and on and on. At the beginning of the budgeting period, you’ve got to validate every assumption as much as possible. It’s also prudent to document assumptions so everyone involved knows the “facts” the budget was built on. To illustrate, in 2020, you should assess and state your assumption about the effect of the coronavirus pandemic on your organization in 2021 – it will be a distant memory, we’ll be somewhat impacted, it will still be a major factor for us or somewhere across that spectrum.

Clearly, your 30-minute exercise this week isn’t long enough to pull together a budget, so the goal is to pull together a budget plan, get the plan to the right people and be able to clearly explain your budget methodology.

According to the Corporate Finance Institute, there are four methods for putting together an operating budget –

  • Incremental – Start with last year’s actual revenue and expense numbers and ratchet them up or down based on a percentage or on anticipated changes in specific budget categories. I’m not a fan of this methodology, since it’s easy to perpetuate a budget that might have been built incorrectly in the beginning. And, it might be feeding budget categories that are no longer relevant to the success of the business.
  • Activity-based – Begins with revenue targets then fleshes out the expenses needed to reach those revenue targets. This methodology works well for “cost of goods sold” expenses but might be a bit unruly when building the underlying administrative costs.
  • Value proposition – Requires every expense to be tied back to some value creation activity for the customer, employee, shareholder, or other stakeholder. I like the premise here because, truly, if an activity doesn’t bring value, then why do it?
  • Zero-based – Every single budget line begins at zero. From scratch, you must build every line item. Consequently, the existence of the line item and the amount must be justified. I like this one also, because of the discipline required and the scrutiny given to each entry.


You can choose one of these methodologies or a hybrid of two or three. The methodology takes a backseat to the real reason for doing a budget – to correctly fund value creation activities so that projected revenue goals are met or exceeded and expenses are right-sized so that all stakeholders receive returns that cement their relationship to the company. This incredibly important point deserves a bit more attention. Customer facing activities must be sufficiently funded so that purchasers receive a product or service that exceeds their expectations and is delivered in a way that makes them feel good about their purchase. Employee compensation must keep value producers inside the organization happy and engaged and not looking for employment elsewhere. Shareholders must receive a sufficient return so their investment in the organization continues to be justified. A similar calculation must be made for every stakeholder in the organization.

Let’s jump into a few mechanics for budget building.

  • Involve the people ultimately accountable for hitting the numbers – The directors and managers who will reap the rewards or bear the consequences for financial performance for the budget entity (department, division, business unit) must create the budget for that entity. If they’re smart, they’ll involve other team members who will impact that entity’s performance.
  • Simultaneously work bottom up and top down – Expectations for profitability should be communicated down and needs for funding value creation activities should be communicated up. The organization’s desired endgame should be baked into the company culture and should be a regularly discussed topic in the organization, so there shouldn’t be any surprises here. This is just an annual exercise dedicated to examining the financial manifestations of what you’re after every day.
  • Use tools that make sense – A smaller organization might get away with an Excel template used by everyone in the organization. Larger organizations probably want to opt for some of the more robust budgeting tools available.
  • Use the right level of detail – In your office supply category, you don’t need a line item for pencils, another for staples and another for paper clips. If you do, you have the wrong people in charge. Budgets reflect the level of autonomy in that business entity.
  • Budgets should include contingencies, but those building the budgets should know that the ultimate determinant of investment is value creation – I’m in favor of adding some contingencies to a budget (for unforeseen circumstances – overtime, equipment failure, opportunity to capture an emergent opportunity), but ultimately, every expenditure in an organization should be about value creation. If a situation arises that affords an opportunity for value creation, even though that opportunity was not apparent at budget creation time, the person responsible for that budget entity should know that they can come to you with that opportunity and not be chastised for considering something “not in the budget.”
  • Budgets function as a “reality check” for projected revenue and projected expense – Let’s say your budgeted revenue reflects the sale of 3 million widgets. What is the sales commission for 3 million widgets? What is the cost of raw materials for 3 million widgets? What is the labor cost for 3 million widgets (that requires that you know how long it takes to make each individual widget)? Will any overtime be required to produce 3 million widgets? Is the present capacity of your plant sufficient to produce 3 million widgets? What does it cost to ship 3 million widgets? Will the production of 3 million widgets force you to add another shift? What will be the cost of supervisors for that shift? Are all those items in your budget? The budgeting process is the mechanism that ensures you’ve accurately identified and synced all of the revenue and costs associated with the value creation activities that get you to your financial targets.
  • At some point in the process, check your work against industry benchmarks – I’m not a big “best practices” person. Every “best practice” was once a wild idea gambled on by some innovative thinker. I’d prefer to put my money on the innovative thinker. However, that being said, it’s not a bad idea to check your work against your competitors – just to make sure you’re not missing something. For instance, you can easily find stats on what percent of revenue is spent on Information Technology in your industry. If your competitors are spending 4% of revenue on IT and you’re spending 2%, maybe you’re not being thrifty. Maybe you’re missing opportunities to automate work or offer new tech-enabled products.
  • Bake in profit margins at the budget level – If you want to make a profit of 20%, make sure your revenue and expense projections enforce that margin. Engineer the value creation activities until you’ve pushed the revenue and expense numbers far enough apart to hit your profit target.


Get the responsible parties together and lay out your plan. If this is your first budget, it’s important to explain your rationale. It’s all about the discipline – the same reason you do a strategic plan or any other deliberate planning activity. It’s the opportunity to step away from the press of all the things that clamor for your attention and focus on, in this case, the finances of your organization.

After your budget is in place, check your performance against it regularly. Make it a part of your balanced scorecard. When opportunities come to deviate from it, use it as a development opportunity for your staff as you discuss the rationale behind decisions to “stick to it” or “stray from it”.

The One Year, Thirty Minute Challenge :: Week 35 :: Finance :: Capital Budgeting

It’s that time of year when companies look at their capital budgets for the upcoming year. Capital budgets differ from operating budgets in a couple of important ways. Capital budgets represent a trade – swapping one type of asset for another – $30,000 in cash for a $30,000 delivery truck, $100,000 in cash for a $100,000 enterprise software package. These capital purchases are reflected only on the Balance Sheet. Later, they make their way to the Income Statement and Balance Sheet a chunk at a time using an accounting mechanism called depreciation. Depreciation is driven by the “class life” for each capital purchase. At the time of this writing (August 2020), IRS guidelines set the class life for real property at 39 years, office furniture at 7 years and autos and trucks at 5 years. So, for our $30,000 delivery truck example earlier in the paragraph, we’re spending the physical $30,000 in cash now and reflecting the purchase only on the Balance Sheet – the cash comes off, the truck goes on. Going forward, we’re going to recognize the depreciation on both the Income Statement and the Balance Sheet. Each year, for the first five years we own the truck, we’ll see $6,000 of depreciation expense on the Income Statement and $6,000 removed from the value of the truck on the Balance Sheet (in actuality, it will be accumulated in a single account with all the rest of the depreciation). Conversely, operating budgets are for those expenses that don’t represent a “swap” of assets. Salaries, utilities, and every other non-capital expense happen here. The accounting piece is very simple – reduce cash (on the Balance Sheet) and recognize the expense (on the Income Statement).

The goal of this week’s One Year, Thirty Minute Challenge, is to begin building a capital budgeting process that you can use this year and sharpen in the upcoming years. Keep using it and refining it so it always serves your organization well. Here’s a high-level outline. Your job is to flesh out the steps and fit it to your organization.

Let’s jump in –

Identify Potential Capital Budget Items – The company’s strategic direction and operational necessities should drive this part of the exercise. Typically, there’s no shortage of items clamoring for your capital expense dollars. You might want to enter a new, promising market that requires a new office, new equipment, or new vehicles. You might have to replace worn-out factory machinery or desktop computers to continue existing operations. You might need new equipment to comply with recently mandated government environmental regulations. You might be able to lower manufacturing costs by capitalizing on a new process, but it requires retooling the factory.

Estimate the Financial Impact of the Proposed Capital Budget Items – Using the best information you can gather (from vendors, from your sales, operations, and finance experts) determine the financial effect of the proposed projects on your organization. What will the item(s) cost to obtain? What will the item(s) cost to operate in the first year and all subsequent years? What additional revenue will the item(s) generate in the first year and all subsequent year? If the items are available from multiple vendors, compare item features, benefits, costs, and expected revenues for each option.

Evaluate the Proposed Items and their Financial Impact – Typically, you’ll begin your capital budgeting process with a pool of money you’re ready to devote to capital projects. After you’ve gathered all the information during the previous step, you’re ready to evaluate the proposed projects, hopefully using more science than art. Regulatory compliance gets first dibs since failure to comply could put the ongoing operation of the business in jeopardy. The remainder of the projects should be evaluated by the finance folks using some tried and true capital budgeting metrics that we’ll discuss shortly, but a couple of things first. In many cases, the money to be spent will come from cash on hand. That money isn’t free. If it sat in an interest-bearing investment, it would have a return. For purposes of discussion, let’s say the return on the cash on hand, if left in the investment, is 3%. The return on investment for the proposed capital project needs to be more than 3%. If the money for the capital project is going to be borrowed at an interest rate of 5%, the return on investment for the proposed capital project needs to be more than 5%. You get the idea – the return on the project needs to be more financially beneficial than doing nothing. Clearly, regulatory capital expenses get a mulligan here. There may be no financial benefit to the project. In fact, there might be only financial detriment. But, most likely, the financial detriment is far less than the impact of closing the company. In these cases, the increased costs must be passed along to consumers or be borne by stockholders in the form of lower profits.

Let’s talk about five of the most commonly employed methodologies for evaluating capital projects –

  • Payback Period – How quickly will the cash inflows generated by the investment pay back the initial investment? If the initial investment is $10,000 and the investment generates $5,000 a year in additional cash, the payback period is two years. This method is quick and simple, but it doesn’t take into account the value of cash inflows after the payback period or the time value of money.
  • Net Present Value (NPV) – This methodology compares the present value of all future cash inflows resulting from the project versus the present value of all the current and future outflows required to execute the project.
  • Profitability Index – The present value of all future cash inflows associated with the project divided by the present value of the current and future cash outflows associated with the project.
  • Internal Rate of Return (IRR) – This methodology identifies the rate at which the project breaks even by examining the cash inflows and outflows.
  • Modified Internal Rate of Return (MIRR) – This methodology is similar to the IRR except that it recognizes that cash inflows can be reinvested at a rate that is different than the rate at which they were generated.

Each of the capital projects under consideration must be evaluated in light of these financial metrics (and possibly others). The purpose of this week’s exercise is not to get deeply in the woods, but there are always additional considerations like tax consequence and accounting methodologies. Your finance folks can guide you into a complete discussion.

Most years, you’ll have more potential projects than you have money. The objective measures above will help the projects with the highest return on investment (ROI) bubble to the top.

Occasionally, you’ll be choosing between proposed projects with similar returns – sometimes offering mutually exclusive options. At that point, the “art” kicks in. The projects that most successfully move your strategy forward, the influence of non-financial data (market sizes, trends, patterns), management knowledge and intuition, and more will inform your decision on which projects to pick and which projects to reject or defer.

Implement – After the winning projects are selected, execute like crazy. Depending on the type of project, you might need to create a project team (hope you included that in your capital budget). Create schedules with timelines and milestones, align vendor resources, employ a solid execution framework, and communicate well. You want to implement the project as quickly as possible so it can start generating the cash inflows.

Measure – The capital budgeting tools were forward-looking. After implementation, rigorously track the actual results. Hopefully, the project is performing better than you projected. However, one of the worst mistakes a company can make is succumbing to “sunk cost fallacy”. If a project is seriously underperforming and there’s no remedy in sight, it’s noble to pull the plug. The fact that you’ve already spend $50,000 or $5,000,000 becomes immaterial. Continually investing resources with the hope that the project will magically turn around is a mistake rooted in pride. Track the performance of each project so you have better information for your next round of capital budgeting.

Capital budgeting, many times, represents an opportunity to make a big leap for an organization. A new market, product, process, or system can catapult a company into the national spotlight or into a level of revenue never even dreamed of before. Take this exercise seriously.

The One Year, Thirty Minute Challenge :: Week 27 :: Finance :: Lifetime Customer Value

I remember it vividly. I was a freshly minted consultant. It was one of my first engagements. The client’s business was growing quickly, but at the end of every month, he barely had any money left.

So, I did an individual profit and lost statement for every single customer. I did some quick math and calculated the percent of each revenue dollar (at his current volume) that went to cover fixed costs, then applied the remainder of that dollar to the variable costs associated with each individual customer. Not a perfect methodology, but it worked well for quickly flushing out the problem. Eureka – the lightbulb moment. For every revenue dollar from the client’s biggest customer, he was breaking even (the reasons why are interesting, but that’s another story for another day). The more this giant customer spent, the more my client “broke even”. We applied the same methodology to every other customer and even found a couple that he went backward on for every dollar the customer spent.

I’m a strong proponent for a P/L for every customer. I realize it only makes sense in certain industries, but if it works in yours, you should do it.

That’s not the topic for this week’s One Year, Thirty Minute Challenge, but that type of math is at the heart of this week’s exercise.

In many industries, a company is upside down financially when they first begin a relationship with a customer. The costs associated with marketing, advertising, selling, onboarding and servicing the customer the first time exceed the revenue from the customer’s initial purchase. Hopefully, just a few purchases in, the company is right side up and making money. In the course of calculating the acquisition and onboarding costs, the company should be projecting and making customer experience decisions based on the potential lifetime value of the customer. Loyal, happy customers, depending on the industry, could represent a lifetime revenue stream of 1000s, 10000s or even 100000s of dollars. Happy customers tell their friends. That can translate into even more lucrative customers.

This week’s One Year, Thirty Minute Challenge is to identify the factors that constitute the lifetime customer value calculation for your products and services.

Let’s jump into this week’s exercise.

  • What are the costs associated with acquiring a new customer? Depending on your industry, it could include annual marketing and advertising expenses (divided by the number of new customers each year), direct selling costs (lead generation, sales technology, sales salaries, sales commission), onboarding costs (customer training, installations services).
  • What does the customer pay for the product?
  • How many times will the customer buy the product? What is the range from the most sporadic customer to the most loyal customer?
  • What does it cost to produce each copy of the product? Depending on your product or service, it will include cost of goods sold, plus additional costs for packaging and delivery.
  • What does it cost to service already acquired customers? There might be customer service calls, technical support calls or costs for billing and collecting.


The math should look something like this –

Number of times purchased * purchase price

– number of times purchased * cost of goods sold (and additional costs)

– initial acquisition costs

– ongoing support costs

= total lifetime value

You’ll probably want to do some math that’s similar to what I did in my initial illustration to reduce the top line purchase price number to reflect the impact of fixed costs.

So, what do you do with this information once you have it? Here are some ideas –

  • What are the primary drivers of purchase frequency? How can we move less frequent purchasers to more frequent purchasers allowing us to spread the acquisition cost over more units and consequently increase lifetime customer value?
  • Can we draw any correlation between purchase frequency and acquisition costs or support costs? Does a more expensive acquisition equal a more frequent purchaser? If so, maybe the extra acquisition cost is desirable? Maybe there’s an inverse relationship between frequency and support cost – the more they use the product or service, the less they need support.
  • If a customer is ready to defect, what can we do to save them? Is there any correlation between defecting customers and their use of support? Based on their potential lifetime customer value, what can we afford to spend to keep them?
  • How can we leverage the personal networks of high total lifetime value customers to find more like them? They should be our best brand ambassadors.
  • Since high total lifetime value customers have demonstrated a willingness to spend money with our company, are there other products or services that might be of interest to them?


Once you’ve completed your exercise, begin educating your team on the importance of lifetime customer value. The first time that new customer walks through the door could be the beginning of a long and profitable relationship. Treat the opportunity that way.

The One Year, Thirty Minute Challenge :: Week Three :: Finance :: Fixed Costs vs Variable Costs

I hesitated to do this one and especially hesitated to do it early in The One Year, Thirty Minute Challenge because it surfaces most frequently with solopreneurs (or those with just a handful of employees). Larger and older companies have already figured it out or else they wouldn’t still be around. However, when I’ve seen it with past clients and corrected it, the results were so dramatic (it’s been the difference between staying in business and going out of business), I felt like I had to share it early on.

It’s really just a math problem. Instead of explaining, let me illustrate and then give the steps for this week’s exercise.

ABC Company charges $60/hour for their widget repairing service. ABC Company is very busy, doing all the widget repair they can handle. They are always booked a couple of weeks in advance. It might be because they are at the lower end of the widget repairing market. Their competitors charge $75 – $80/hour for the same service. The owner of the company pays his widget repairing employees $35/hour (the market rate), leaving him what he calculates as a $25/hour margin. However, at the end of every month, he just has a few dollars in the bank – not even enough to cut himself a check that would equate to 40 hours at minimum wage. So, what’s the problem? It could very well be that the owner is failing to take into account fixed costs.

Fixed costs are those incurred by the business just by being open. They wouldn’t change, even if the business serviced no customers or sold no products.

To illustrate with our fictitious organization, the owner of ABC Company pays each month –

Rent on the Shop $1000
Payments on Two Trucks $600
Tools $200
Truck Insurance $300
Liability Insurance $400
Utilities $400
Cell Phones $400
Accounting Service $150
Internet Service $100
Health Insurance $2500
Advertising $500
Total $6550

That’s $6550 to keep the doors open and the lights on (so to speak). If the two widget repairers get 40 billable hours per week every week, they log 344 hours per month (40 hours per week * 4.3 weeks in a month * two repairers). To cover these fixed costs shaves $19.04 off each hour that ABC company bills ($6550 / 344 hours = $19.04).

When the owner pays the widget repairers, variable costs kick in. Variable costs are those that are driven by volume of work or product produced – for instance, hourly wages, the cost of materials to build a product, shipping costs for a product, etc. In our example, the owner incurs variable costs of $35/hour in wages and an additional $2.67/hour to pay the employer share of Social Security and Medicare.

Here’s what’s left of the $60 the owner collects from customers –

$60.00   Customer rate
– $19.04   To cover overhead (fixed)
-$35.00   To the widget repairer (variable)
-$2.67   To cover employer share of Social Security and Medicare (variable)
3.29   Remaining margin

So, the $25.00 per hour margin the owner thought he was creating with his pricing and salary policy is really $3.29. Now it’s apparent why his competitors are in the $75-$80/hour range for the same service. It’s also apparent why he has no money left to pay himself at the end of the month.

You might be wondering if I’m exaggerating for purposes of this exercise. Unfortunately, the answer is no. I’ve worked with one client where the margin number was 0 and another where the number was in the single digits.

Let’s move on to this week’s exercise.

1.  For the last three months, go through your checkbook or copy of Quickbooks (or whatever your bookkeeping methodology is) and list each fixed expense.

Here’s a starter list (it’s by no means exhaustive). Go through your records and be thorough in finding every fixed expense.

Rent or loan repayment for your place of business

Vehicle payments or leases

Vehicle insurance

Business insurance (property, liability, E&O, etc)

Health insurance

Professional services (accounting, legal, consulting)

Technical services (website, internet, email, desktop support)

Communication (landline, cell phone)

Office supplies


Administrative employees (those who would be paid even if no services or product were delivered)

Property Taxes

Total the numbers and calculate a monthly average for fixed expenses

2.  Calculate the opportunity to cover those fixed expenses – 

For service businesses –

For the last three months, calculate the number of hours for which you can collect money from customers (i.e. hourly charges that you can use to cover fixed costs) and calculate a monthly average.

For businesses that sell products (this calculation is trickier if you sell multiple products with different price points) –

For the last three months, calculate the number of units across which you can spread the fixed costs and calculate an average.

For retail businesses –

For the last three months, calculate the number of hours you are open, across which you can spread fixed costs and calculate a monthly average.

3.  Calculate the fixed cost to be covered each hour or by each unit –

Service – monthly fixed costs / monthly billable hours = fixed cost to be covered each hour

Products – monthly fixed costs / monthly units = fixed cost to be covered by each unit

Retail – monthly fixed costs / monthly hours open = fixed costs to be covered each hour

4.  Incorporate the fixed cost per hour/per unit into your pricing model.

For service businesses

variable cost per hour

+ fixed cost to be covered each hour

+ desired margin

= Customer price per hour of service

For businesses that sell products

Cost of good sold (labor + materials or purchase price)

+ fixed cost to be covered by each unit

+ desired margin

= Customer price per unit

 For retail businesses, the use of the number is a bit different

 Aggregate price of all goods sold in an hour

 – aggregate cost of goods sold in an hour

 = aggregate gross margin

Aggregate gross margin must be greater than fixed cost to be covered in an hour

Calculate this over the course time to determine which hours the retail establishment should be open.

5.  Check these calculations frequently. As volume (more hours or more units) goes up, fixed costs per hour or per unit go down, until you increase volume enough that you have to add fixed costs (hire another admin person, buy another truck, lease a bigger building). At that point the math changes again.

6.  I realize this week’s exercise can get complicated very quickly. If the simple examples in this exercise aren’t sophisticated enough for your business, consult your accounting or bookkeeping professional.

This exercise is incredibly important and could be the difference between staying around to serve customers for many years or being gone in just a few months.

If you have questions on this week’s challenge, contact me at 816-509-9838 or

Use the comments section below to benefit other business owners and managers by sharing insights you gained by working on this week’s challenge.