Most companies are for-profit entities, and unless you purposely try to break even or lose money every month, so are you. While large companies have finance departments whose sole purpose is to keep things financially on track, most of us only have ourselves. We are our own financial planning and analysis group. What if we budgeted our personal finances using the same process as a large company? That’s just what I’m going to do this year, and I’ll show you exactly how you can too.
Profit Plan – The Mother Budget
Not to be confused with Mother Budgeter. Companies spend the last several months of the year putting together their Profit Plan, which is basically a budget for the entire next year. Every company has a slightly different process and use different names, but we will refer to it as the Profit Plan.
Bottoms-up & Top-down Budgeting
The first step in building the Profit Plan is a bottoms-up budget. Budgeting from the bottom up simply means adding up all of the individual costs and sales of every anticipated product and service.
Top down budgeting happens when the executives hold their fingers up in the air after licking them and say “We will make this much money next year and lower our costs by X%.”
There is usually a big gap between the results of the 2 methods, and the business has to come up with creating ways of bridging the gap.
The infamous GAP
Also known as the “task” or “challenge” because that’s essentially what it is. It is building a challenge into your budget. Profit Plan is a time of much whining at work. People are constantly complaining about how their gap is unreasonable and how there is no way they can hit their Profit Plan numbers. But at the end of the day, they have to roll up their sleeves and come up with a feasible way to make it happen. They do this by renegotiating contracts, accelerating projects, trimming their budgets, and anything else that might boost income or reduce expenses.
So why do they spend months building a bottoms-up budget only to have management pick its own numbers? That’s a fantastic question, and thousands of analysts ask it every year. That could be a whole post on its own, which I won’t tackle here.
Finalizing the Profit Plan
Once the gap is bridged and approved by management, the Profit Plan becomes final and essentially basically serves as the financial Bible for the new year. Exceeding or falling short of the Profit Plan will largely determine employee bonuses and performance reviews.
Does it really make sense to create a profit plan that far in advance? What if raw material costs skyrocket or if the economy tanks? These realities necessitate almost constant fine-tuning, which is where the forecast comes into play.
The forecast is basically a monthly revision of what was originally the Profit Plan. Forecasting is a monthly process designed to provide more accurate predictions of where companies think they will end up financially given new information.
Every month, actual results are compared to both the forecast and the profit plan. The actual results should not deviate much from your forecast since it’s updated monthly. Any large variations to the forecast should be investigated and understood.
Large variances to the profit plan may simply stem from timing issues. You may have planned property taxes in a different month than you actually paid them, which is not a big deal when you look at the year as a whole. This is why it’s helpful to look not only at the monthly comparisons but also other periods of time. For example, if it’s May, you would compare your May actual results to what you planned and forecasted for May. You would also compare your actual results from January through May to the same plan and forecast period (known as year-to-date comparisons).
How to create a Personal Profit Plan
Still with me? This is the fun part! I think there are huge benefits to following this model and applying it to your personal financial planning.
So where do you start? Start with the information you have. It’s ideal to start with your actual income and expenses from the prior year. You can easily see or download this activity from mint.com or any other financial management service you might be using. If you haven’t been tracking your expenses, scan your bank and credit card statements to get a realistic idea of your spending.
Using what records you have in addition to what you know about your spending, use a spreadsheet to project all of your anticipated income and expenses for the full year.
Remember to consider:
Income – Sometimes with budgeting we focus so much on our expenses that we lose sight of something even more important-our income! Will you get a raise this year? Incorporate it into your numbers. If you plan to get a bonus, make sure you plug that into the month you think you’ll get it. Are you going to generate any additional income on the side? Make sure to include it.
Seasonality – Some things such as rent and groceries might remain fairly steady each month. Utilities and lawn & garden probably have a seasonal component to them. To be as accurate as possible, you’ll want to capture as much of the seasonality element as you can. Here are my electricity charges by month for last year. For 2015, I basically just used the same amounts to incorporate the seasonality. I reduced them slightly to challenge us a little.
Irregular expenses – This might include property taxes (unless you pay monthly with your mortgage), vacations, or any other expense you don’t incur on a monthly basis.
Unexpected expenses – We all know what these are. It’s one of the main reasons we might never seem to get ahead. We often cannot accurately predict car repairs, house repairs, medical expenses, traffic tickets, etc. But that doesn’t mean that we shouldn’t plan for them.
Let’s say you usually spend $600 per year on your kids’ sports activities, but you’re not sure when you’ll incur them. There are 2 main ways of incorporating irregular and unexpected expenses into your annual budget.
- Averaging – You can just take the average and budget $50 for each month of the year.
- High level – Include the $600 in your annual total while excluding the expense from each individual month. If you had a spreadsheet with a column for each month, you would also have an extra column for “high-level” expenses that would only be included in the annual total.
Each method has it’s drawbacks. You just need to remember which method you are using when reviewing your budget each month.
My Personal Profit Plan
You could also call this my annual budget. When I finished building my annual budget from the bottom up, I was delighted to see that I was on track to save about $30K this year. That seemed a little too optimistic though based on what we saved in 2014. In order to get a more realistic estimate, I downloaded all of my actual expenses for 2014 from mint.com to compare to my 2015 Profit Plan.
I saw that I had only budgeted $2,000 for fuel in 2015 but that I had spent $4,000 in 2014, so I had to think about if I was really going to drive that much less this year. After I made a few adjustments based on a few other things I had forgotten to include, I was now only projecting to save $20K.
In order to challenge myself, I am setting my planned savings to about $27K (top-down approach). That leaves a gap of $7K. I had to then figure out if I wanted to bridge the gap with increased income or cost savings. I think I can do more consulting with my CPA business as well as shave off some of our expenses, so I reflected that in my plan to the tune of $7K.
At work, if we are progressing through the year and find ourselves falling far behind the profit plan, people can literally freak out and try to pull out all the stops to get back on track. You need to decide how far you are willing to go. In a work setting you can always lay people off, but in a family, not so much.
Click here to see my personal profit plan for this year in all of its detailed glory.
Am I really going to be this fastidious with the budget this year? Yes I am. And I will update you with all the detail you could never want every month.
Do you have an annual budget? Do you break your annual financial goals down into detail?