What is a profit and loss budget?
A profit and loss budget shows the expected income and expenses of the company. This means that the profit and loss budget will indicate the company’s expected result for the next year. The profit and loss budget will be based on the profit and loss accounts of the company and must accordingly include the exact same items. You may also consider the profit and loss budget as a financial forecast estimating the income, expenses, and profit in each period. It is a plan for how you expect your company’s financial results to look in the future. By setting up a profit and loss budget you can create a realistic overview of the company’s financial state and make important decisions based on these forecasts.
How to make a profit and loss budget
Now that we are familiar with the concept of a profit and loss budget, let us look at how to prepare the profit and loss budget.
And as if it was not complicated enough already, you also must consider different aspects:
Start by analysing previous data: Go through your company’s previous financial results to identify patterns and significant indicators. This will form the basis for creating realistic estimates.
Include relevant interested parties: Include different departments and interested parties in the process. This will guarantee a broader expertise and perspective, which may improve the accuracy of your budget.
Predict income: Evaluate your expected sources of income, such as sale of products or services, license fees, investment income etc. Be realistic and conservative in your estimates.
Identify expenses: Examine your fixed and variable costs, including raw materials, wages, marketing, operating expenses etc. Make sure to include all necessary expenses and take possible changes in costs into account.
Calculate the expected result: Deduct your expected costs from your expected income to calculate the expected result (profit or losses). This will indicate whether your company is on the right track to reach its financial goals or not.
When working with your profit and loss budget it is recommended to be familiar with the direct method and the indirect method. You can learn more about these below.
The direct method
When using the direct method to prepare the profit and loss budget, you base your budget on each individual item number. The method is, however, most efficient when you as a company have only few products. Otherwise, the process will simply be too time consuming.
The indirect method
If you decide to use the indirect method for the preparation of your profit and loss budget, you must look at the company’s total range of products, or the overall product categories of your company. Contrary to the direct method, this approach is most efficient if you as a company has a wide range of different products. The method is significantly less time consuming, but it does have its disadvantages.
You must be aware that product groups with different sales patterns will be budgeted together. This may not be an issue in your company, but if it is, it can be solved by collected the most comparable products in the various categories.
What is included in the profit and loss budget?
The profit and loss budget includes:
- Turnover divided by product/service
- Fixed costs
- Variable costs
As mentioned earlier, the profit and loss budget must be based on the profit and loss accounts. It is essential that the budget includes all expected income and expenses to present a fair view of the next year’s result.
Why is it important to prepare a profit and loss budget?
A profit and loss budget is essential for several reasons:
Financial control: A profit and loss budget allows you to take control of your company’s financial situation by providing a clear image of income and expenses.
Basis for decision-making: The profit and loss budget works as the basis for making essential strategic decisions. It helps you assess whether you need to make changes in your business model, invest in new markets/products, or optimize costs.
Identification of risks: By making a profit and loss budget, you can identify potential risks and problems that may affect your company’s financial stability. This will enable you to take precautions and anticipate challenges.