The order of building before the numbers
The budget of a trading business is not a single table but a series of tables, each depending on the one before it. The logical order is: the sales budget, then the purchases budget, then the operating expenses budget, then the budgeted income statement, and finally the cash budget. Any error in the sales estimate flows into everything that follows, so this part deserves the most effort.
In this article we will build a budget for a company that sells commercial supplies wholesale, broken down into four quarters. All figures exclude Value Added Tax (VAT) to simplify the calculation, because the tax is neither revenue nor an expense for the business, although its cash effect must be added later when preparing the actual cash budget.
Step one: the sales budget
Start with last year's sales for each quarter, then adjust them with what you know: the Ramadan season, back to school, a large new customer, or a competitor that opened nearby. We assumed a gross profit margin of 30%, meaning cost of goods sold is 70% of sales.
| Item (SAR) | Q1 | Q2 | Q3 | Q4 | Year |
|---|---|---|---|---|---|
| Sales | 300,000 | 350,000 | 280,000 | 400,000 | 1,330,000 |
| Cost of sales (70%) | 210,000 | 245,000 | 196,000 | 280,000 | 931,000 |
Step two: the purchases budget
Purchases do not equal cost of sales, because you need inventory at the end of each quarter that is enough for the start of the next quarter. The formula: Purchases = Cost of sales + Target closing inventory − Opening inventory. We assumed that the target inventory at the end of each quarter equals 50% of the next quarter's cost of sales, that opening inventory for the year is 100,000 SAR, and that the target at year-end is 110,000 SAR.
| Item (SAR) | Q1 | Q2 | Q3 | Q4 | Year |
|---|---|---|---|---|---|
| Cost of sales | 210,000 | 245,000 | 196,000 | 280,000 | 931,000 |
| + Closing inventory | 122,500 | 98,000 | 140,000 | 110,000 | 110,000 |
| − Opening inventory | 100,000 | 122,500 | 98,000 | 140,000 | 100,000 |
| Required purchases | 232,500 | 220,500 | 238,000 | 250,000 | 941,000 |
Step three: expenses and the budgeted income statement
Split expenses into fixed costs that do not change with sales volume, such as rent of 25,000 SAR and salaries of 45,000 SAR per quarter, and variable costs that move with sales, such as commissions and delivery, which we estimated at 5% of sales.
| Item (SAR) | Q1 | Q2 | Q3 | Q4 | Year |
|---|---|---|---|---|---|
| Gross profit (30%) | 90,000 | 105,000 | 84,000 | 120,000 | 399,000 |
| Rent | 25,000 | 25,000 | 25,000 | 25,000 | 100,000 |
| Salaries | 45,000 | 45,000 | 45,000 | 45,000 | 180,000 |
| Variable expenses (5%) | 15,000 | 17,500 | 14,000 | 20,000 | 66,500 |
| Net profit | 5,000 | 17,500 | 0 | 30,000 | 52,500 |
The third quarter is exactly at the break-even point. This is the first useful piece of information the budget produces: management knows in advance that summer is weak, so it plans promotions or postpones hiring.
Step four: the cash budget
Profit does not mean cash. We assumed that 60% of sales are collected in the same quarter and 40% in the following quarter, and that the customer balance at the start of the year is 120,000 SAR. Purchases are paid half in the same quarter and half in the next, and the supplier balance at the start of the year is 100,000 SAR. Expenses are paid in cash. Management plans to buy shelving and equipment for 30,000 SAR in the third quarter, with a minimum cash balance of 30,000 SAR.
| Item (SAR) | Q1 | Q2 | Q3 | Q4 |
|---|---|---|---|---|
| Opening balance | 40,000 | 38,750 | 54,750 | 19,500 |
| + Collections from customers | 300,000 | 330,000 | 308,000 | 352,000 |
| − Payments to suppliers | 216,250 | 226,500 | 229,250 | 244,000 |
| − Expenses | 85,000 | 87,500 | 84,000 | 90,000 |
| − Equipment purchase | 0 | 0 | 30,000 | 0 |
| Closing balance | 38,750 | 54,750 | 19,500 | 37,500 |
Sample calculation for the second quarter: Collections = 60% × 350,000 + 40% × 300,000 = 330,000 SAR. Payments to suppliers = 50% × 220,500 + 50% × 232,500 = 226,500 SAR.
The result: in the third quarter the balance drops to 19,500 SAR, which is 10,500 SAR below the minimum. Management's options: postpone the equipment purchase to the fourth quarter, pay for it in installments, or arrange a short-term bank facility in advance.
Before approving the budget: test the assumptions
Every figure in the tables above rests on an assumption: a 30% margin, 60% collected in the same quarter, and inventory equal to half of the next quarter's cost. Before presenting the budget to management, ask: what if collections slow down to only 50% in the same quarter? In the first quarter alone, collections fall by 30,000 SAR, and that alone is enough to push the balance below the minimum. Testing a pessimistic scenario and an optimistic one gives management a realistic range instead of a single figure that implies precision that does not exist.
Make sure department heads take part in preparing the figures: the sales manager knows the expected customers, and the purchasing manager knows the upcoming supplier price increases. People who help prepare a budget are more committed to it than to a budget imposed on them by the accountant alone.