A GREAT BULIDING STARTS WITH A SOLID FOUNDATION
This past May I was in Orange County, California visiting 5D Building Systems, a manufacturing client that supports the construction industry. It is really a fascinating company. They have a developed a fully patented process to fabricate interior and exterior wall and bracing systems that are delivered to the jobsite and installed to create the infrastructure of a building.
Not being a typical accountant, I wanted to better understand the manufacturing as well as the delivery and installation processes. So, off I went on a tour of the facility with John (the Company’s CEO) and Lynette (the Company’s CFO). The manufacturing process was absolutely amazing and I was gaining an understanding of what was delivered to the jobsite, but was unclear about how the work would flow in the field. So, off Lynette and I went to a jobsite. A hotel was being built and the 5D had just delivered the first floor (the entire interior and exterior wall structure) of the hotel to the site. I thought to myself, “Wow, what an amazing process, this is going to revolutionize the way that construction is performed”.
One thing struck me that will never change about construction. Without a solid foundation the walls can’t go up.
I have spent years convincing business owners that budgeting and planning are the keys to success and that budgeting to achieve a specific level of profit was far superior to budgeting for a specific level of growth and having the profit be whatever is left over after all expenses are paid. It is just like a construction project, where you start with the bottom of the structure and build up from there.
Let me walk you through the process quickly and you will better understand what I mean by building a budget from the bottom-up. The process starts by understanding the owner’s or primary stakeholder’s personal financial goals and objectives. Additionally, there are typically other financial goals and objectives of the organization that will require profit. At this point an analysis of the company’s fixed costs and variable margin are analyzed to determine the required gross profit to reach the profit objectives and then, voila, the revenue volume necessary to achieve the gross profit.
Have I thoroughly confused you yet? Good, that’s how I put food on the table for my family!
Let’s assume the following made-up facts about Lynette, John and their business. I do need to stress, that these are made-up facts. Lynette and John are real people and you can visit them and their business in the OC anytime, but what I outline below is completely fictitious.
Personal goal – Lynette and John both would like to begin investing in assets outside of the business in order minimize their personal dependence on the business. To do this, they each want to systematically invest $100,000 per year for the next five years.
Business goals – The business has a debt covenant that requires them to have $50,000 of bottom line profit. Additionally, the business has $500,000 of permanent working capital debt sitting on its line of credit. Lynette and John really want it paid off over three years.
Fixed Costs – Lynette, being the ever diligent CFO has looked at the total fixed costs of the company (administrative and factory overhead) and has budgeted annual fixed costs of $1,500,000.
Variable Margin – John is an engineer at heart. He has the factory working lean and mean. Although the previous year’s margin was 22.5%, mid-year adjustments to the manufacturing process began creating better efficiencies, so John is expecting variable margin of 25% moving forward.
Based on these facts, here is how we utilize the bottom-up budget with PROFIT as the foundation for our structure:
THE BOTTOM-UP BUDGET
Required profit per bank covenant $ 50,000
Profit to support pay down of permanent working capital debt $ 166,667
Personal investments for shareholders $ 200,000
Required profit $ 416,667
Fixed expenses $1,500,000
Required variable gross profit $1,916,667
Divided by expected gross profit percentage 25%
Required sales volume $7,666,668
And so there you have it. Assuming that the production process is managed correctly and that the fixed expenses come in on budget, in order to achieve their personal and business financial objectives for the year John and Lynette need to generate $7.7 million in revenue.
The process is relatively simple but just like the concrete slab for a building, it becomes the foundation for the operational planning for the year.
Check back in next week when I discuss the next phase in the planning process, “Turning the Dials”.
Oh, and just a little bit more about 5D, John and Lynette are absolute mavericks on the West Coast innovating the construction industry in a miraculous way. To find out more about 5D, visit their website at www.5-dsystems.com.