Developing a useful operating budget is extremely valuable, and extremely challenging. Learn the keys to building an operating budget and using it to track what is going well, and head off the things that aren’t.
Now for the hard part, we're going to talk about budgeting and forecasting. This is frequently the toughest thing for startup entrepreneurs because we're asking them to predict the future. Hitting your budget may be the difference between success and failure. And I'll tell you, the most frequent reason that venture capital investors fire founders and CEOs is because they miss their budgets. You want to be the CEO that hits his or her budget every time. So let's see if we can offer some approaches to make the budgeting and forecasting process a little bit easier for you. Now don't worry, we know it's not going to be right. That's a given. But at least it frames out your thinking so you know if things don't work out the way you expect, you know exactly which way they worked and which way they didn't.
So let's start with the operating budget. The operating budget is the detailed plan of how you're going to spend money and hopefully earn revenues over the next year. When you do your operating budget you start by figuring out what are the key drivers for my expenses and for my revenues going forward. What are the things that are going to cause me to spend money and enable me to make money? Think those through. Most entrepreneurs, they make the mistake of finding some template, some Excel template out there. And then trying to plug their numbers into somebody else's framework. I would urge you instead, start by figuring out the design of your business and the key drivers of your business. So the key drivers of expenses, generally those are going to be related to people; the people you fire for different tasks in the company. Your revenues are a function of your customer contact. So in order to have customer contact you have to have those marketing and sales programs in place in order to generate those revenues.
When you're putting together your operating budget you want to put it together using frames of reference that are going to make sense to your whole team on the inside as well as to your board of directors and investors on the outside. And that's more likely going to be an around your milestones rather than the traditional accounting categories. So a term you might hear is a term called milestone‑based budgeting. And this is a really powerful concept for developing your operating budget. Instead of designing your budget around just the plain old accounting terms that your accountant might use, instead frame your operating budget around the key milestones that you need to hit. So for this budget period, one of your key milestones may be we need to build and ship a product. So you're going to organize your expenses around that process, that milestone of building and shipping your product. Unfortunately, I got to tell you, once you've put together your operating budget, your work has only just begun. As I mentioned, it's almost certainly going to be wrong. So you're going to have to iterate. How often should you iterate? Probably you're going to have to make adjustments every quarter, certainly every six months. Prepare your investors for that. Prepare your board for that. It's going to be a continuous process, especially during the early years. But once you get the processes down for putting together your operating budget, it will yield enormous results for you in helping you manage your company more effectively.
So entrepreneurs ask well how long should we do an operating budget for. What I would recommend, you do a 12‑month, monthly operating budget. And then do the two following quarters just to get some sense of visibility into the period beyond. How much detail should I put into my operating budget? Well, that's going to change over time. In the early days of your company, you're not going to have a lot of data on which to base a very, very detailed operating budget. As you have more experience with your company, as you go through different years of operating budgets you're going to be able to fill in more and more detail.
Get this question all the time from entrepreneurs. Entrepreneurs are wondering, so how much cushion should I build in to my operating budget. Because, you know, entrepreneurs know if they miss their budget it's a really bad thing. I encourage you to put a little bit of cushion around each of the elements of your operating budget. But do not do what we've seen some entrepreneurs do, which is they put a big plug number at the bottom that says this is our cushion number. And that doesn't help you. Investors are just going to look at that and they're going to say this guy doesn't really know how to budget. Instead try to incorporate as best you can, your best guesses with a little bit of cushion around each of the elements of your operating budget. And hopefully you'll come in under budget on terms of your expenses and over budget in terms of your revenues.