What is an Operating Budget?

First of all, a budget is a plan to spend money. Therefore, it follows that budgeting is the process of creating that plan on how the money will be spent. Within the budget, business entities will account for all costs and necessary expenditures. These daily expenses are projected from daily operations, including raw materials, machinery, labor and utility expenses among others. The company will generally use income projections when planning for an operating budget. Operating budgets are usually created before the start of a new financial year. They are often presented in an income statement format with a schedule that allows the management to provide updates of monthly expenses incurred. This allows the management to make updates based upon monthly expenses incurred. In addition, they are always prepared before the financial budget since many of the financing activities aren't known until the operating budget is made.

How Does an Operating Budget Work?

The operating budget is one of the two parts of the master budget and is mainly divided into two broad categories of either revenue or expenses:

• Revenue This refers to any income coming into the business through sales, services, contracts or grants. The operating budget will specify how much revenue is expected in each reporting period, be it weekly, monthly or quarterly, and when are such revenues due to the business.
• Expenses  This refers to money needed to keep the business running such as salary and utility expenses among others. Like revenue, expenses are also recorded in each reporting period, be it weekly, monthly or quarterly.

Objectives of an Operating Budget 

An operating budget is a vital tool for business managers as it provides them with a clear profit objective that the business aims to attain. Below are examples of reasons behind the formulation of an operating budget:

•  Effectively plan ahead With an operating budget, an organization can compile at the beginning of the year how much they intend to spend in order to achieve desired profits with detailed guidance that guarantees the attainment of such profitability.
• Proper allocation of resources A budget helps the business to properly manage the inflows and outflows of allocated funds as well as a line of credit throughout the financial year. Also, it helps the business to cater for any unexpected rise in costs by setting up a budget contingency.
• Coordinate the activities as well as expected goals by all departments- Each department knows what is expected of them in order for the entire business to achieve a common goal. For instance, the sales teams are made aware of the expected sales volume, and the marketing teams are informed of how much they ought to spend.
• Provide a basis for performance evaluation - Budgets, sales, and costs are all quantitative amounts that can be measured and reported. Therefore, it is easier for a business to evaluate the performance of each department on how well they met set objectives at the end of the year.

Operating Budget Components 

As a business grows the process of assembling an operating budget may become complicated and therefore require more time in the process. Typically, an operating budget consists of revenue and expenses. The expenses may be variable such as of raw materials, fixed costs, such as the monthly rent, or operating expenses, such as interest on business loans. These items are essential in enabling an enterprise to calculate their projected net income and net profit percentage. Creating an operating budget can be broken down into two stages: 

Preparing to Make an Operating Budget

• Collect previous detailed reports of actual revenue through sales as well as expenses from multiple departments, company branches or sales teams.
• Review the sales reports from history. Knowing what previous sales actuals were can help you determine what target to set for this year. Take into account changes such as adding a new sales location or reducing sales headcount before estimating this year.
• Clearly identify fixed expenses such as rent, some salaries, liability insurance, fees and other known costs that will need to be paid regularly.
• Also, get a precise estimate of varying expenses which are usually influenced by external factors such as the cost of raw materials or the price of an advertisement, that can fluctuate quickly.
• Identify a contingency budget for unexpected costs such as legal fees, consultants or accountants for short-term projects, or repairs.
• Use up-to-date market research to determine what kind of sales can be projected with a new product for more profitability.

Formulating an Operating Budget

• Sales Budget.

Sales forecast collected earlier from the sales team and in consideration of factors such as the general state of the economy, pricing policies, advertising, and competition is put together to form an aggregate sales forecast. The sales budget may be slightly different from the sales forecast after it is adjusted according to the business goals.

• Production Budget.

After developing a sales budget, the next task is the production budget which budget tells the business owner how many units of the product to produce to meet sales needs and ending inventory requirements. There are three parts to the production budget: direct materials purchases budget, direct labor budget, and overhead budget.

• Direct Materials Purchases Budget.

This outlines the amount and the cost of each type of the raw materials that the business needs for the production process. The firm's inventory system helps in determining the number of raw materials needed at a particular time which can be factored in the budget.

• Direct Labor Budget.

The amount of funds allocated for work provided in the business is usually determined by the relationship between labor and production outputs. That is how the total number of hours in direct labor and the cost per unit is determined.

• Overhead Budget.

This includes anything that has not been budgeted for in the direct materials purchases and direct labor budgets that is involved in the production. Generally, direct labor drives the overhead budget. The costs that vary with direct labor are called variable overhead; everything else is fixed overhead.

• Ending Finished Goods Inventory Budget.

This budget is significant as it provides the information needed to calculate per unit costs of a product. Per unit cost is computed from the direct materials purchases budget, direct labor budget, and overhead budgets. Also, it provides data for the balance sheet that is crucial in calculating the cost of goods sold on the income statement.

• Cost of Goods Sold Budget.

If you have the ending finished goods inventory from the previous period, then a business can comfortably prepare the cost of goods sold budget using the information from the direct material purchases budget, direct labor budget, and overhead budget.

• Selling and Administrative Expenses Budget.

The non-manufacturing part of the operating budget is selling and administrative expense which can either be a fixed or. For example, Utilities may be fixed, but sales commissions are based on sales volume and are therefore considered variable costs.

• Budgeted Income Statement.

When all the above budgets are prepared, the necessary information to create budgeted or forecasted income statement will be available. The income statement prepared is the operating budget for the business. This information is what will be used to develop a financial budget for the company to complete the master budget. 

Variance Analysis 

Variance analysis is a tool that applies to both operating as well as financial budgets. Analysis of variances helps to identify the cause of variation in actual costs incurred versus the initial budgeted expenses. Sales volumes can change due to timing and unanticipated expenses as well as product demand can emerge for specific products. Effective monthly variance analysis can help an enterprise to identify such trends and opportunities as well as threats to short-term or long-term business goals. For example, a decision to hire additional seasonal labor to meet a peak in product demand will change the operating budget. Identifying a variance allows enterprises to adjust the operating budget accordingly to cater for the variations by looking at:

• Budget vs. Actual Costs

Variance analysis is essential in managing budgets by monitoring and controlling planned versus actual expenses. It helps to identify costs variances that might lead to adjusting business goals, objectives or strategic plans.

• Materiality Threshold

A variance analysis will be able to identify the level of statistical sales variance deemed a successful sales threshold in a financial year according to the companys goals.

• Relationships Between Variables

Variance analysis helps to establish relationships. For instance, it may prove that when sales volume for product A rises, there is a correlated rise in the sales for product B.' Improved features for one product might result in sales increases by the business. Also, Variance data allows an analyst to identify factors such as seasonal changes as the root cause of positive or negative variances. 

Benefits of an Operating Budget 

Some of the benefits of planning for the day-to-day operations of business include:

• Managing Current Expenses that could benefit a business total budget and ease some financial strains by tracking revenue, expenses and cash flows.
• Projecting Future Expenses by evaluating actual past and current expenses then using the hindsight to compensate for past budgeting mistakes going forward so that the new operating budget is more closely aligns with the exact needs of an enterprise.
• Building Financial Reserves that can help in reducing debt since operating budgets involves cutting costs, investing and planning for unforeseen circumstances by keeping cash reserves.
• Operating budgets establishes financial accountability that ensures that a business manager diligently sticks to it instead of spending beyond the company projected income.
• Can help a business secure a line of credit by providing a budget that shows the company is viable and of economic concern.
• Attract investors who can rely on the statement of income to make an informed investment into the business.
• A budget lets a business to track performance throughout the year, allowing flexibility to make necessary changes in strategy, when necessary if unanticipated costs outpace projected earnings or increase spending to take advantage of growth opportunities.
• A budget helps the business to have immediate tax information in readiness to filling estimated annual returns.

In conclusion, it is clear that the importance of a budget cannot be overstated, therefore to ensure budgeting is done accurately; it may be worthwhile to hire a professional accountant, or a business manager to help in the budgeting process. An expert can help establish an accounting system for the business, track expenditures and provide timely reports that help enterprises to get informed decisions about business operations.