Successful businesses base their plans on calculated financial projections to minimize the chances of failure. One such projection is an operating budget.
What's an Operating Budget?
An operating Budget details an organization's projected revenue and expenditure over a stipulated period. This time frame could be monthly, quarterly, or a business year.
Components of an Operating Budget
An operating budget typically consists of revenue, fixed and variable costs, plus other expenses.
Revenue details all the ways a company generates income through its operations. Most companies don't prepare a year-over-year forecast but instead break it into its underlying parts. This way, they gain significant insights into their income sources.
Typical Components of Revenue
- Average Price
- Per Unit Price
- Segment Price
Variable costs are expenses dependent on sales volume. They aren't constant and include, but are not restricted to, payments for raw materials, freight, sales commissions, labor.
This component refers to set expenses that companies pay independent of sales volume. Fixed costs are mostly constant and include rent, utilities, insurance, management salaries and benefits, and more.
Company expenses outside fixed and variable costs also appear in an operating budget.
Non-cash expenses don't impact cash flow, except on taxes. It includes depreciation, stock-based compensation, unrealized gains, amortization.
These expenses aren't directly linked to a business's operating activities. Interest payments, taxes, costs from currency exchanges, and more belong to this category.
Companies typically don't include capital costs in their operating budget. The latter targets a business's income statement and doesn't include capital expenditures.
Why a Business Needs an Operating Budget
An operating budget helps companies map out and achieve their business objectives. Managers routinely compare actual results to this projection and answer the following questions.
- Is the company meeting or surpassing its estimated sales target?
- Were there expenses unaccounted for in the budget?
- Does the operating budget provide a fair cost estimate, or are there cost overruns?
Analyzing the operating budget helps businesses achieve the following.
- Adapting to changing market conditions
- Updating strategies
- Improving performance
- Manage expenses
- Reduce business debt
- Develop financial accountability
How to Prepare an Operating Budget
Preparing an operating budget requires all managerial hands on deck.
Step 1— Projecting Revenue
Executives and managers draw up a revenue estimate for the coming financial year. They achieve this feat by analyzing the organization's performance history while considering market variables that could influence sales volume. Examples of these elements include the following.
- Changing market trends
- New products coming to the company's line-up
- Competing brands' actions
- Seasonal changes
- Economic changes
- Policy changes
Step 2 — Projecting Expenses
The next step in creating an operating budget is drawing up potential expenses. Managers will need to create one for their respective departments.
- The production department needs to have accurate knowledge of the cost of raw materials, seasonal inventory costs, and so on.
- The HR sector would need to draw up budget projections involving employee benefits, recruitment costs, and more.
When calculating expenses affecting the entire business, such as taxes and rent, executive members are often best fit for drawing up such projections. Also, considering previous records and market variables can help businesses create reasonable expense estimates.
Operating Budget Takeaways
- An operating budget is a projection of a company's potential income and expenses.
- It's best to prepare an operating budget for the short term. The further out your projection, the less accurate your estimates are.
- An operating budget helps companies attract new investors, aid with securing credit lines, serve as a basis for performance evaluation, and more.
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