In practice, business needs financial planning as a reference for running business operations during a specified period. The operating budget is one of two parts of the master budget.
What is the Business Operating Budget?
The operating budget is a record of activities that generate income for the company, such as sales, production, and finished goods inventory. It can be said that the operating budget is a pro forma income statement and the operating profit margin.
The operating profit margin is not the same as net profit, which is calculated when the financial budget is prepared. The operating budget is prepared before the financial budget because many financing activities are not known until the operating budget is prepared.
Here is an example of a small pottery business, ArtCraft Pottery, to illustrate the basic concepts and calculations related to a business’ operating budget.
The operating budget consists of a budgeted or forecasted income statements, which are supported by a number of schedules:
1. Sales Budget
Most business owners and managers use “bottom-up” sales forecasting techniques. In other words, they collect sales figures from salespeople in the field because they generally have the most information on what sales will be in the future. These sales figures are then put together to form an aggregate sales forecast.
Sales forecasts from both offline companies and online businesses (e-commerce platforms) have to be included.
Other factors in the sales forecast include general economic conditions, pricing policies, advertising, competition, and other factors.
In our example, pottery store may suffer during an economic recession because pottery would be considered a luxury item at that time. Usually after a recession, companies also need time to restore operations, after reduction in workforce and sales.
The sales budget may be slightly different from the sales forecast after adjusted to desires of management.
2. Production Budget
After developing the sales budget, the next task in developing the operating budget is to put together a production budget. The production budget tells the business owner how many units of product to produce to meet sales needs. In our example, the pottery shop owner must know how many pieces and what types of pottery to make during the recession period.
There are three parts to the production budget: direct materials purchases budget, direct labor budgets, and factory overhead budgets. Each is needed to produce the production budget.
3. Direct Materials Purchases Budget
The direct materials purchases budget is directly related to the raw materials needed by the company for its production process. This budget states the amount and cost of each type of raw material needed.
However, a separate direct materials purchases budget must be prepared for each type of raw material. The company’s inventory policy helps determine the amount of raw materials stored in inventory.
The direct materials purchases budget in our example of a pottery company is the raw material in the form of clay and the color paint for the pot.
4. Direct Labor Budget
The budgeted hours for direct labor are determined by the relationship between labor and yield. The number of units of direct labors are determined in the production budget. Then, the total number of direct labor hours and the cost per unit can be obtained.
5. Overhead Budget
The overhead budget is all that is left from production which is not included in direct materials purchases and direct labor budgets. Usually, direct labor budget drives the overhead budget. Costs that vary with direct labor are called variable overhead.
6. Ending Finished Goods Inventory Budget
The ending finished goods inventory budget is very important because it gives the company the information needed to calculate the cost per unit of its product. This unit cost is calculated from the information collected from the direct materials purchases budget, direct labor budget, and overhead budget.
This budget also provides data for the balance sheet and for calculating the cost of goods sold in the income statement.
7. Cost of Goods Sold Budget
If you have the initial finished goods inventory (which is the ending finished goods inventory from the previous time period), then you can prepare the cost of goods sold budget using the information from the direct materials purchases budget, direct labor budget, and overhead budget.
8. Sales and Administrative Expenses Budget
The non-manufacturing part of the forecasted budget is sales and administrative expenses. This expense has fixed and variable components. For example, sales commissions are based on sales volume and are variable.
9. Budgeted Income Statement
When you complete these eight budgets, you have the information you need to develop a budgeted or forecasted income statement.
The result of the budgeted income statement is the company’s operating income, not net profit. You cannot find the net profit until after you complete your financial budget.
Easy Steps to Create a Balanced Business Budget
Step 1: Calculate Your Source of Income
The first element of a good business budget is finding out how much money you make each month.
Start with your sales numbers, then go further by adding other sources of income for your business.
Step 2: Determine the Fixed Costs
Fixed costs are expenses that are charged the same amount every month. As you can imagine, this step is the easiest part of making your business budget.
Step 3: Include the Variable Costs
Items that do not have a fixed price tag every month are called variable costs. Many parts of these expenses can actually be increased or decreased depending on your business condition.
Your monthly profit are determined by the income you have after paying all your costs.
Step 4: Predict Rare Expenses
In making a budget, do not forget it is likely that you will need to occasionally spend unexpected amount. For example, there are office laptops which are suddenly broken so you need to repair them or even buy new ones.
This kind of rare expenses need to be prepared in order to protect your business from unexpected financial burdens.
Step 5: Get to know budget examples
From the steps above, you need to study specific budget examples to be able to detail out the components of a business budget. The followings are common components of a business budget.
Source of income:
- Hourly Income
- Product sales
- Investment income
- Rental / Mortgage
- Government and bank fees
- Mobile phones
- Website hosting
- Accounting Services
- Legal Services
- Raw materials
- Contractor’s salary
- Other Marketing Costs
- Travel & events
- Printing Services
- Office equipment
Developing a monthly business budget may seem troublesome, but it is very important for business people to make careful financial decisions so your business can stay on track and keep on growing.