Operating Budget

What is an operating budget?

An operating budget is a financial projection outlining the expected revenues and expenses for running an organization’s operations over a specific period (usually a fiscal year). It is a predictive management approach for budgeting and revenue planning for various business functions.

The key components of an operating budget include:

• Sales budget: The expected sales volume and revenue for upcoming periods.
• Production budget: Amount needed to be produced according to the sales budget.
• Material, labor, and overhead budget: Projected material cost with labor rates and manufacturing budget.
• Selling and administrative budget: Non-production expenses like marketing, sales commissions, office supplies, utilities, and administrative salaries.
• Budgeted income statement: The final financial projection that combines all budgeted revenues and expenses to show expected profit or loss for the period.

What are the types of operating budgets?

Businesses have multiple departments working together and each department has its unique requirements. Hence, there are individual operating budgets for different teams or functions catering to various spending habits or activities.

The main types of operating budgets are:

1. Sales budget: This budget is presented by the sales team of a company based on factors like past sales data and market trends. It helps in planning production, inventory, and marketing activities.
2. Production budget: Outlines the number of units that need to be produced to meet sales targets and helps determine raw material, labor, and manufacturing overhead requirements.
3. Cash budget: Your cash-flow budget tracks expected cash inflows and outflows and helps maintain adequate liquidity for operations.
4. Expense budget: It details all anticipated operating expenses and includes fixed costs (rent, salaries) and variable costs. Expense budgets are often broken down by department or cost center.
5. Profit budget: It shows estimated net income for the budgeting period and helps management make strategic decisions about pricing, cost control, and resource allocation.
6. Responsibility budget: This type of budget is specifically assigned to individual managers or department heads who are accountable for their respective financial outcomes. It clearly defines spending limits, revenue targets, and performance expectations for each organizational unit.
7. Static budget: This is a fixed budget that remains constant regardless of changes in business activity levels. It’s created at the beginning of the fiscal period based on a single anticipated level of output or sales.
8. Labor budget: This budget focuses on workforce planning and associated costs across the organization. It includes projections for direct labor hours, wage rates, benefits, training expenses, and potential overtime costs.

What information is included in an operating budget?

There are two primary information components in an operating budget: anticipated revenue and expected expenses for a period of time (usually the upcoming fiscal year).

These two can be further drilled down as information that acts as a financial roadmap to track projected performance and make necessary adjustments throughout the year. The key information included in the operating budget includes:

1. Revenue projections

Revenue projections include all anticipated income sources of the business, sales forecasts, service fees and charges, as well as licensing and royalty income if there is any.

The best practice in revenue projections is to break down all components in average pricing, unit volume, month-wise distribution, etc.

2. Cost of goods sold (COGS)

The cost of goods sold or COGS accounts for the production budget including raw materials cost, direct labor expenses, overhead manufacturing costs, and all other production related costs.
This also includes expenses in freight, commissions, and unexpected costs.

3. Operating expenses

Operating expenses are usually fixed costs like rent, utility, staff salaries, insurance premiums, administrative costs, etc. Operational costs cannot be affected by the revenue or sales in a fiscal year and need to be paid up regardless.

4. Non-cash expenses

Common non-cash expenses come in the form of depreciation, amortization, deferred charges, or even asset write-offs. Although the numbers in this section can vary over time and unexpected costs may be incurred, they still need to be accounted for while creating the operating budget.

5. Non-operating expenses

Non-operating expenses cover costs that are not directly tied to the company’s core business operations. This category includes interest payments on loans, losses from investments, legal settlement costs, and restructuring expenses.

6. Capital expenditures

Capital expenditures are significant investments in long-term assets that are essential for business growth and maintenance. Purchases of new equipment, property improvements, technology infrastructure upgrades, and major facility renovations are examples.

7. Unexpected expenses

The operating budget must account for contingency funds to handle unforeseen circumstances. This includes emergency repairs, crisis management costs, unexpected maintenance, and other unplanned expenditures.

A well-structured budget typically allocates a specific percentage or amount for these contingencies to ensure financial stability during unexpected situations.

8. Net income

The bottom line of the operating budget, calculated by subtracting all expenses from the total revenue projections is the net income. The final figure helps establish performance benchmarks and financial targets for the fiscal year.

How do you create an effective operating budget?

Such a comprehensive financial plan as an operating budget needs a significant amount of time and analysis put into it. It acts as a planning tool for management and requires authorization from the board members of your business.

During the course of the year, the operating budget also serves as a point of comparison between the projected and practical scenario and provides room for gap analysis.

Here’s an overview of all the steps involved in creating an effective operating budget:

Step 1: Set clear budget goals

Focus on building cash reserves and net assets for long-term sustainability. There must be revenue strategies, such as securing unrestricted contributions, launching fee-for-service programs, or negotiating performance-based contracts that allow for profit retention.

Deficit budgets must be avoided unless they are backed by a strong financial position and a clear purpose.

Step 2: Document all assumptions

All assumptions used to project income and expenses must be documented systematically. In projecting income, base it on retention rates, contribution trends, and expected outcome of campaigns.

For expenses, detail the cost schedules for all planned costs including staffing, benefits, and major operational needs. Always ensure that the assumption is based on past data available where possible, but adjusted to suit future plans.

Step 3: Identify all types of costs

There are multiple types of costs like management, fundraising, direct, shared, etc, and these can be arranged in a cost center structure for organized expenses. Further sub-cost centers can be created for specific sources or program elements to provide a granular view of cost allocation.

Step 5: Allocate costs to respective stakeholders

Proper allocation of costs to respective stakeholders can be done by using an agreed-upon methodology, such as the percentage of full-time equivalent (FTE) staff per program or other fair allocation bases, for shared or indirect costs.

Businesses can also consider suing cost pools for shared expenses and ensure allocations comply with federal guidelines or the requirements of other funding sources.

Step 6: Consider special/unexpected expenses

Unexpected expenses cannot be ignored at any cost. It’s a good practice to distinguish between unrestricted and restricted contributions to make sure that any restricted funds can be used correctly and tracked in accordance with compliance requirements.

Step 7: Get the board’s approval

Present the operating budget to the board with explicit documentation of financial assumptions, allocation methods, and key decisions made. Emphasize major priorities, challenges, and trade-offs.

Format the budget accordingly so that it follows the financial report format, which will help track and compare easily throughout implementation.

Step 8: Implement the budget and track performance

After approval, the budget can be implemented by delegating income and expense targets to managers. Track financial performances monthly or quarterly with the budget for actuals compared to projections. Also, track significant variances and investigate their cause and take action to correct the same.

Operating budget vs. capital budget

An operating budget includes day-to-day expenses and revenue in a business and is usually spanned annually, while a capital budget is a long-term plan including infrastructure investments, improvements, new projects, etc.

While the operating budget addresses annual, recurring expenses, the capital budget plans major, often multi-year investments that enhance the city’s physical infrastructure and long-term capabilities.

Here’s a table highlighting the differences between the two:

Aspect	Operating Budget	Capital Budget
Purpose	Covers day-to-day operational costs like salaries, utilities, and maintenance.	Focuses on long-term investments such as infrastructure, equipment, and facility upgrades.
Timeframe	Typically short-term (1 year or less) or mid-term (1-2 years).	Always multiyear, usually spanning 2-10 years.
Nature of costs	Includes recurring, out-of-pocket expenses required for regular operations.	Involves one-time or long-term costs associated with acquiring, building, or upgrading assets.
Source of funds	Primarily funded through the organization’s revenue or cash flow.	They may rely on external sources like loans, bonds, or equity, which reflect strategic priorities and investment.
Allocation	Allocated to departments for their operational needs, such as personnel and utilities.	Prioritized among projects based on factors like ROI, compliance, and business strategy.
Scrutiny	Subject to more frequent and detailed examination, often targeting cost-cutting.	Undergoes less scrutiny but requires justification for strategic alignment and long-term value.
Examples of expenses	Salaries, rent, minor repairs, utilities, and routine maintenance.	Large equipment purchases, facility construction, major renovations, or modernization projects.