by Operating budgets include the sales budget, production budget, direct materials budget, direct labor budget, overhead budget, cost of goods sold budget, selling and administrative budget, and pro forma (or budgeted) income statement.
Financial budgets include the capital budget, pro forma balance sheet, pro forma statement of cash flow, and cash budget.
Operating Budget
The operating budget contains the expenditure and revenue generated from the daily business functions of the company. The operating budget concentrates on the operating expenditures, including cost of produce sold in the market or popularly known as cost of sold goods (COGS) and the revenue or income. COGS is the cost of direct labor and direct materials that are tied to production.
The operating budget also depicts the overhead and administration costs tied directly to manufacturing the goods and providing services. However, the operating budget will not contain capital expenditures and long-term loans.
An operating budget consists of all revenues and expenses over a period of time (typically a quarter or a year) which a corporation, government, or organization uses to plan its operations. An operating budget is prepared in advance of a reporting period as a goal or plan that the business expects to achieve. Below is an example of a downloadable budget template and an explanation of how to prepare one.
Components of an Operating Budget
The main components of an operations budget are outlined below. Each business is unique and every industry has its nuances, but these items are general enough to apply to most industries.
Revenue
Revenue is usually broken down into its drivers and components. It’s possible to forecast revenue on a year-over-year basis, but usually, more detail is required by breaking revenue down into its underlying components.
Revenue drivers typically include:
- Volume (units, contracts, customers, products, etc.)
- Price (average price, per unit price, segment price, etc.)
Variable costs
After revenue, variable costs are determined. These costs are called “variable” because they depend on revenue, and are often calculated as a percentage of sales.
- Variable costs often include:
- Cost of goods sold
- Direct selling costs
- Sales commissions
- Payment processing fees
- Freight
- Certain aspects of marketing
- Direct labor
Fixed costs
After variable costs are deducted, fixed costs are usually next. These expenses typically do not vary with changes in revenue and are mostly constant, at least within the time frame of the operating budget.
Examples of fixed costs include:
- Rent
- Head office
- Insurance
- Telecommunication
- Management salaries and benefits
- Utilities
Non-operating expenses
Non-operating expenses are those that fall below Earnings Before Interest and Taxes (EBIT) or Operating Income. Examples of expenses that may be included in a budget are:
- Interest
- Gains or Losses
- Taxes
Non-cash expenses
An operating budget often includes non-cash expenses, such as depreciation and amortization. Even though these expenses don’t impact cash flow (other than taxes), they will impact financial reporting performance (i.e the figures a company reports at the end of the year on their income statement).
Capital costs in an operating budget
Capital costs are usually excluded from an operating budget. The term operating refers to a statement of operations (income statement) which does not include capital expenditures.
Financial Budget
A budget helps an organization allocate the resources of the company to different departments and activities and manage the cash flows of the business in an effective way. There are many types of budgets. One of them is a financial budget.
The financial budget is one part of a business’s master budget. The second part of the firm’s master budget is the operating budget. The master budget is the financial portion of the business’s strategic plan for the near future. The strategic plan for the business maps out the firm’s planned financial activities for the next five years.
The purpose of the financial budget is to estimate the firm’s cash budget, capital expenditures, and balance sheet line items like assets, liabilities, and owner’s investment. The financial budget is the last budget to be developed by the firm every year since all other budgets, like the individual budgets in the operating budget, are necessary first. The financial budget helps the firm by allowing it to calculate net profit when the budget process is complete.
The capital expenditures budget is the first budget of these three budgets to be prepared within the framework of the financial budget. The information from this budget is needed for both the cash budget and the budgeted balance sheet.
Capital expenditures are fixed asset expenditures. Fixed assets are equipment or facilities needed for a business to operate. These expenditures also include maintenance for these items. While there are businesses that purchase larger amounts of fixed assets, most smaller businesses do not.
Small businesses tend to be more conservative in their capital expenditures since these types of purchases can be very costly. Many do not own the facilities they operate in, reducing capital expenditures.
While an expenditures plan for maintenance of the equipment is likely, a smaller business may lease, rather than own, their equipment. Consider depreciation and standard lifetimes of your equipment when designing your capital budget if you own your plant and equipment.
Different Sections of a Financial Budget
Budgeted Balance Sheet
The budgeted balance sheet comprises many other budgets. The major component of this budget includes the production budget and its associated budgets.
Cash Budget
The cash budget contains information on the inflows and outflows of the business. On the other hand, the cash flow of the business continues changing and with that, the cash budget should also change. Making a cash budget is a dynamic process, not a static one. There must be an immediate reflection of any change in the cash flow in the cash budget of the business.
Capital Expenditure Budget
As the name suggests, the capital expenditure budget relates to expenses related to plant and machinery or any capital asset of the business. This budget determines the expenses that would be incurred if an existing plant is replaced or any new machinery is bought. Factors like depreciation, cost of the plant, life of the machinery, etc. are taken into account when preparing the capital expenditure budget.
Financial Budget Plan
The financial budget plan is comprised of the following steps:
- Calculate the expected outflow
- Calculate the expected inflow
- Set the targets
- Keep track of components in the budget
- Divide the expenses into different categories
- Set up the ledger
Capital Budgets
Capital budgeting involves choosing projects that add value to a company. The capital budgeting process can involve almost anything including acquiring land or purchasing fixed assets like a new truck or machinery.
Capital budgeting is the process a business undertakes to evaluate potential major projects or investments. Construction of a new plant or a big investment in an outside venture are examples of projects that would require capital budgeting before they are approved or rejected.
Corporations are typically required, or at least recommended, to undertake those projects that will increase profitability and thus enhance shareholders’ wealth.
However, the rate of return deemed acceptable or unacceptable is influenced by other factors specific to the company as well as the project.
Objectives of Capital budgeting
Capital expenditures are huge and have a long-term effect. Therefore, while performing a capital budgeting analysis an organization must keep the following objectives in mind:
Capital expenditure control
Selecting the most profitable investment is the main objective of capital budgeting. However, controlling capital costs is also an important objective. Forecasting capital expenditure requirements and budgeting for it, and ensuring no investment opportunities are lost is the crux of budgeting.
Selecting profitable projects
An organization comes across various profitable projects frequently. But due to capital restrictions, an organization needs to select the right mix of profitable projects that will increase its shareholders’ wealth.
Finding the right sources for funds
Determining the quantum of funds and the sources for procuring them is another important objective of capital budgeting. Finding the balance between the cost of borrowing and returns on investment is an important goal of Capital Budgeting.
