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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.

Cash flow forecasting is the process of estimating the flow of cash in and out of a business over a specific period of time. An accurate cash flow forecast helps companies predict future cash positions, avoid crippling cash shortages, and earn returns on any cash surpluses they may have in the most efficient manner possible.

Cash flow is the amount of money going in and out of your business. Healthy cash flow can help lead your business on a path to success. But poor or negative cash flow can spell doom for the future of your business.

If you want to predict your business’s cash flow, create a cash flow projection. A cash flow projection estimates the money you expect to flow in and out of your business, including all of your income and expenses.

Typically, most businesses’ cash flow projections cover a 12-month period. However, your business can create a weekly, monthly, or semi-annual cash flow projection.

Advantages of projecting cash flow

Projecting cash flows has many advantages. Some pros of creating a cash flow projection include being able to:

• See and compare business expenses and income for periods.
• Predict cash shortages and surpluses.
• Determine if you need to make adjustments. (e.g., cutting expenses)
• Estimate effects of business change. (e.g., hiring an employee)
• Prove to lenders your ability to repay on time.

Forecasting:

Determine Your Forecasting Objectives

To ensure you see actionable business insights from a cash flow forecast, you should start with determining the business objective that the forecast should support. We find that organizations most commonly use cash forecasts for one of the following objectives.

• Short-term liquidity planning: Managing the amount of cash available on a day-to-day basis to ensure your business can meet its short-term obligations.
• Interest and debt reduction: Ensuring the business has enough cash on hand to make payments on any loans or debt they’ve taken on.
• Covenant and key date visibility: Projecting your cash levels for key reporting dates such as year, quarter, or month-end.
• Liquidity risk management: Creating visibility into potential liquidity issues that could arise in the future so you have more time to address them.
• Growth planning: Ensuring the business has enough working capital on hand to fund activities that will help grow revenues in the future.

Choose Your Forecasting Period

Once you’ve determined the business objective you hope to support with a cash flow forecast, the next thing to consider is how far into the future your forecast will look.

Generally, there’s a trade-off between the availability of information and forecast duration. That means the further into the future the forecast looks, the less detailed or accurate it’s likely to be. So, choosing the right reporting period can have a big impact on the accuracy and reliability of your forecast.

• Short-period forecasts: Short-term forecasts typically look two to four weeks into the future and contain a daily breakdown of cash payments and receipts. As you might expect, short-term forecasts are often best suited for short-term liquidity planning, where day-to-day granularity is important to ensure a business can meet its financial obligations.
• Medium-period forecasts: Medium-term forecasts typically look two to six months into the future and are extremely useful for interest and debt reduction, liquidity risk management, and key date visibility. The most common medium-term forecast is the rolling 13-week cash flow forecast.
• Long-period forecasts: Longer-term forecasts typically look 6–12 months into the future and are often the starting point for annual budgeting processes. They’re also an important tool for assessing the cash required for long-term growth strategies and capital projects.
• Mixed-period forecasts: Mixed-period forecasts use a mix of the three periods above and are commonly used for liquidity risk management. For example, a mixed period forecast may provide weekly forecasts for the first three months and then on a month-to-month basis for the next six months after that.

Choose a Forecasting Method

There are two primary types of forecasting methods: direct and indirect. The main difference between them is that direct forecasting uses actual flow data, where indirect forecasting relies on projected balance sheets and income statements.

Choosing the right forecasting method depends on the cash flow forecasting window you selected above, as well as the kind of data you have available to build your forecasting model.

Source the Data You Need for Your Cash Flow Forecast

Direct forecasting provides the greatest accuracy and works for the majority of business objectives that companies build forecasts to support. Therefore, we’ll focus on where to find actual cash flow data for your forecast in this section.

The right places to source cash flow data for your forecast ultimately depends on how your business manages its finances. But, generally speaking, most of the actual cash flow data you’ll need to build your forecast can be found in bank accounts, accounts payable, accounts receivable, or the accounting software you use.

• Your opening cash balance for the forecasting period: This is normally taken from the most up-to-date and accurate reflection of current positions.
• Your cash inflows for the forecasting period: Anticipated sales receipts from within the forecasting period are usually the primary source of data for your cash inflows. Other types of cash inflows to consider including are intercompany funding, dividend income, proceeds of divestments, and inflows from third parties.
• Your cash outflows for the forecasting period: We recommend capturing wages and salaries, rent, investments, bank charges, and debt payments. But you can include anything that’s relevant to your business.