Operating Budget – Meaning and Significance

Ruchi Gandhi

08 Jul, 2020

A budget is a projection of any expense or revenue over a given period of time. The timing may be one month or one year. A budget is an instrument that is useful to individuals or any organization as it indicates the goal of business owners to take their company where they want to in the coming period. The operating budget is an all-inclusive document that outlines both the operating expenses to be incurred and the profits to be generated for a given period of time. This article strives to elucidate the concept of the operating budget, its purpose, components, and manner of preparation.

What is an Operating Budget?

The operating budget consists of both revenue and expenses over a period of time (usually a quarter or a year) and is used by a corporation, government or agency to estimate, plan, and finance its activities. An operating performance budget is planned as a target or schedule which the organization plans to meet in advance of a reporting period.

An operating budget is a projection of the anticipated revenues and expenses for one or more future periods. The management team usually formulates an operating performance budget just before the start of the year, which displays planned levels of operation for the whole year. Indeed, if the operating budget is for a period of one year, the same may be subdivided into additional parts like a quarter or a month.

Operating incomes and operating expenses

To quote precisely, the operating budget is a comprehensive document that outlines both the operating expenses to be incurred and the incomes to be generated for a given period of time.

Operating expenses such as raw material acquisitions, manufacturing costs, interest on a short-term loan, employee’s compensation, office repairs, administrative expenditures, etc. are considered for operating budget purposes. Similarly, the operating incomes such as sales revenue, income by the sale of by-products, etc. are considered for operating budget purposes.

A variety of subsidiary schedules might support this budget, containing details at a more detailed level. For instance, separate supporting budgets might be available that cover payroll, the cost of the products produced, factory overheads, and inventory.

To assess the magnitude of any variances from predetermined plans, actual results are then compared with the operating budget. Over the year, the company’s management can adjust its activities to match actual results with the operating performance budget.

The usefulness of an Operating Budget

An operating performance budget is useful to a business for the following purposes:

• The operating budget helps to keep track of the revenues and expenses.
• The operating performance budget monitors the expenditures while promoting hard work as well as meeting the ambitious sales targets.
• The operating performance budget increases the organization’s overall performance and efficiency.
• A company owner or manager may review the operating budget to see if the business is on track or having problems.
• If an operating performance budget shows a company’s monthly expenditures, a manager or owner is given the opportunity to set money aside to cover those expenditures.
• It helps to make the plant run at its full and optimal capacity.
• It also directs workers to have effective and more efficient plans in place, which are beneficial in carrying out the company functions, apart from holding the staff accountable.
• The operating performance budget can be classified into a deficit budget, a balanced budget, or a surplus budget based on the actual results over the reporting period.

Components of an Operating Budget

The operating performance budget is an estimation of operating profit derived from routine business activities of a company. This is done by comparing the operating revenues and operating expenditures of a budget period. The company’s cost of the goods sold (COGS) is subtracted from its revenue to obtain its gross income. Upon the calculation of gross revenue, all operating expenses are subtracted to achieve the operating profit of the company. Operating profit refers to the profit generated from core business activities of the company and hence, excludes the accounting for non-operating expenses such as interest costs, dividend, etc.

An operating performance budget begins with revenue, then shows every type of expense. Each sector is special, and each market has its variations, but some elements are fairly universal to refer to most of the industries. Some of these main components of an operating performance budget which are generic to all industries are as follows:

• Revenue: Revenue is normally broken down in to drivers and elements thereof. Revenue can be predicted year-over-year, but more information is typically needed by breaking revenue down into its underlying components. The revenue drivers typically include volume, units, customers, products, average price, per unit price, etc.

• Variable expenses: Usually, variable costs are deducted after determination of sales. Such costs are called “variable” because they are dependent on earnings/output, and are often expressed as a percentage of revenue. Some examples of variable costs include the cost of raw materials, cost of goods sold, freight and carriage, direct wages, direct selling costs, sales commission, stores and spares, payment processing fees, etc.

• Fixed expenses: Typically, fixed costs are next after the variable costs are deducted. Such expenditures do not vary as much with the variations in revenue, and are often constant, at least within the operating budget’s time frame. Some examples of fixed costs include premise rent, factory rent, insurance premium, telecommunication, utilities and facilities, managerial salaries and remuneration, etc.

• Non-cash expenses: Non-cash costs, including depreciation and amortization, are also included in an operating performance budget. While these costs do not affect cash flow (other than taxes), they do have an effect on the results of financial statements (i.e., the numbers a corporation presents on its income statement at the end of the year).

Exclusions from the Operating Budget

The following items are usually dispensed with while preparing an operating budget:

• Non-operating expenses: Non-operating expenses are those falling below the company’s Earnings Before Interest and Taxes (EBIT^[1]) or operating profits. Some of the examples include interest, gain or loss on the sale of fixed assets, gain or loss on the sale of investments, dividend payments, taxes, etc. Such expenses do not find a place in an operating budget but are rather taken into consideration while projecting a comprehensive budgeted statement of profit and loss.

• Capital costs: Commonly, capital expenses are omitted from an operating budget. This is so because the term ‘operating’ refers to a statement of recurring business operations (declaration of revenue) not including any kind of capital expenditure. Many businesses plan a distinct and separate budget for capital investments.

Factors Influencing the Preparation

Operating performance budget is designed by taking into account several considerations and assumptions. Below are some of the considerations that are used to plan the organization’s operating budget:

• The past pattern of sales
• Past patterns in the material purchase price
• Past trends of the requirement of the raw material quantity for consumption
• The pattern of sales and consumers’ demand
• Patterns of production and manufacturing overheads
• Changes in laws and policies in relation to specific industry
• Overall economic condition

Based on the above-mentioned factors, sales or income budget is developed at first. The reason is that all the expenses shall be based on the sales projections made by the business organization. When the sales or income budget is created, the expenditure budget is prepared. The expenses have to be calculated on the basis of the sales, past tax regulatory patterns, and, interest rates on borrowing, etc.

A sample proforma of an operating budget

An example of an operating performance budget is given as follows:

Operating Budget for the year ending 31st December 2020

Takeaway