What is an Operating Budget?

An operating budget is typically prepared on an annual basis. It contains estimates of monthly expenses and revenue projections. An operating budget serves as a planning tool and helps businesses keep track of their profitability throughout the budgeted period.

How to Create an Operating Budget:

An operating budget encompasses several smaller or sub-budgets. The different budget components are pulled together into one comprehensive overview of the business's monthly revenue, costs, and expenses.

1. Sales Budget.

The first step in creating an operating budget is to draw up a sales budget. This also doubles as a sales plan for the year. Begin by listing all the products and services you plan to sell along with their pricing. Then make monthly sales projections for the budget period, typically one year.

Use your past sales data and reports as a starting point. Also, keep in mind that seasonal changes, new product launches, and planned marketing activities may impact your potential sales.

2. Production Budget.

A production budget helps you to plan exactly how many units of each product must be produced to meet your projected sales volume while maintaining sufficient inventory levels.

You will have to determine how much inventory you have to begin with and how many units of each product should make up your closing inventory at the end of each month. You can calculate the number of units that must be produced as follows:

Number of Units to be Produced = (Number of Expected Sales + Desired Closing Inventory) - Beginning Inventory

Use the number of expected sales from your sales budget.

3. Direct Materials Budget.

Next, determine the number of direct materials that are needed to fulfill the requirements of the production budget. Direct materials are the raw materials needed to manufacture a product.

The total cost of raw materials required to produce each product item listed in the production budget is multiplied by the total number of products that must be produced each month to determine the total cost of direct materials per month.

These costs may vary from month to month depending on the required production volume as well as your suppliers. Therefore, keep in mind the possibility of fluctuations in the availability and pricing of supplies.

4. Direct Labor Budget.

The direct labor budget, similar to the direct materials budget, aims to define how many hours of labor are required to produce each type of product listed in the production budget. This can be somewhat more complex if you decide to break down the hours by each labor category involved.

Determining the total number of labor hours needed to meet the requirements of the production budget helps businesses plan how many employees they will need.

5. Overhead Budget.

The overhead budget contains all other manufacturing costs. Examples of costs that are assigned to the overhead budget include supervisor salaries, payroll taxes, logistics, rent, and utilities.

On the budget sheet, these costs are typically split into fixed and variable costs. Some items might contain both fixed and variable costs, in which case the differences are noted as such or simply added as a third category of mixed costs.

The cost of the overhead, direct materials, and direct labor together make up what is referred to as the cost of goods sold. Presenting these costs per unit also helps businesses with the development of pricing strategies.

6. Selling, General, and Administrative Expenses.

The costs associated with managing the business and selling and delivering products and services are documented as the selling, general, and administrative expenses (SG&A).

These are all the direct and indirect expenses of a business that cannot be assigned to a specific product or service the business manufactures or performs. They include items such as management salaries, business licenses, accounting, legal, and human resources expenses, rent, advertising, marketing, and more.

7. Unexpected Expenses.

To avoid being caught off guard by unexpected expenses, it is wise to pad your operating budget a little, leaving room for unforeseen costs. Using your previous years' planned and actual budgets as a reference might give you an idea of how much to put aside. You might decide to determine a specific annual dollar amount or to add a percentage margin to the monthly budgets.

8. Budget Summary and Review.

Once all the sub-budgets have been drawn up, you can move on to creating a budget summary and calculate your anticipated net income. This is done by subtracting all budgeted costs and expenses from the projected revenue.

Net income = Revenue - Costs - Expenses - Unexpected Expenses

The budget can now be reviewed. Determine whether the budget is realistic. You may have to make adjustments. Before changing the numbers in the budget, you will have to consider how you can optimize your operations, perhaps revisit supplier contracts or product lines, and reduce costs and expenses. Since SG&A expenses are not directly linked to production volume, this is usually the first area businesses reassess to cut costs.

10. Budget Tracking.

Keep track of your actual revenue, costs, and income and compare these to your budget on a regular basis. If your actual numbers deviate from your budgeted amounts you will have to investigate what is causing the deviations and may need to adjust your budget or optimize your operations to ensure that your business remains profitable.