What is an operating budget?

An operating budget is a detailed estimate of what a company expects from its revenues and expenses over a certain period of time. Companies usually prepare an operating budget at the end of the year to show expected activity during the next year.

How is the operating budget used?

Operating budgets help organizations set business goals and achieve them. Each month or quarter, managers can compare actual results with the operating budget and analyze the results by asking questions such as the following:

• Are sales higher or lower than anticipated?
• Were there any unexpected expenses?
• Do the figures for the rest of the year need to be adjusted?

Analyzing the results can help companies adapt to changing circumstances, update their actions and strategies if necessary, and achieve better performance.

What are the parts of an operating budget?

The more detailed the operating budget, the more relevant and valuable it will be. Operating budgets can include a high-level summary as well as several supporting sub-budgets that provide more detail. The most common components of an operating budget are as follows:

Income

It includes all the different ways a company makes money by selling goods or services. Projected revenue can be based on a simple year-by-year forecast, but breaking down revenue into its underlying components, such as unit volume and average price, can provide more information.

variable costs

These are costs that increase or decrease with sales volume. Examples include expenses for raw materials, labor, freight, and sales commissions.

fixed costs

Fixed costs are expenses that remain largely constant; they must be paid even if sales increase or decrease. Examples include rent, utilities, equipment leases, and insurance.

Non-cash expenses

The most common non-cash expenses include depreciation, amortization, unrealized gains or losses, stock-based compensation, and deferred income taxes.

Non-operating expenses

These are costs that are not directly related to the core activity of a business. The most common non-operating expenses include interest payments, losses on disposal of assets, and costs arising from currency exchange.

Some industries or organizations may include other items in their operating budget. However, capital expenditures are not usually part of the operating budget because they are long-term costs and the operating budget is a short-term budget.

How do you create an operating budget?

Creating an operating budget is a collaborative effort involving executives and managers. First, they must estimate the coming year's revenue. This involves examining the firm's historical performance and then considering market variables that could affect the next year's sales for better or worse. Among them:

• changing trends in the industry or sector
• New products to be launched by the company
• Activities of competitors
• Seasonal changes in sales
• Changes in the economy

Next, executives and managers must estimate projected expenses for each part of the business. Managers can keep track of their own departments. For example, HR's budget may include recruiting expenses, changes in benefits costs, the cost of replacing the department's old laptops, and many other expenses. CFOs and other executives may be in the best position to tally up projected expenses that affect the entire company, such as rent and taxes.

As with revenue projections, considering historical data and market variables can help create solid expense estimates.

Gathering all the necessary data can be a daunting task for all but the smallest organizations. But it's essential to creating an accurate operating budget—and to enjoy the clarity and guidance this document provides.