The purpose of an Operational Budget is to:
- Plan for the future – If you want to expand marketing but know that in order to pay for that Sales have to grow, this is an example of planning. Planning allows an owner to translate their vision into a language that people can understand
- Basis of Accountability – Because the budget is clearly communicated in a language broadly understood by the stakeholders, the owner can begin to hold employees accountable for properly executing the plan that was envisioned.
- Facilitates Analysis – The budget usually is developed based upon relationships between revenues and the underlying costs used to generate those revenues. When these connections are made, owners can start asking the necessary questions to improve cost structure, efficiency and the effectiveness of generating revenue.
- Basis of Comparison – After the budget is complete and the year has begun, actual results are compared to the budgeted amounts. The resulting observations are insightful and illuminate what may have gone right or what may have gone wrong.
Operational budgets have at least three components: Revenues (Sales), Costs of Sales and Selling, Administrative and General (SGA) Expenses.
Usually budgets are driven by the ‘top line’, or the Revenue (Sales). That makes sense because you are in business to provide goods and services to your customers. Costs and expenses will follow as a result of you producing goods and services to sell.
Revenue or Sales can be budgeted based upon how many units of each product you intend to sell, or how much in services you intend to render. The budgeted Revenue can be established by using the prior years’ experience as a starting point. But you will also need to understand how the current year is different from prior years. Sales are the product of units sold multiplied by the Sales price. Calculating budgeted Sales based upon prior year activity is calculated as follows: increase (decrease) in units sold multiplied by prior year Sales prices, added to the increase (decrease) in Sales prices multiplied by the prior year units sold, plus the increase (decrease) in units sold multiplied by the increase (decrease) in Sales price.
Costs of Sales refer to the materials and labor that it costs to produce the units you sell. You should have a good idea about what those costs are. If not, just review your prior experience to understand what this relationship has been historically. In Cost Accounting, we break each product down into its component parts and develop a cost model based upon these component parts and the related labor. This would be useful in the budgeting process, but is not necessary. Dividing prior year costs for each product line by the units sold will give you a good big-picture understanding of your costs – and you can use that for budgeting purposes. But just like when you budgeted for Sales, you will need to understand how much your costs will increase for the coming year (you already have an idea of how much the units sold will change because you just budgeted that in the Sales section).
Finally, Sales, Administrative and General (SGA) expenses will need to be budgeted. These are all the other costs that do not bear much relationship to Sales and Costs of Sales. For example, rent will be the same each month, unless you move or renegotiate your lease. Utilities will fluctuate according to seasonal variances. Insurance, administrative salaries and other types of expenses will also track fairly evenly during the year. That is a characteristic of most SGA expenses. Like all rules of thumb, there are exceptions. Sales commissions should vary based upon Sales. Again prior experience is very helpful in determining the nature and amount of your SGA Expenses.