Having realistic and practical operating budgets for Small and Medium Enterprises (SMEs) is crucial for their survival. Some of the top reasons that startups fail include running out of cash or not raising enough funds, and pricing and cost issues, a 2021 CB Insight survey found. Gain control of your operational costs to stabilize your company’s cash flow and increase your margins by having an operating budget in place. An operating budget is one of the three main parts of a master budget (the other two components are the capital expenditure budget, and the cash (or financial) budget) used for a business’ overall financial planning. Here in this article, we will list the 9 parts of an operating budget for an SME.
This Article at a Glance
An operating budget is all the projected revenues and expenses that a company expects to have within a specified period. SMEs need an operating budget as part of their financial planning, and to evaluate their companies’ performance at year end and against previous years’ performances. Operating budget is presented on a budgeted income statement, and comprises the sales, production, direct materials purchase, direct labor, overhead, ending finished goods inventory, cost of goods sold, and sales and administrative expenses budgets.
What Is the Business Operating Budget?
In business, an operating budget is all the projected revenues and expenses that a company expects to have within a specified period, (e.g. quarterly or yearly). In an operating budget, revenues and expenses are usually sorted by types, such as product type or fixed and variable costs. The operating budget is forecasted using past years’ business eperformance, and other sources of data such as projected sales. The operating budget is not rigid and it could be updated throughout the year, in line with any operational changes. The operating budget is usually presented in a pro forma, or a forecasted income statement format.
|Operating budget||Base budget||Add'l income|
|1) Manager ($70k x 75% + Fringe)||$68,250||$68,250|
|2) Assistant ($60k x 50% + Fringe)||$0||$39,000|
|3) Admin ($60k x 50% + Fringe)||$16,250||$16,250|
|Rent (shared/reduced rate)||$5,000||$5,000|
|Operations & Maintenance|
|BID Management Charge (ongoing)||$17,500||$22,000|
|Ambassadors (1.0 peak; 0.6 events)||$80,000||$120,000|
|Maintenance (Elec, Plumb, GC)||$25,000||$40,000|
|Event Rental (Institutional)||$0||$50,000|
|Event Rental (Other)||$0||$50,000|
|INCOME LESS EXPENSE||$0||-$30,500|
A conceptual Urban Public Realm project operating budget example by Peter Hendee Brown.
Why Does My Business Need an Operating Budget?
An SME needs an operating budget so as to manage current expenses and plan for future ones. An operating budget keeps your business on track, and could reduce business debt. In addition, an operating budget is useful for your business to:
- Plan for the future efficiently. Planning could be done at financial year end to budget for the forecasted expenditures needed to achieve the targeted profits.
- Optimize resources allocation. A budget details out allocated funds’ inflows and outflows, and preps your business to factor in any contingencies.
- Communicate an SME’s goals to the whole team. With an operating budget, each department is informed of the anticipated revenue they are expected to generate or the allocated budget set aside for their expenses.
- Evaluate company’s performance. At the end of the fiscal year, review if the actual sales and costs match the year’s planned budget to evaluate each department’s performance.
A sales budget approximates a business' total revenue within a specific duration. It includes the quantity and price of products sold, and both online and offline sales are included too. Sales budget helps you to set a realistic target since it is based on the previous sales numbers within the same time period. To prepare your SME's sales budget, ensure that you have your income statement, balance sheet and cash flow statement at hand. evaluate your product prices, take stock of your inventory, and consult your sales team and customers to allocate a sales budget for the upcoming quarter or year. A sales budget differs from a sales forecast as it takes a bottoms-up approach and the sales team's ability to meet the desired sales is taken into consideration.
The production budget is a calculation of the number of units of products that needs to be produced or manufactured. It takes into account the sales forecast numbers and the finished goods safety stock inventory (minimum number of inventory required to prevent being out-of-stock). A production budget is also required for material requirements planning.
The formula for production budget planning is:
Expected Unit Sales + Period End Unit Inventory − Period Start Unit Inventory = Required Production Budget in Units
Production budget could be presented either in number of units or cost per unit, and could be calculated monthly, or quarterly. Having an accurate forecasted production budget is crucial to avoid holding too much or too little inventory, which may lead to wastage and lost sales.
Direct Materials Purchases Budget
After setting sales and production budgets, determine your direct materials purchase budget, which is how many units of raw materials that must be purchased for your company's production process. Examples of raw material include rubber, plastic, steel and water.
A direct materials purchases budget lists the quantity and price of each type of raw materials required. You will need to know the production level, beginning and ending direct materials inventory, and the types and prices of raw materials needed to correctly gauge this part of the operating budget. Direct materials purchase budgeting could be done monthly or quarterly, and you can avoid cash flow problems by budgeting for it accurately.
Direct Labor Budget
The direct labor budget is a typically monthly or quarterly calculation of the number of labor hours required to manufacture the total number of products listed in the production budget. (There is also the complex labor budget where labor hours are further broken down into labor categories). Direct labor budget aids management to roster the adequate number of manufacturing employees necessary during the budget period. It could also help estimate the number of overtime hours needed to manufacture the production output, and if hiring or laying off workers are required.
The formula for direct labor budget planning is:
Units to Produce X Direct Labor Hours Per Unit (No. of Hours Needed to Produce One Unit Product) = Total Direct Labor Hours
Total Direct Labor Hours X Labor Cost Per Hour = Total Cost of Direct Labor
An overhead budget is a budget outlook that lists all future costs associated with a company's goods or services manufacturing, minus the direct materials cost and the direct labor cost (both of which are computed in the costs of goods sold budget instead). An overhead budget helps management to estimate and project profitability and to comprehend their expenses’ limitations. Manufacturing overhead includes a range of costs such as depreciation, small production supplies, utilities, and rent.
Ending Finished Goods Inventory Budget
All the previous five budgets that we have mentioned above (overhead budget, direct materials purchased budget, direct labor budget, production budget and sales budget) are needed to prepare the sixth part of the operating budget: the ending inventory finished goods budget.
The ending finished goods inventory budget calculates the total costs of unsold inventory produced.
The total costs of raw materials, direct labor and overhead are added together and divided by the total number of goods produced. This total cost per unit would then be multiplied by the total number of finished goods held in inventory. This would give the total costs of ending finished goods inventory.
The formula for calculating finished goods inventory is:
Beginning Finished Goods Inventory + Cost of Goods Manufactured - Cost of Goods Sold
The ending finished goods inventory budget could be used to determine the rate of production of new units of finished goods. For example, the production rate must slow down if the finished goods inventory number exceeds the rate of sales. Likewise, production must be ramped up if the goods are undeserving the potential market.
Cost of Goods Sold Budget
The Cost of Goods Sold (COGS) budget is the direct cost or expense of producing goods sold by a company. The COGS comprises raw materials and labor costs, but not indirect costs such as marketing and overhead expenses. COGS only counts costs directly involved with manufacturing goods meant for sale. Sold inventory recorded under COGS on the income statement. Unsold inventory from the previous year is considered as next year's beginning inventory.
In a Cost of Goods Sold budget, the Budgeted Manufacturing Costs is listed, which comprises the sum of the costs of Direct Materials and Direct Labor used, and the Overhead. The Beginning Finished Goods is also listed, and the total value of the Goods Available for Sale is added to it. The Ending Finished Goods is then deducted from this sum, which gives the Budgeted Cost of Goods Sold.
Sales and Administrative Expenses Budget
The Sales and Administrative Expenses Budget encompasses all non-manufacturing expenses which include expenses from sales and administration, accounting, marketing, engineering, etc. departments. It is a considerable budget and could amount to the production budget. As such, sometimes the sales and marketing budget is separate from the administration budget.
The Sales and Administrative Expenses Budget is usually done monthly or quarterly and does not rely on the other parts of the operating budget listed above. This budget is most commonly drawn up by gauging the appropriate level of expenditure for each corporate activity (activity-based costing) or by incremental budgeting (based on most recent spending). However, the drawback of this method is that excessive spending might be extrapolated.
Budgeted Income Statement
With all these eight budgets prepared, you can make a budgeted or forecasted income statement. You would derive your company's operating income (total profit after regular, recurring costs and expenses) from the budgeted income statement. Net profit could only be found after completing your financial budget.
To create a balanced business budget:
1. Identify Your Income Sources.
This is how much money you make each month and include sales figures and other sources of income. (E.g. Product sales, loans, and savings.)
2. Calculate Fixed Costs.
These are the expenses that you incur monthly. (E.g. Rent, utilities, and salary.)
3. Add in Variable Costs.
These costs fluctuate from month to month and are not fixed. (E.g. Raw materials, transport, and advertising.)
4. Anticipate Rare Expenses.
Rare expenses are one-off purchases or expenses that you need to spend for your business occasionally. (E.g. Office equipment, software, and gifts.)
We hope you have a clearer idea of operating budgets and understand the importance of having a planned budget for each quarter or year. If you are searching for an online bank for international and local trade for your SME, look no further. Silverbird opens your account in minutes and has transparent exchange rates.
Author: Syahirah Aiman
Illustration: Kate Faldina