An operating budget serves as a roadmap for companies to lay out their financial plans for the upcoming year. It includes both revenues and expenses, is typically presented in an income-statement format and provides a valuable way for the company to document financial targets and goals for activities it wants to achieve going forward.
As a business owner, you may find yourself needing a budget to guide and support your company's financial decisions. Different budget types exist depending on what type of spending you're planning, and many companies use versions such as a divisional budget, budget by cost-center, top-down or bottom-up budget each year to document their goals for the next 12 months.
What Is an Operating Budget?
An operating budget is a projected statement of upcoming operational revenues and expenses for a company. It does not include costs for capital purchases or investments, such as the cost to construct a warehouse. Operating budgets are typically assembled on a monthly or quarterly basis and cover a one-year period.
Expenses include the cost of sales (the direct costs to produce a product) and operating expenses related to the selling and general and administrative activities of the company. Depending on the level of detail, an operating budget might also include the depreciation, amortization, interest expense and tax expense expected for the upcoming year.
An operating budget is often assembled with expenses on a line-by-line basis so that when planning the budget it can be refined by item. For example, if a company knows that it will be paying a consultant for the first three months of the year, it helps to have this line-item detail in the budget so that the costs can be removed from the budget for the rest of the year. Or, if the company knows that its rent will be increasing in June, it can also factor this into its line-item detail budget.
Larger companies that have many divisions or other entities often assemble separate operating budgets for each business unit and then consolidate them into one summary-level master budget for the company as a whole.
What Are the Different Types of Budgets?
Companies use different types of budgets for a variety of reasons, and each of the four main types or methods works for various situations.
- Incremental budgeting: Possibly the most commonly-used, straightforward budgeting method. One simply takes the company's actual numbers from last year and increases or decreases them by a specific percentage. For example, a company might budget a 10-percent increase in sales revenue for its top-selling product and a 5-percent decrease in spending on unused office space. This is a common method because of its ease but tends to ignore outside influences such as inflation. Additionally, managers might estimate expense growth at a higher percent to give the appearance that they always come in under budget. This budgeting method can disincentivize managers to make efforts to cut costs or increase efficiencies.
- Activity-based budget: A type of top-down budget with output goals such as a target of $150 million in revenue. Top-down budgets involve senior-level managers who formulate a high-level budget based on their objectives. This budget is given to department managers to determine the activities needed to hit this target and the costs of doing those activities.
- Value-proposition budget: This type of budget requires more thought, and it involves asking the question of whether every item in the budget creates value for customers, employees and the company's other stakeholders.
- Zero-based budgeting: This type of budget assumes that each department starts with zero budget, and each budgeted expense needs to be justified before it's added. While this type of budgeting is time-consuming, it works for companies that need to restructure their operations financially, or otherwise, need to exert very tight control over spending. This type of budgeting is more effective for discretionary costs, rather than for the core operational costs that keep the business running.
Why You Need an Operating Budget
Companies must be able to stay in touch with the current financial state of the business to be successful, as well as to project what they're expecting in future months so they can plan for the coming year's revenues and expenses. An operating budget is important because it gives management a way to set and communicate its financial goals and targets for the next 12 months, and it can be used to hold employees and management accountable to those targets. It is not uncommon for companies to prepare a schedule that compares the budget to actual financial results each month, or at least each quarter, to see how the company's actual performance is tracking with its budgeted targets.
The operating budget and the planning process also provides an opportunity for companies to be prepared in the event of unforeseen circumstances. For example, a company can set its revenue and expense targets and plan them so that it has enough profitability to put money into a slush fund. The fund could be used in case of a downturn in the economy, the loss of a large supplier, the loss of a frequent customer or any other type of business issue that could impact the company's cash flow in a negative way.
Creating an effective budget is part art and part science. As a business owner, you will need to figure out where to set the bar in terms of creating a budget that reflects the kind of performance that your team is capable of, while also considering what your company needs to do to keep in line with or beat its competitors and peers and excel in its marketplace. It's important to set budget goals at a high enough level that the market and any investors perceive your company as a leader and an achiever, yet keep the targets at a realistic enough level that you don't create a negative perception by missing the targets.
Companies choose to assemble budgets in different ways, depending on the company's size, structure, type of business and other considerations. For example, you might decide to put together a budget by department, with categories such as CEO, finance, facilities or IT. Each of these sections will have the same components, such as payroll, legal fees, computer expense and office costs.
Some companies prepare their budget by cost center. A cost center is a department, rather than a division. In a manufacturing company, it might be a fabricating department or maintenance department. These departments are responsible for direct operating expenses and have no involvement or control over the selling, or revenue-generating part of the business. For this type of budget, it's difficult to calculate the profit of each cost center because it requires revenue and overhead costs, such as building rent, to be allocated.
Another budget example is the method of top-down budgeting. This process for formulating a budget involves management setting goals and targets for the company at the top and then pushing those targets and goals down to the division managers of the company. The budget targets are dictated by management, and the departments must find a way to structure their separate budgets to meet the goals and targets set by senior executives.
This type of budgeting has a drawback in that the mid-level and lower management in the divisions do not take ownership of the budget because it wasn't created by them and was imposed on them. Some feel that top-down budgeting is not as effective because management is often disconnected from the detail of what happens out in the field and with the day-to-day operational needs of the company.
Bottom-up budgeting is the reverse of a top-down budget, and it starts with the people out in the field. Each department is responsible for formulating its own budget, and the personnel that is involved in the day-to-day operations is typically the most knowledgeable about all the line items on the departmental budgets. For this reason, bottom-up budgets tend to be more detailed and in many cases, more accurate than top-down budgets. The budget is still built based on targets, though, so even with the extra detail, it could be entirely different from the company's actual results.
Budgeting Challenges: Sandbag or Stretch?
Budgeting is not as easy as just adding a growth rate or reduction to revenues and expenses and then doing a copy paste for each of 12 months for the upcoming year. Especially when the budget is constructed by people out in the field, a dilemma might arise. Perhaps the team should put together a budget that includes stretch goals, that are very optimistic but may be difficult to reach. Or maybe the team should put together a budget that is sandbagged, which means that the goals are easier to reach.
This is an especially tricky issue when employees know that their bonuses are tied to their performance against the budget, and it can test management's ethics, especially if a sandbagged budget results in the company performing worse than its peers or competitors, all in the name of employees ensuring their bonuses.
Each approach has its potential issues. While there's something to be said for under-promising and over-delivering, on the other hand, setting stretch goals can push people and teams outside of their comfort zones to achieve previously unexpected or unobtainable, positive results.
If the budget goals are too outrageous, employees will start to either ignore the budget or question leadership's mindset, and it's ability to assess the staff's capabilities accurately. Additionally, if the revenue budget is set at a level that is unachievable, and operating expenses such as hiring and salaries for additional personnel are set to correspond with the inflated sales, the company could end up spending too much money on underutilized resources.
Capital Budgets and Forecasts
A company's capital budget may interact with the operating budget, but it's a completely separate pot of money. The capital budget details out the plans and associated revenue and expenses for large or expensive projects, such as buying new production equipment, constructing a new warehouse or investing in, and launching a new product. The capital budget is often done on a project-by-project basis as well and might be financially modeled as a Net Present Value or NPV calculation, or an Internal Rate of Return or IRR calculation.
Both of these methods are commonly used, and they offer management a way to assess the viability of a project, estimate the amount of cash flow that the product could generate, determine the rate of return on the investment and make a decision about whether or not to take the project. A company might perform two or three different scenarios of an NPV or IRR calculation with various assumptions to determine which could generate the most profit for the company.
Many companies also put together a forecast along with their operating budget. While it may seem duplicative, the budget represents what the company wants to achieve, such as a certain percentage increase in sales for the year, a certain decrease in expenses or a certain number of additional staff hired.
The forecast, on the other hand, represents an idea that's closer to financial reality. The company creates a forecast at the beginning of the year, and it may closely resemble the budget in January. However, as the real results roll in, the company will update the forecast based on what's really happening, which may or may not resemble the budget. The forecast offers management a tool to help with near-term planning and to redirect efforts if the company is looking like it may not meet its budget targets for either revenue or expenses.