Your Basic Operating Budget



Creating an Operating Budget

Forecasting future financial results

Purpose of This Idea:

The purpose of this idea is to create your system and tools to forecast and track your financial results based on executing your annual strategic plan.

Result or Output:

The result of this process is to create your business operating budget and internal processes for monitoring, tracking and making course corrections through out the year, based on actual financial results.

What is an Operating Budget?

An operating budget is your organization’s financial plan of action for a defined time period.

Why You Need an Operating Budget:

An operating budget is one of the most useful business tools. It enables you to break your annual strategic plan and goals into monthly predictions or forecasts about financial results (revenues) and the operating expenses associate with achieving those results.

Approaching budgeting a process and not annual event allows you to monitor and track results a regular basis. This in turn helps your firm respond more quickly to both internal and external changes and increasing your odds of reaching your annual goals. Because this process is repeated based on a planned cycle, it is often referred to as the budgeting cycle.

For some the term “budget” has a bad connotation. Mainly because the way we learned and applied budgets in the past has been around “limiting” spending. While being fiscally responsible is something we want to instill in every one, a better way to look at budget is a “spending” plan. In other words what and where do you need to spend money to ensure your properly execute your strategic plan and reach your annuals goals.

Key Points:

An operating budget process will enable you to make confident financial decisions and ensure you are taking the steps required to move closer toward your Business Vision. Here are a few key points to in mind when creating your operating budget:

• The easiest and most common way to design your budget is to pattern it exactly after your income statement.

• The heart of budgeting is making reliable forecasts of revenues and expenses.

• Operating budgets start with your annual strategic plan. Looking at annual revenue and profit goals, you can forecast what activities are required to reach those goals and what it will cost you to do those activities. Forecast and plan each line item separately.

• You may have to go through several iterations before arriving at a “realistic” budget.

• The best forecasts are two-step process: First, project past trends into the future. Then, make predictions, based on your knowledge and plans about what is likely to occur. Use predictions to modify your projections.

• Budget variance reports help you see where you are off course.

• Everything your business does either uses money or generates money. Creating your system to predict your planned use and receipt of money is your budget.

The Operating Budget Process:

You can create your Operating Budget in 4 steps:

1. Set up the Budget – Decide on the format and layout for your operating budget. Deciding on the schedule for your budgeting cycle. Assign accountabilities for generating and inputting the numbers, producing and distributing the budget, and reviewing and analyzing it.

2. Plan and forecast – Based on your annual strategic plan (annual goals and strategic initiatives) determine specific activities required to reach goals. Assign accountability to each activity. Where applicable estimate and project costs associated with each activity. Project and forecast results from the activities in terms of revenues, expenses and profits.

3. Monitor and report – Gather actual results from your accounting system. Either download or enter results into your specific budget format. Produce budget reports and distribute to appropriate staff.

4. Review and manage – Analyze your budget reports. Look for progress towards goals and variances between the actual numbers and what you had forecasted. You make now make informed management decisions and “course corrections” based on real data.

Basic Operating Budget Checklist

First Step – Set up your budget

❑ Decide on budget schedule – budget cycle

❑ Decide on layout and formatting.

❑ Assign accountability for:

❑ Generating the numbers

❑ Producing the document

❑ Reviewing and analyzing the budget

Second Step – Plan and forecast

❑ Establish goals and targets = successful outcome

❑ Brainstorm strategic initiatives and activities required to reach your successful outcome

❑ Document inputs and assumptions

❑ Identify and forecast costs

❑ Assign accountabilities for each action

❑ Project revenues, expenses and profits

Third Step – Monitor and report

❑ From accounting system gather actual results

❑ Enter into budget forms

❑ Produce reports

❑ Distribute to appropriate staff

Fourth Step – Review and Monitor

❑ Review budgets / variance reports

❑ Confirm assumptions, plans and forecasts

❑ Identify problems (early on)

❑ Make “course corrections” if necessary – including budget review cycle

Digging Deeper into Operating Budget Details

First Step – Set up your budget

When setting up your budget there are a few decisions you will need to make based on the key components of your operating budget. Those key components are: your budget format; the types of budget reports you plan to generate; your budget review schedule or budget cycle: and assigning accountabilities for the steps within the process. Let’s look at these components in some additional detail.

Format and Reports

There are two things to consider when setting up your budget. First is the budget itself, and the other is the monthly reports you’ll be producing and using to review the company’s performance.

For the budget, our recommendation is to use a similar format to your income statement. The typical format for a income statement and therefore for your budget would be to list your revenues and expense categories (line items) down the left hand column of a spreadsheet. Your expenses are going to be subdivided into variable costs (direct) and fixed costs. {Review the Financial Statements process for more information on this topic.}

As in your income statement you will also want line items for: net revenues; total variable costs; gross profit (contribution); total fixed costs: operating profit; non-operating income & expenses; and profits after taxes. Here is a sample: (insert a sample here)

Reports – The Budget Variance

If the budget itself is the tool you will use to plan and forecast financial results, the budget variance report is the tool you will use to monitor results. Adding two additional columns to your budget will allow you to create monthly variance reports.

Currently in one column you’ll have the actual budget you’ve been working to achieve during the past month. You can then add a column with the actual results you achieved for each line item in the new column = the Actual column.

Adding a second column that shows the difference between what you tried to accomplish (budget) and what you actually did. It is normally shown as a percentage.

This comparison report can help you spot problems and help you discover new areas of strength and opportunity. It can help you decide where to focus your (or your management team’s) attention, and give everyone a sense of confidence because they all know what’s going on.

A budget is great, but if you don’t constantly review and monitor your progress it won’t do you much good. This review and revision process is known as the budget cycle.

Budget schedule or cycle

There are four elements of timing that you need to know about:

• Budget horizon- This is the time span that will be covered by your budget. Usually this is one year, but at the beginning you might want to start with a 3-6 month time frame.

• Planning cycle- This is how often you’ll update your plans and forecasts. Most companies do this once per year. Don’t just stick to this “once per year” method no matter what, however. If something major happens in your business then you’ll need to plan and forecast accordingly.

• Review cycle- This is how often you’ll review your budget. Most companies do this once per month. It’s easier if your review cycle coincides with your accounting cycle. Connect to their schedule / controlling calendar; connect financial statement review process – too make sure we use what we produce. Predict changes.

• Rolling budgets- A rolling budget always goes one year into the future. This means that when you get done reviewing one month, another month gets tacked on at the end of the 11th month, meaning your budget is always rolling one year ahead of you instead of getting shorter and shorter as the year goes on. This keeps you focused on the short-term as well as the long-term in your business.

Where Do I Start?

Your budget must be focused on the short-term goals of your business, but it would be wasted if it did not also take into your long-term goals as well. When you set out to create your budget you need to keep two things in mind: revenues and profits. Of the two, profits are most important. Your goal, then, is to create annual goals and then break them down into smaller “monthly” goals that your budget will help you achieve.

The best way to do this is to start with your annual profit goal in dollars, and then determine how much you’ll revenue you’ll have to bring in each month to make this goal.

To calculate this, you can follow this formula:

Revenue Target = (Operating Profit Goal – Fixed Expenses) – Contribution Margin

This information can be taken directly from your income statements.

Forecasting

Now that you know what you’re shooting for you can start creating your budget line by line. This is the real heart of the process, and chances are high that you’ll need to go through this a few different times before you get it just right.

The best way to start forecasting is to follow a two-step process. Begin by making projections that are based on your past and present experiences. Then, use your projections to predict what can be accomplished in the future. The combination of projection and prediction is your forecast for the future.

It’s a good idea to keep track of how you arrive at your budget. When you’re going through the forecasting process keep notes on how you arrive at all the numbers in your budget. This record of your thinking process can really help you if you need to backtrack or adjust your estimates later on.

Now, forecasting is not a science, but it’s not all guesswork either. To forecast well you need to know your business, understand your market, and know what you want to accomplish in the months to come. It’s important that you not be overly optimistic. Rather, be realistic and use your common sense.

Tips For Forecasting

• Take into account cycles in your business. If August and September are slower months in your industry, then make sure your budget reflects this. Conversely, if November and December are extremely busy, then make sure you budget extra for supplies and labor during this time.

• Don’t set unrealistic goals for your target market. Make sure you have historical and statistical data to support your sales goals. Also, if you’re planning to begin an aggressive marketing campaign or you’re introducing a new product then make sure your forecast takes into account the changes you’re expecting.

• Whatever sales goals you’re setting in order to meet your profit goals, make sure that you budget enough for labor and supplies to meet these goals. Will you have to hire more workers, or pay overtime? These unexpected costs can wreak havoc on your budget if they’re not accounted for. No, you can’t plan for everything, but you can try!

The 5 Steps to Budgeting

There’s a lot to think about when creating your budget. Fortunately, you can create your budget pretty easily using the following 5 steps:

1. Establish your profit goals- Like we stated earlier, break your annual profit goal into 12 monthly benchmarks for your budget.

2. Establish revenue targets- Using the formula provided earlier determine how much revenue you must bring in to reach your profit goals.

3. Forecast variable costs- These costs change as your revenue changes, so forecast each month’s variable costs as a separate line item for your budget. Try and find ways to reduce costs.

4. Forecast fixed expenses- These expenses are pretty stable compared to your variable costs, but they should also be listed line by line.

5. Forecast net profit- Although you’ve determined your profit goal for the month, your line-by-line forecast may give you a very different operating profit forecast. It’s up to you to determine if your profit forecast is reasonable or not for your business. If you look it over and decide it’s not, then re-evaluate your forecast and make adjustments.

The Bottom Line

Your budget is going to be an ever-evolving process. By taking the time to review and monitor your progress, making adjustments as soon as they’re needed, the likelihood that you’ll accomplish what you set out to do is very high.

As time goes by you’ll get faster at interpreting the monthly variance reports, and before you know it you’ll be skimming quickly and have the ability to see the things that really need your attention. You’ll be able to spot problems before they become serious and opportunities will show themselves early on when you’re in a position to take advantage of them. Most importantly by creating a budget you’ll have a firmer sense of control over your business.

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