Prepare budget

Operational Budgets

Operational Budgets are aligned to operational plans and focus on the day-to-day operations of a business, including the costs of producing goods or services, employee salaries, and other expenses necessary for ongoing operations. An operational budget serves as a roadmap for management to guide their decision-making and ensure that the business remains financially stable and on track to meet its goals.

An operational budget's components include:

• The sales and collections budget (revenue budget)
• The projected cost of goods sold budget (sales budget)
• The inventory and purchasing budget
• The budget for operating expenses

Operating budgets are generally based on projected quarterly performance. Much of the challenge in formulating a valid operating budget is to learn from historical performance and then factor in the probability of additional costs or market variables.

Preparing an operating budget requires a balancing act of analysing the existing data of your company's sales and expenses and forecasting the numbers for the year ahead. While it is unlikely that your budget forecasting will be completely accurate, having an operating budget helps you figure out where to allocate funds, which departments are over- or under-performing, and how to better budget for the future. By breaking down the elements of profit and expense into digestible sections, you will be able to prepare an operating budget.

There are four (4) benefits of developing and using an operational budget.

• Managing current expenses: Fixed overhead costs, such as office rent and staff salaries, are a starting point for an operating budget. These are not the types of expenses that can be trimmed from your budget unless you can reduce your staff or work hours. If you actively track some of your operating expenses, such as the cost of office supplies, you may find areas of considerable savings that could benefit your total budget and ease some financial strain
• Projecting future expenses: Evaluating actual past expenses can benefit your budget going forward. If you underestimated last year’s or last quarter’s operating expenses, you could write your new operating budget so it more closely aligns with the actual needs of your business. Conversely, if you overestimate past expenses, pare down the line items in your budget that correspond to unnecessary costs. You can apply these overages to other areas that were deficient in your previous budget or increase your projected reserves
• Building reserves: An operating budget should be liberating instead of restricting. It can help you reduce debt as you work toward the goal of building financial reserves. Saving, investing and planning for unforeseen circumstances are solid benefits of a successful operating budget. Sometimes, your income may be unexpectedly reduced, although your operating costs remain the same when contracts fall through or inventory doesn’t move as expected. If you’ve built your budget around being able to keep some cash reserves, your business can more easily endure temporary setbacks
• Accountability: You can rein in your tendency to spend beyond your means if you diligently stick to an operating budget. With a well-written and closely followed operating budget, you can establish financial accountability instead of spending haphazardly and losing sight of your goals. This kind of budget is not meant to be outlined on paper and then filed away in the bottom drawer for future review. Your accountability in keeping the operating budget timely requires your ongoing involvement.

The following 11-minute video explains the difference between fixed and variable expenses, how to manage increased sales and overheads as well as the benefit of categorising expenses. 

Budgetary Control

As per CIMA (Chartered Institute of Management Accountants), budgetary control involves controlling costs by comparing the budget with the actual results and investigating any significant differences between the two. Any differences (variances) are made the responsibility of key individuals who can either exercise control action or revise the original budgets.

Key Principles of Budgetary Control

Note: These principles are often called 'steps of the budgetary control process'.

Click on the following headings to read further about each of the five (5) key principles/steps:

You can read more about budgetary control in this article.

Key Principles of Statistical Analysis

Reliability and validity are essential criteria for evaluating the quality of measurements in research. The process of measuring an individual or item involves assigning scores to represent a specific attribute, generating the data necessary for analysis. To ensure that research results are meaningful, the data must be of high quality. However, not all data meet this standard.

Researchers cannot assume the accuracy of their measurements; they must rigorously assess their quality. This typically involves collecting data using an appropriate instrument and evaluating the reliability and validity of the measurements. Such assessments are generally conducted before the primary research begins.

Reliable and valid data are crucial for drawing meaningful conclusions from a study. Reliability refers to the consistency of the measurements, indicating whether the measurement system produces similar results under the same conditions. Validity, on the other hand, concerns whether the measurements accurately capture the intended attribute.

Reliability

Reliability refers to the consistency of a measurement. High reliability indicates that the measurement system produces similar results under the same conditions. When measuring the same item or person multiple times, comparable values should be obtained, demonstrating reproducibility.

If repeated measurements yield significantly different values, the data are deemed unreliable. Such inconsistency makes it impossible to determine the true value, rendering the data meaningless. This inconsistency hinders the ability to draw valid conclusions and understand relationships.

For instance, a bathroom scale that provides varying results with each use is highly unreliable. Such a scale complicates the determination of accurate weight and the monitoring of weight loss.

Unreliable data can result from inadequate data collection procedures or the use of low-quality or defective tools. Additionally, some characteristics are inherently more challenging to measure reliably. For example, measuring the length of an object is straightforward, whereas assessing psychological constructs such as conscientiousness, depression, and self-esteem is more complex.

When evaluating studies, it is crucial to assess the data collection methodologies and identify any issues that could undermine reliability.

Validity

Validity pertains to whether measurements accurately reflect the constructs they are intended to measure, and it represents a broader issue than reliability. Researchers must consider whether they are measuring the intended attribute or if the measurements reflect an unrelated factor. This evaluation addresses the appropriateness of the data rather than its repeatability.

For tangible measurements such as height and weight, validity is less of a concern. A biased bathroom scale may consistently read too high or too low, yet it still measures weight. However, validity is a more significant concern in the social sciences, where researchers measure complex and elusive concepts such as a positive outlook and self-esteem. When assessing a psychological construct like conscientiousness, it is crucial to ensure that the instrument's questions accurately appraise this attribute rather than another trait, such as obedience.

Financial Administration

Financial policies are the rules that govern the financial activities within an organisation. Well-designed financial policies should align with the overall goals of the business. They should be written with enough clarity to be understood by all individuals throughout the organisation and provide flexibility to operate within such policy. For example, a policy may state that “the organisation will prepare sales, COGS and expense budgets annually".

Financial procedures outline how certain tasks are done and/or policies are adhered to. They can take the form of flow charts, checklists, or written narratives. No matter the form, they should succinctly provide the necessary “how to” information to the individual(s) tasked with carrying out those procedures. Thus, some relevant considerations when developing procedures are identifying who, by role, is involved in the procedure, when the procedure needs to be applied, and how the procedure should be applied. For example, a procedure related to a financial reporting and budgeting policy may state that “By the 1oth day of the following month, the accounting manager reviews the monthly sales budget in preparation for the monthly managers meeting.”

• Financial administration policies and procedures should align with business goals and plans. Thus, if business goals are to expand into a certain area, budgets may be created focusing on the area of growth.
• Financial administration policies and procedures should be flexible to allow for a range of circumstances, as well as changing circumstances.
• Financial administration policies and procedures should be easily interpreted and understood by everyone.
• Financial administration policies and procedures should be written in a step-by-step style so that the order of procedures from beginning to end is followed.
• Financial administration policies and procedures should refer to other associated documents, for example, templates that are to be used for budgets or forecasts.

Other key considerations when developing organisational policies and procedures that relate to operations and finance are:

• Include role authorisations so that it is clear which job roles can authorise financial transactions within the business
• Document purchasing procedures in order to be able to determine when and how equipment and assets need to be purchased.
• Document Debt collection procedures in the event of customers defaulting on payments.
• Include customer credit limit policies so that customers don’t go too far into debt without a payment plan in place or work being stopped.
• Include petty cash procedures so that the upper limit of small business expenses is defined and so that procedures for the use of petty cash are in place.
• Include the use of a business credit card policy so that it is clear who can use a business credit card and for what purposes.

Master Budget

To achieve budget goals, all business divisions must work together. Business decisions are based in part on budgets. Achieving budget targets in one section of the business will depend on meeting other sections' targets. For example:

• Sales Budget – impacts on purchases, production and stock levels.
• Production Budget – meet targets to have the stock to sell.
• Purchases– dependent on the Sales budget, purchase raw materials and/or stock so the production targets can be met.
• Capital Expenditure Budget – need to buy more non-current assets to enable production?
• Expense Budget – keep to targets for costs of sales, production and other operating costs.

A master budget is the central planning tool that a management team uses to direct the activities of an organisation, as well as to judge the performance of its various responsibility centres. Normally it is prepared for a full year and includes operating budgets and budgeted financial statements.

• Direct labour budget
• Direct materials budget
• Manufacturing overhead budget
• Sales budget
• Production budget
• Selling and administrative expense budget

It also includes budgeted financial statements.

Operating Budgets for Service Industries

For a service business, operating budgets consist of the revenue budget and all expense budgets, namely: marketing, administration and financial expenses.

Example:

Surrey Hills Accounting and Bookkeeping Services are preparing revenue and expense budgets for the financial year ending 30 June.

They require the following budgets prepared:

The following 4-minute video explains what an operating expense budget is and how to complete it.

An income statement budget can be prepared based on the revenue and expense budgets.

Operating Budgets for Trading Industries

Trading and manufacturing firms prepare sales budgets, and these budgets can be prepared by product, period, regional area or combination. The sales figures in the ledger account should be shown exclusive of GST and, therefore, GST is not included in the sales budget.

Sales Budget

The sales budget is an important part of the master budget as it sets the basis for all other expenses, such as procurement, staffing, and administration costs. It all starts by figuring out how many units of a product will be sold and the price per unit. This information is used to calculate the total value of sales.

When creating the sales budget, certain factors are taken into consideration, including:

• estimating the demand for the product
• determining the production capacity
• analysing the industry
• evaluating the current supply facility.

The marketing team helps with estimating the market demand, while the production team helps determine the production capacity.

The following is an example of a sales budget prepared by product:
Montgomery Aviation Supplies produces the following clothing and accessories for pilots, e.g. pilot shirts, jackets, sunglasses and watches.
Estimated sales figures for the following year are 5,000 shirts, 4,000 jackets, 3,000 sunglasses, and 2,000 watches.

The sales budget for the following year is as follows:

In the above example, estimated sales were based on previous figures and adjusted according to current market trends.

Sales can also be estimated based on previous figures and a change in market conditions.

Mitchell Evans imports and sells genuine Swiss alarm clocks. Mitchell’s sales for the previous year were 1,060. Due to an increase in the Australian dollar, Mitchell believes he will be able to reduce the price of his products by 5% and estimates his sales will then increase by 15%.

• Total sales for previous year: 1,060 x $260 = $275,600
• Estimated increase in sales: 1,060 x 1.15 =1,219
• Reduced price per item: $260 x .95 = $247

The sales budget for the following year can be prepared as follows:

The following 3-minute video explains what a sales budget is and how to complete it.

COGS Budget

COGS relates to all costs that are directly attributable to the purchasing of goods that are sold. This amount is then deducted from the total sales figure to determine the gross profit for the period. The following formula can be used to calculate the selling price, COGS and mark-up % provided estimates are provided.

Formula: ((Selling Price))/COGS – 1 = mark-up %

Example:
If the selling price and the COGS values are known, the mark-up on cost can be estimated as follows:
Mark-up on cost: $350,000/$200,000 – 1 = 75%

Alternatively, where the mark-up % and selling price are known, the COGS can be calculated as follows:
COGS: $350,000/1.75 = $200,000

If the COGS and mark-up on cost are known, the selling price can be calculated as follows:
Selling Price: $200,000 ×(1+0.75)=$350,000

If sales estimates are given for the following year and the mark-up on COGS is provided, COGS and gross profit can be estimated as follows:

Using this information, Gross Profit can be calculated:

The following video explains what COGS Budget is and how to complete it.

Purchasing Budget

The purchase budget is the estimated value of the purchase expense for the period. The purchase budget will differ from the COGS budget as the purchase of goods may include opening and closing stock.

The COGS is usually presented in the income statement as:
Opening inventory + purchases – closing inventory = COGS

Consider the following example.
Kosta Cameras buys its inventory and marks it up by 70%. The business sold goods to the value of $550,000 in the last financial year. The opening stock was $45,000, and the closing stock was $22,000. What is the cost of purchases for that period?

COGS: $550,000/1.7 = $323,529

The closing inventory amount is less than the opening inventory. Therefore, some of the sales have come from the opening inventory and purchases made throughout the year.

Purchases: Total COGS + Required Closing Inventory - Opening Inventory: ($323,529 + $22,000) - $45,000 = $300,529

Most trading businesses are required to maintain a minimum level of stock on hand to cover expected sales in the next period. The purchases for the month must be sufficient to meet expected sales and to maintain inventory levels for the next period.

The closing stock of one period becomes the opening stock for the following period.

Example:
Kosta Cameras expects to sell 400 cameras in November and 700 in December. The business estimates that 20% of the stock will need to be kept on hand at the end of each month in order to fill sales expected in the next month.

The purchases budget for November is estimated as follows:
Closing inventory on 31 October is 20% of 400 = 80.
Closing inventory on 30 November is 20% of 700 = 140.

The number of cameras to be purchased in November is estimated as follows:

Purchases (Qty) = Total sales quantity + Closing inventory – Opening inventory = 400+140-80 = 460

Break-Even Point Using Sales and Expenses Budget

What is the break-even point?

This is the point where the business's total revenue equals total costs. The business makes neither profit nor loss, meaning the business has 'broken even'. Understanding the break-even point is crucial for deciding selling prices, setting a sales budget, and preparing a business plan.

Determining break-even point

To accurately determine the break-even point, a business must distinguish between variable costs and fixed costs associated with the sale of products or the provision of services.

Variable costs are those costs that change in accordance with changes in activity levels, such as sales or production. Variable costs include cost of sales and commission on sales, If a business intends to sell more units, the costs must increase in direct proportion to the additional units purchased/produced.

For example, if 20 computers are sold in a computer retail business, the business must purchase 20 computers. If 50 computers are to be sold, 50 computers must be purchased.

Fixed costs are business expenses that do not vary with the level of goods sold/produced or services provided. Fixed costs include expenses such as rent, insurance, depreciation, and wages. These costs remain unchanged despite an increase in sales. Although fixed costs can rise, they are not influenced by the number of sales the business generates.

Calculation of break-even point

• Contribution margin: Calculate the contribution margin, which is Sales less Variable Costs. “Contribution” in the contribution margin represents the portion of sales revenue that is not consumed by variable costs and so contributes to the coverage of fixed costs. For example, Mount Bike Pty Ltd sells its bicycles for $280 per bike. The purchase price for each bike is $100. In this case, the contribution margin will be calculated as $280 - $100 = $180.
• Break-even point: Where contribution margin equals the fixed costs. This means there is no profit or loss made. For example, let’s say the Mount Bike Pty Ltd.’s fixed costs (rents, insurance and other operating expenses) totalled $97,740 per annum.

If so, the break-even point will be as follows (How many bikes should the business must sell to break-even?):

Total fixed costs $97,740 = $280 * Quantity - $100 * Quantity

Quantity to sell = $97,740 / ($280-$100) = $97,740/ $180 = 543 bikes (If this calculation results in decimal places, the figure must be rounded up).

You can read more about break-even profit here.

Cash Budgets

A cash budget is a document that sets out the estimated cash receipts and cash payments for a future period. It is used to predict liquidity and as a control tool to ensure an organisation can pay its debts when they fall due.

A reliable flow of cash is essential to the survival of the organisation.

A cash budget will only incorporate those items that involve the actual flow of cash, e.g. receipts and payments. However, it is not restricted to revenue and expense items as it can also include capital items such as the purchase and sale of assets, payment of dividends, drawings, and repayment of loans. Any items that do not involve a flow of cash are excluded, e.g. depreciation, provision for doubtful debts, bad debts, gains or losses on the sale of non-current assets.

The following 3-minute video explains what a cash budget is and how to complete it.

There are four (4) distinct areas of a cash budget:

The closing balance for a previous period becomes the opening balance for the next period. The receipts and payments must be calculated separately, and a worksheet for the cash receipts and cash payments budget is prepared before the actual cash budget.

Credit Sales and Accounts Receivable

When an organisation makes sales on credit, it must identify when the cash will actually be received. A schedule can be prepared for this purpose.

Consider the following example:

Marshall Vacuum Cleaners is preparing its cash inflow budget for the next three months (e.g. January, February, and March). Total sales are estimated at $170,000 (January), $180,000 (February) and $190,000 (March) plus GST.

Cash sales for each month are estimated at 50% of total sales. Credit sales are estimated at 50% of total sales. It is estimated that 50% of credit customers will pay in the following month of the sale, and the remainder will pay in the month after that (e.g. February and March for January sales).

Total credit and cash sales: 170,000 (January), 180,000 (February), 190,000 (March).

From this schedule, a cash receipts budget can be prepared for the quarter.

Cash Payments

When determining a budget for cash payments, many of the cash payment amounts will be fixed costs. Other payments can be determined as a percentage of sales revenue.

Based on our previous example, Marshall Vacuum Cleaners has estimated purchases and payments for the quarter to be as follows:

• The purchase of inventories is estimated to be 25% of sales, e.g., 25% of estimated sales figures for January, February, and March.
• Marketing is estimated as 10% of sales figures.
• Miscellaneous expenses are fixed at $5,000 per month.
• The rent of the premises is fixed at $10,000 per month.
• Salaries are fixed at $10,000 per month (GST-free).
• Sales are estimated at $170,000 (January), $180,000 (February) and $190,000 (March), and the business makes all payments in the month they fall due.

From this schedule, a cash payments budget can be prepared for the quarter.

Integrated Cash Budget

The cash receipts and cash payment budgets can be integrated into one cash budget.

Using the above example, the open cash balance as of 1 January was $35,000. Based on the cash receipts and cash payments budgets, an integrated cash budget can be prepared as follows:

Cash Budgets Using the Accrual Method

In the previous example, a cash budget was prepared using the cash method of accounting for GST. With the accrual method of accounting, GST becomes payable when invoices are issued to customers and not when the cash is received. Using the accrual accounting method, GST is calculated on 10% of sales and purchases made in the current month.

Variance analysis

Variance analysis is the investigation of the difference between actual and planned results.

This level of detailed variance analysis allows management to understand why fluctuations occur in its business and what it can do to change the situation.

Examples of commonly derived variances in variance analysis:

• Purchase price variance
• Material price variance
• Labour rate variance
• Labour efficiency variance
• Material yield variance
• Fixed and variable overhead variance

Reasons why variance analysis may not be a useful tool:

• Steady production is assumed, so variances are only calculated after each month, and so by the time the figures are sent back, it may be too late to do anything about the issues, or the information is irrelevant.
• Variances may not give much information at a gross level. For example, if the labour efficiency variance is 50%, you would still have to drill down further to find out what happened, so it takes a long time to get usable information to management.
• Standards used may be biased, as they are set by those with a vested interest.

Key principles of measures of variance from financial data analysis

• A budget variance refers to the difference between the projected budget or target figure and the actual outcome
• A budget variance is considered favourable when the actual income exceeds the budget estimate or when the actual costs are lower than the budget estimate.
• Conversely, a budget variance is deemed unfavourable when the actual income falls short of the budget estimate or when the actual costs exceed the budget estimate.

Stakeholders can influence management decisions for all types of companies. In public companies, shareholders are a key stakeholder group. Their decisions impact the budget, funding and resource allocation of the business.  Discussions with stakeholders related to the company’s budget status must, therefore, be conducted in a manner that promotes ongoing cooperation.

Who are the stakeholders in a business?

Stakeholders are people who have a vested interest or a stake in the business operation. They work to deliver intended results while ensuring the business stays viable.

Stakeholders are differentiated in terms of their relationship with the business as either internal or external stakeholders.

Stakeholders may also be grouped according to how actively they engage in the business's operations. They can be classed as Market Stakeholders and Non-Market Stakeholders.

Market stakeholders, for example, are employees, customers or suppliers in direct economic exchange with the business.

Conversely, non-market stakeholders are those who do not engage in economic transactions with the business but may have an effect on its actions. Examples of non-market stakeholders include business support groups, communities, activist groups and the media.

Stakeholders emphasise the importance of corporate responsibility over corporate profitability. Stakeholders hold the general belief that an organisation should strive to achieve satisfaction among all parties involved.

In a public company, shareholders are the owners of the business, and stakeholders have a binding fiduciary duty to put shareholders’ value needs first. Directors have a difficult job managing the expectations of shareholders with the demands of stakeholders.

Are all shareholders stakeholders?  Watch the following 1-minute video to answer this question.

Stakeholder management is the process of managing the expectations of anyone who has an interest in a project business or will be affected by its deliverables or outputs.

A collaborative approach, as opposed to a pacifying approach, allows managers to view stakeholders’ relationships as a source of opportunity and competitive advantage. This takes into account elements such as cooperation and mutual opportunities that form the basis of a collaborative relationship.

The following table compares the characteristics of the term ‘stakeholder management' with the term 'stakeholder collaboration'.

In addition to increasing organisational effectiveness and consistency of response, a collaborative approach with higher-level managers allows an organisation to build on synergies when a positive relationship with one stakeholder group (such as a local community) impacts another stakeholder group (such as customers), in beneficial ways.

In working collaboratively with stakeholders, it is important that you discuss and clarify identified budget information with stakeholders. You must do this in a manner consistent with your organisation’s relevant policies and procedures.

Budget Communication Plan

It is important all businesses have a clear budget communication plan. The purpose of the budget communication plan is to make sure that all budget information is communicated clearly and effectively to all responsible budget managers and team leaders. Through the communication of information to this level of the organisation, there will be a natural flow from manager to team leader and from team leader to team members, enabling the information to filter down throughout the entire organisation.

So, it is important that the communication plan has an objective to convey maximum information to the recipient. The ways and means of communicating information to employees also need to be planned.

Stakeholder Engagement and Management

Stakeholder engagement means talking to people who are involved in the budget. Ways you can communicate with stakeholders include:

• Figuring out who your stakeholders are and planning how to talk to them. This is especially important if you have a lot of stakeholders with different needs.
• Email is a good way to communicate with stakeholders. You can send updates and other information that they need. You can also track who opens the emails.
• You can use automatic emails to send regular updates to stakeholders. This can save time and make sure everyone gets the same information.
• You can give presentations online or in person. Online presentations can be shared with stakeholders afterwards.
• Draft Budget Reports are another way to share information. You can customise these reports for each stakeholder.
• Group video calls are a good way to get everyone together quickly. This is especially useful if there's an urgent problem that needs to be addressed.
• Informal communication, like chatting with stakeholders in a casual way, can be effective, too.

Consultation and Negotiation

Consultation and negotiation are focused on finalising the budget for approval and implementation; however, once the final budget has been approved, the requirements for stakeholder involvement and ongoing consultation and negotiation regarding measuring and reporting on performance are still significant.

Example of the consultation process

Consultation: Stage 1 – Draft budget issued

• The first draft of the proposed budget is emailed to all division heads.
• Draft budget circulated to respective managers or team leaders.
• Comments and suggestions are returned via email.

Consultation: Stage 2 – Draft budget discussions

• Meetings to enable focused, face-to-face discussions are held with respective division heads to clarify and negotiate any changes and to determine how these could be incorporated into the overall organisational budget proposal.
• A meeting is held with divisional managers and team leaders to provide information about the successfully agreed changes as well as those changes that could not be accommodated due to misalignment with strategic objectives.

Consultation: Stage 3 – Final budget release

• The final budget document is issued to all relevant personnel within the organisation who have been delegated to manage a budget.