The finance leader's guide to operating budgets
Understanding, creating, and managing effective operating budgets
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1 minute
September 11, 2024
Isabel Peña Alfaro is a guest contributor. The views expressed are theirs and do not necessarily reflect the views of Rho.
The word “budget” often gets a bad rap, but it deserves a second chance. A budget is an extremely useful tool to guide financial decisions.
An operating budget, in particular, helps to ensure that business resources are allocated efficiently. It provides a structured financial plan that guides ongoing operations, helping finance leaders make informed decisions about spending and staying on top of key objectives.
In this guide, we’ll dive into the components of an operating budget and how to create one.
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An operating budget estimates the income and expenses of a business or organization for a specific period of time, usually one year. With an operating budget, you can monitor the financial performance and allocate resources efficiently. It also helps as a base to evaluate the actual results with the expected results and make adjustments if needed.
An operating budget is used in various ways, and these depend on the needs and objectives of the business.
Common uses are:
There are various types of budgets, and each has its utility and downsides. Let’s go over them.
A static budget is based on an unchanging or fixed level of activity or output.
Utility: Useful for planning and controlling fixed costs, such as rent, salaries, and depreciation.
Downsides: It does not reflect the changes in variable costs, such as materials, labor, and utilities, that depend on the activity level or output. Therefore, a static budget may not be accurate or realistic for evaluating a business or an organization's performance.
A flexible budget adjusts to the actual activity or output level during the budget period. It shows how the budgeted revenues and expenditures would change if the activity level or output changes.
Utility: Useful for measuring and comparing the actual performance of a business or an organization with the budgeted performance. It also helps to identify the sources of variances and take corrective actions.
Downsides: May be more complex and time-consuming to prepare and update than a static budget.
A zero-based budget starts from zero (hence the name) and requires every expense to be justified and approved for each budget period. It does not rely on the previous budget or historical data.
Utility: Useful for eliminating wasteful or unnecessary spending, improving efficiency, and aligning the budget with the strategic goals and priorities.
Downsides: May be more difficult and costly to implement and maintain than a traditional budget. It may also create conflicts and resistance among the budget managers and the staff.
An incremental budget is based on the previous budget or historical data and only adjusts for the changes or increments expected to occur in the current budget period. It does not question the existing expenses or the assumptions.
Utility: Useful for maintaining stability and continuity, saving time and resources, and avoiding conflicts and disruptions.
Downsides: May discourage innovation and improvement.
A performance budget links the budgeted expenses to the expected results or outcomes. It shows how the money is spent and what is achieved with the spending.
Utility: Useful for enhancing transparency and accountability, improving decision-making and resource allocation, and evaluating the effectiveness and efficiency of the programs and activities.
Downsides: Attributing and measuring results to specific programs or activities can be subjective.
Revenue, also known as sales or income, is the amount of money that a business earns.
These are the expenses that change in proportion to the business activity. They’re also called unit-level costs, as they vary with the number of units produced. For example, for a bakery, the variable costs would be flour, sugar, eggs that could vary based on the volume produced.
Fixed costs are the expenses that a business has to pay regardless of its level of production or sales. These costs include rent, insurance payments, etc.
Non-cash expenses are reported on the income statement but do not involve cash payments. These include the cost of a fixed asset that depreciates over time.
Non-operating expenses are the costs that a business incurs outside of its core operations. These expenses are not related to the production or sale of the business's goods or services, but rather to the administration, financing, or legal aspects of the business.
We’ll go into more detail below. Excluding capital costs from an operating budget helps to maintain clarity and focus on the financial management of ongoing business operations. Capital budgets handle the planning and financial implications of long-term investments.
In contrast to an operating budget that handles day-to-day expenses, a capital budget covers the long-term investments of a business, such as machinery, equipment, vehicles, buildings, real estate, and technology. The time and scope of operating and capital budgets differ significantly.
An operating budget typically covers a short-term period, usually one fiscal year. A capital budget, on the other hand, encompasses multiple years.
Operating budgets primarily deal with operating assets required for the business's day-to-day functioning and are used to generate revenue from core business activities.
Capital budgets focus on capital assets, which are long-term assets that provide future economic benefits extending beyond one year. These assets can be tangible, such as equipment, or intangible, such as patents and trademarks.
Operating budgets cover recurring purchases necessary to run a business day to day. These purchases are typically smaller, regular expenses (e.g., utilities, rent, office supplies, salaries, and routine maintenance costs) that are essential for maintaining operations .
Capital budgets concern major purchases that involve significant investment in long-term assets. These purchases are typically one-time or infrequent and include property, plant, equipment, and technology infrastructure.
Creating or calculating an operating budget involves four main steps: forecasting revenue, estimating expenses, calculating net income, and reviewing and adjusting the budget.
Let’s assume a food startup is planning ahead and projects $100,000 in revenue for the year.
For fixed costs, it expects to spend $20,000 on rent, $15,000 on utilities, and $30,000 on salaries.
Variable costs might include $10,000 for raw materials and $5,000 for marketing, adjusting these figures based on expected sales volume and operational needs.
This is a very simplified table. From here, you would create an excel spreadsheet and add more detail to anticipated costs and then compare back with the actual costs and expenses. You can do this regularly throughout the year to check on progress and at the end of the year as well.
An operating budget primarily focuses on expenses, detailing the anticipated costs necessary to run the day-to-day operations of a business over a specific period, typically one fiscal year. It may also include revenue projections to ensure expenses align with expected income, but its primary purpose is to manage and control operational spending.
An annual operating budget typically includes revenue, variable costs, fixed costs, non-cash expenses, and non-operating expenses, such as interest payments.
An operating budget includes projected revenue, which details how much money a company expects to earn, and anticipated expenses, which cover variable costs (e.g., materials and labor) and fixed costs (such as rent and utilities). It also accounts for non-cash expenses like depreciation, and non-operating expenses such as interest payments.
An operating budget does not include capital expenses, which are costs associated with acquiring or upgrading long-term assets like buildings or machinery. It also excludes amortization payments (e.g., mortgage) and other financing costs, as these are considered non-operating expenses. Additionally, costs related to structural changes or improvements that extend beyond daily operations are typically not part of an operating budget.
No, an operating budget is not the same as planning expenses, although they are closely related. An operating budget encompasses projected revenues and expenses, serving as a comprehensive financial plan for managing a company's day-to-day operations over a specific period.
Planning expenses is a crucial part of creating an operating budget, the budget provides a broader framework that includes income projections and financial performance metrics.
Yes, a nonprofit’s annual operating budget differs from corporate ones, mainly in its focus and structure. Nonprofit budgets emphasize categorizing revenue by sources such as donations, grants, and fundraising and expenses by program, administrative, and fundraising costs, reflecting their mission-driven nature. On the other hand, corporate budgets typically focus on maximizing profit and efficiency, with revenue generated from sales and services being the centerpiece of financial planning.
An operating budget is a financial plan that outlines a company's expected revenues and expenses over a specific period, typically a year. It is a crucial tool for managing day-to-day operations and ensuring financial stability.
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Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.