What is an Operating Budget? Definition, Components, Advantages, And Limitations

Introduction

There is no doubt to the fact that budgets tend to be increasingly important in order to ensure that businesses continue to operate efficiently and effectively. It helps them to maintain their productivity and eventually their profitability over the course of time.

There are numerous types of budgets that are used by companies over the course of time. Operating Budgets tend to be one of the most used types of budgets, because of their ability to help organizations achieve the respective targets, and ensure better performance over the course of time.

Definition

Operating Budgets are drawn in order to showcase the company’s projected revenue, as well as associated expenses for the given period.

It is mostly presented in form of an income statement, and it lists down all the expected revenue and expenses over the fiscal year of the company.

Components of Operating Budgets

Operating Budgets have components similar to that of a typical income statement. These components are presented below:

  • Revenue: Operating Budgets are supposed to include an estimate about the sales revenue that the company is expected to generate over the period of time. This is a highly important aspect of the operating budget because of the reason that it helps the company to predict the amount it is going to earn in the form of sales, and the respective cash generation that is going to be made possible as a result of the revenue generated.
  • Purchases: Based on the Sales Revenue that is generated over the course of time, purchase budgets are subsequently drawn in order to plan the procurement budget for the respective year. In this regard, it is rudimentary to align purchases with the expected sales, so that organizations can have a clear-cut idea regarding what they need to produce, and the inventory levels they are going to maintain over the course of time.
  • Variable Costing: In the case of a manufacturing concern, it can be seen that it is also necessary to ensure that all the other associated variable costs, in addition to the basic manufacturing costs, are includes in the costing. This might include costs for Direct Labor, Direct Materials, as well as Direct Overheads. It is useful to plan ahead for these expenses so that it can be used as a vital decision-making tool for the company. 
  • Fixed Costs: Fixed Costs, or Overheads are also important because it is overhead management that tends to have the most significant impact on the profitability of the company.  Therefore, an estimation of these fixed costs tends to benefit the company by ensuring that they are able to plan their expenses well in advance. If they need to procure additional financing for fixed, operating budgets will give them an idea to do so.
  • Non-Cash Expenses: Non-Cash expenses include depreciation, and amortization are also included in the analysis for the operating budget. These are essential because of the reason that non-cash expenses do not impact cash, and hence, they are supposed to be used in order to get an idea about the cash that would be required to pay for other operational expenses over the course of time.
See also  Zero Based Vs. Activity-based budgeting

Advantages of Operating Budgets

Operating Budgets can be regarded as a very useful tool for all companies, regardless of their size or stature. Particularly, for Small and Medium Enterprises, Operating Budgets tend to be really useful, essentially because of the fact that it helps them to plan out their expenses and create strategies that are centered on the scenario illustrated by the operating budget.

For example, using the information presented by the operating budget, they can decide on the resources that they require in terms of funding their operations for the coming year.

It also helps in performance evaluations over the course of time, essentially because of the reason that it helps companies to understand if their required KPIs were duly met, as stated in the budget.

It can then be used for future strategic purposes, where companies can use their past budgets and performance to come up with strategies to improve their operations over the course of time.

Limitations of Operating Budgets

Just like a lot of other budgets, it can be seen that Operating Budgets don’t always tend to be very accurate. This is because of the reason that targets are not always met by the company.

Therefore, these budgets need to be set with proper strategy, otherwise, they might backfire in terms of demotivating the employees if targets or budgets are not met over the course of the fiscal year.

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