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Budgeting - Preparing the Operating Budget for a Small Business

What you Should Include in the Operating Budget

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The operating budget is one of the two parts of the master budget. The purpose of the operating budget is to describe the income-generating activities of the firm such as sales, production, and finished goods inventory. The ultimate conclusion of the operating budget is the pro forma income statement and the operating profit margin. The operating profit margin is not the same as net profit, which you cannot calculate until you prepare the financial budget. The operating budget is prepared before the financial budget since many of the financing activities aren't known until the operating budget is prepared.

In developing a sample operating budget, I'm going to use a small pottery business, ArtCraft Pottery, located in Zanesville, OH, as my example. They produce reproductions of the famous art pottery produced in the Ohio area in the early 1900s.

The operating budget consists of a budgeted or forecasted income statement which is supported by a number of schedules:

1. Sales Budget

Most business owners and managers use what is called a "bottom-up" sales forecasting technique. In other words, they solicit sales figures from the sales people out in the field as they figure they have the most knowledge of what sales will be in future time periods. These sales figures are then put together to form an aggregate sales forecast.

If the company has a brick and mortar shop, forecasted sale from that shop must also be included as must forecasted online sales if the company has an online presence.

Other factors that go into the sales forecast include the general state of the economy, pricing policies, advertising, competition and other factors. In our example, the pottery store may have suffered during the Great Recession because art pottery at that time would have been considered a luxury. Since unemployment is high after the Great Recession and the recovery is slow, it may still be considered a luxury and sales may be forecasted as slow.

The sales budget may be slightly different from the sales forecast after it is adjusted according to the desires of management.

2. Production Budget

Directly after developing the sales budget, the next task in developing the operating budget is to put together the production budget. The production budget tells the business owner how many units of the product to produce to meet sales needs and ending inventory requirements. In our example, the owner of the pottery shop must know how many pieces and what type of pottery to make during the budgeting time period.

There are three parts to the production budget: direct materials purchases budget, direct labor budget, and overhead budget. Each is required to produce the production budget.

3. Direct Materials Purchases Budget

The direct material purchases budget deals with the raw material that the firm needs for its production process. It states the amount and cost of each type of raw material needed by the firm, but a separate direct materials purchases budget must be prepared for each type of raw material. The firm's inventory policy helps determine the amount of raw materials kept in inventory.

The direct materials purchases budget in the example is for the clay needed for the pots only. You can follow the example and prepare a similar budget for the color needed for the pots.

4. Direct Labor Budget

The budgeted hours for direct labor are determined by the relationship between labor and output. The number of units of direct labor are determined in the production budget. Then, the total number of direct labor hours and the per unit cost are determined.

5. Overhead Budget

The overhead budget is everything left over from production that isn't included in the direct materials purchases and direct labor budgets. Usually, the direct labor budget drives the overhead budget. The costs that vary with direct labor are called variable overhead and everything else is fixed overhead.

6. Ending Finished Goods Inventory Budget

The ending finished goods inventory budget is important because it gives the company the information it needs to calculate the per unit cost of its product. This per unit cost is calculated from the information gathered from the direct materials purchases budget, direct labor budget, and overhead budget.

This budget also supplies data for the balance sheet and to calculate the cost of goods sold on the income statement.

7. Cost of Goods Sold Budget

If you have the beginning finished goods inventory (which would be the ending finished goods inventory from the previous time period), then you can prepare the cost of goods sold budget using the information from the direct material purchases budget, direct labor budget, and overhead budget.

8. Selling and Administrative Expenses Budget

The nonmanufacturing part of the forecasted budget is selling and administrative expenses. These expenses have fixed and variable cost components. For example, sales commissions are based on sales volume and are variable. Utilities may be fixed.

9. Budgeted Income Statement

When you complete these eight budgets, you have the information you need to develop the budgeted or forecasted income statement. The result of the budgeted income statement is the operating income of the firm, not net profit. You are not able to find net profit until after you finish the financial budget.

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