The operating budget is a management tool for controlling the financial aspects of a firm. Although organizations prepare operating budgets annually, they can breakdown the budget preparation into either monthly or quarterly stages. The operating budget contains the revenues and expenses relating to everyday business activities in an organization. The preparation of the operating budget requires an organization to determine all the expected expenses in the budget period and project the income to a level where the organization can cover its expense and retain appreciable profit.
The operating budget helps to discipline a firm’s management by providing a means to enforce accountability and transparency through the comparison of the actual outcomes and projected budget outcomes. The creation of the operating budget influences an organization to plan its expenditures to maintain them within reasonable financial limits. The operating budget forces an organization to examine its costing and pricing policies to ensure sustainable profits.
For example, the operating budget will demonstrate unsustainable operating costs that might predispose an organization to losses or low profits. The organization will have to identify strategies to raise the projected profits without undermining the planned growth in operations and profits (Kubr, 2002).
The operating budget provides a framework that an organization can use to put its operations back on track in case of deviation from the strategic goals. The operating budget helps an organization to identify the required resources and project when the resources will be of use. The strategy is an effective way to eradicate irresponsible use of resources by setting strict guidelines on the organization’s expenditures.
The main elements of the operating budget include sales, manufacturing costs, selling costs and administrative expenses. Sales tax does not constitute part of the budget and the organization accounts for it separately. An organization determines the gross profit by calculating the difference between sales and variable costs (Schick, 2014).
Manufacturing costs mainly relate to specific projects in an organization and include salaries and wages, employees’ benefits, consultation fees, equipments, supplies, contractual costs and traveling costs. A budget item charged as a direct cost must be a necessary cost, accounted consistently in compliance with accounting principles and should not constitute part of the cost of any externally funded program. An organization estimates its direct costs using experiences and present costs.
The estimation of direct costs includes the computation and inclusion of inflation for each year. Facilities and Administration (F&A) costs entail the expenses that do not relate to specific projects. Indirect costs include administrative costs, repair costs, payroll processing, utilities, library services, janitorial services and sponsored research (Hansen & Mowen, 2003). The direct cost items appear first followed by the indirect cost items during budget preparation.
Organizations present the indirect cost items as a percentage of the direct costs because the individual elements of the overhead costs are difficult to relate with specific projects. The representation of the indirect costs may be a percentage of all the direct costs (Total Direct Cost base) or a percentage of the selected direct costs (Modified Direct Cost base).
The construction of the operating budget entails planning and projecting various elements of the budget, which include sales, operating income and cost of sold items. The administrators in charge of constructing a budget must have a comprehensive understanding of the current market rates and establish the link between the operating budget, fiscal budget and capital and expenditure budget. The first step in the construction of the operating budget is the preparation of the sales budget.
The sales budget contains information on the units the administrators intend to sell. The budget relies on sale predictions and facts on the product presented by the administrators (Lanen & Anderson, 2011). The second step in the construction of the operating budget is the computation of the expected income from the sale of the proposed units and the price for an individual unit.
The third step is the determination of the final stock budget based on the dollar-value of the agreed stock of products and materials. The final stock budget, which describes the present assets, is the main ingredient in the preparation of the fiscal report. The construction of the operating budget requires the administrators to create the production budget and direct material budget. The fourth step in the construction of the operating budget is the preparation of the production budget using the information in the sales budget and material budget.
The material budget should reflect the information in the production budget. The fifth step in constructing the operating budget is the preparation of the direct labor budget and production overhead budget. Other budgetary preparations include the creation of the cost of goods budget, income report and administrative expenditure budget. Efficient construction of the operating budget requires administrators to identify the relationship between different budgets to ensure the incorporation of accurate information and computation of all essential requirements.
The budget variance analysis entails the evaluation of the differences between the actual and projected costs and revenue. The variance analysis is an essential tool in the control and regulation of budgeting procedures because it allows an organization to identify the causes of the differences between the actual and estimated values in the budget.
The variance analysis involves analyzing an organization’s revenue and cost of labor and materials to establish discrepancies in the values in the budget and the causes of the discrepancies. A firm facing low revenue can use the variance analysis to determine the variance that relates to low sales or prices (Ettredge et al., 2010). The variance analysis is essential in the management of labor costs in an organization. For example, an organization can use the variance analysis to establish the causes of labor costs exceeding the working hours estimated in the budget. Calculating variance guides organizations in implementing corrective actions to steer operations.
For example, a budget variance analysis showing lower sales compared to the budget estimates demonstrates the need for an organization to adopt measures such as the re-evaluation of its price policies to increase sales. When a variance analysis illustrates unexpectedly high working hours, an organization should implement measures to improve the work planning. Budget variance analysis allows organizations to streamline budget elements to achieve accurate projection and planning.
Conclusion
A change in the planned expenses would require an organization to analyze the fixed and variable expenses and scrutinize each expense in terms of the expected growth. The organization can identify discrepancies between the actual values and the estimations in the budget, which would allow it to take corrective actions to ensure its operations and strategic goals remain intact. The operating budget is an essential tool for any organization that is keen on planning and controlling its operations to optimize productivity and minimize waste.
References
Ettredge, M., Bedard, J., & Johnstone, K. (2010). Empirical Tests of Audit Budget Dynamics. Behavioral Research in Accounting, 80(1), 28-35.
Hansen, D., & Mowen, M. (2003). Cost management: Accounting and control. Mason, Ohio: Thomson/South-Western.
Kubr, M. (2002). Management consulting a guide to the profession. Geneva: International Labour Office.
Lanen, W., & Anderson, S. (2011). Fundamentals of cost accounting. New York: McGraw-Hill Irwin.
Schick, A. (2014). The metamorphoses of performance budgeting. OECD Journal on Budgeting, 1(2), 49-79.