Businesses of all sizes use operating budgets to decide where and when to allocate funds, make sure all expenses are covered, and keep things running smoothly. You cannot efficiently run a business without one. Here's an introduction to operating budgets and tips to help you create your own.
Before you begin, remember that all things change. Your operating budget process will always be a work in progress because economic conditions, competition, and technology can alter your revenue and expenses. Use this article as a guideline to create your first operating budget, but schedule reviews and continue financial planning and analysis to keep it up-to-date.
What is an operating budget?
An operating budget is the blueprint for how your company is going to spend its money over a given period of time. There are multiple factors that go into creating one, including revenue, fixed costs, and variable costs.
An operating budget is different from a capital budget in the sense that it is used to plan finances for daily operations and recurring expenses, while a capital budget helps businesses plan long term spending. The objective is to always make sure that cash outflows don’t exceed cash inflows. In other words, don’t spend money that you don’t have. To accomplish that, companies need to evaluate incoming revenue and expenses.
Smaller operating budgets can lead to higher profitability, but limited budgets might create inefficiencies in your company. This is the balance that entrepreneurs and small business owners look for when measuring their operating expenses for the current fiscal year, or when planning their operating costs and budget for the next year. Keep this in mind as we walk you through the steps of how to create an operating budget for your company.
Key components of an operating budget
The first step in creating an operating budget is to document your revenue, costs, and expenses. It is important to track business expenses so you can have accurate numbers, so double-check your figures after you get them. Most business owners or finance teams start out using an Excel spreadsheet so they can calculate sums and percentages.
Don’t use projected revenue at this stage. It’s inadvisable because emotions can distort your perception of what the company is capable of. List actual revenue from your financial statements and don’t worry if your initial operating expenses are higher than what your company is pulling in for sales revenues. Most businesses start out by “burning” a certain amount of cash each month until they reach the point of profitability.
Variable costs include items like direct materials, piece rate and direct labor, production supplies, sales commissions, and monthly fees on credit cards. You’ll want to list the actual costs when you create your operating budget so you can calculate percentages on variable costs later. As you start to do revenue projections, it’s important to know how variable costs will change.
Fixed costs are expenses that don’t change each month. Included in this category are rents, salaries, insurance, equipment rentals, car leases, utilities, and phone bills. Profitability is achieved when fixed costs and variable costs are a small percentage of incoming revenue. Knowing what those fixed costs add up to is a key step to achieving that.
Challenges of creating an operating budget
It sounds simple on paper, but there are some underlying challenges that you need to be aware of when creating an operating budget. Getting the correct numbers and then managing expenses going forward are two of the most common areas of concern. When looking into tools for real-time expense tracking, be sure to look for one's that give you up-to-the minute insights and information, so that you're always in the know about your budget.
Poor visibility into company spend
If this is your first attempt at creating an operating budget, you will most likely run into this. How is your company spending money and where is that spending documented? Many new and small businesses don’t have real-time expense management, so they need to go back into the company records to see costs and expenses. Unfortunately, very often those records are incomplete.
Line items in company accounting or credit card statements need supporting documentation (i.e., receipts, invoices) so they can be properly allocated in your operating budget. When the reason for those expenses is a mystery because of incomplete documentation, it creates a dilemma for budgeting. How and why did you spend that money?
Implementing expense tracking
An operating budget is useless if you don’t have checks and balances in place to make sure it’s properly implemented. Part of that is implementing a system for expense tracking. Incorporate this into the budget creation process and you’ll save yourself some extra steps down the road.
How to create an operating budget
At this stage, you should have actual revenue and cost information. As your company grows, you’ll need an operating budget that is able to sustain it. That requires some industry research and revenue projections. Be conservative. It’s better to underestimate revenue than to overestimate it, that’s how you avoid losses and protect your operating income. Check out our page on zero based budgeting for more budgeting ideas.
1. Analyze the impact of industry & economic trends
What is the state of your industry right now? Manufacturing and distribution can be affected at any time by random events, like materials shortages across the globe. Are there industry or economic trends that could affect sales volume, the cost of raw materials, and revenue for your company? Look at this objectively because the next steps are dependent upon the research you do here.
2. Forecast revenue based on past sales trends
This is difficult if you’re a startup because you don’t have a history of sales from previous years to evaluate. If that’s your story, look at sales numbers for your competitors. Their financials will be available online if they’re public companies. If your company has been operating for a while, use your own numbers (such as income statements). Are sales numbers rising? Do they fluctuate seasonally?
3. Forecast prices for relevant goods or services
Prices are going up and will likely continue to rise at least in the near term. Price all your goods and services at their present level and then apply a multiplier to them based on the current rate of inflation. You’ll be doing this now for your costs, but you should also keep it in mind when you set prices on your company’s products and services. Remember, it’s OK to raise your prices if the situation calls for it.
4. Project expenses for each department
Breaking costs down (such as administrative expenses or capital expenditures) by department is one of the most effective ways to handle expense management for small businesses. Each department should have its own operating budget and a person responsible for managing that budget. This creates accountability within that department and gives you a more macro approach to the full company operating budget.
5. Calculate the total necessary budget for operations
Add it all up and you’ll have your total operating budget. Double-check the numbers, be prepared to make changes as economic conditions evolve, and schedule regular budget reviews to make sure you stay on track. Of course, you’ll need more than a simple spreadsheet to do all that. In the last section, we’ll go through solutions for managing your monthly and annual operating budget.
Manage expenses and simplify the creation of operating budgets with Ramp
One of your primary objectives as a business owner is to create a financial culture that is transparent. To do that, you want software that properly documents expenses and expenditures in real-time, produces financial reporting documents on demand, and simplifies the spending process for you and your employees. Ramp does all those things, making it an effective tool for creating an operating budget, managing cash flow, and reducing operational costs.
To learn more about creating an operating budget, expense management, and spend controls, visit Ramp.com.
The term operating budget is defined in our Ramp Finance Glossary.