Defining a Budget

A business shouldn’t open its doors without having some idea of what to expect, and it shouldn’t close its doors without knowing what happened. A business should also plan and prepare for its future. One way to do this is to budget, to plan ahead for future income and expenses.

Budgets provide the baseline against which to measure actual performance. The actual performance of an organization is documented by the accounting system and the reports it generates. Supervisors should compare expected performance against actual performance. With this information, supervisors with budget responsibilities act as physicians to assess the current financial health of their organization. They should look for areas where they have done well and areas that need attention.

Budget Responsibilities

If the latest report from the accounting office says sales are too low compared to budget, the sales manager has to figure out why. If overtime costs are running too high, the production manager has to figure out why. And if there are too many rejects on the shop floor, it may be up to the quality control officer to figure out why.

Why should we bother with budgets in this age of change? Sometimes, you go through all that work and then senior managers make changes that knock your whole budget for a loop. However, even though planning is difficult, we must plan in order to maintain focus and prevent wasting resources. A budget is an educated guess that reflects your long-term plans. Planning is the key characteristic of budgeting.

Key Budgeting Points

The Budget Committee

  • Should one department be responsible for the budget?
  • Should the budget be handed down from the executives?
  • Should the budget for one department interact with another (e.g. sales and production)?

The Budget Period

  • How small should a budget period be?
  • Should it coincide with the fiscal period?
  • Should a long range budget be in place? How accurate are they?

Types of Budgets

As companies grow, their budgeting process understandably becomes more complex. No matter how big it gets, however, you can prepare a budget for almost any singular aspect of the operation.

Sales Budget

Your sales budget incorporates the estimated number of products or services that you will sell in an upcoming period. Total revenues are estimated by simply calculated by multiplying the number of units by the price per unit.

The sales budget is normally the starting position for the budgeting season. The sales budget normally grows from a reconciliation of business forecasts, capacity estimates, proposed selling expenses (advertising, sales salaries, etc.) and the quantity of sales estimated for the period.

The sales budget drives a very important part of the expense budget: the Merchandise Purchases Budget. This budget would be used in a company that manufactures, builds, or further processes materials for future sale. This will also spill over into inventory level budgets, which assists in warehouse capacity planning, plant usage, and labor.

Expense Budget

Expense budgets include things like office equipment, stationary, travel, and refreshments for meetings.

Sales expense budgets should be derived almost directly from the sales budget. Overhead and general costs associated with the sales process can normally be estimated as a derivative of the sales volume in a variable budget.

General and administrative expenses usually are the responsibility of the office manager(s) who should base a budget on past history, with a forecast component that takes into account staff levels, inflation, new technology that may reduce or increase expenses, and other management policies (such as bonuses and raises).

Production Budget

The production budget is prepared after the sales budget, since this process takes the sales budget and estimated quantities to be sold and then calculates the cost of staffing, construction or manufacturing materials, and other expenses required to create the products. Often, production budgets are based solely on a per unit cost basis. So if production was to be 10,000 units and the budget was estimated at $1,000,000 in expenses, there would be a unit cost budget of $100/unit.

Manufacturing Budget

A manufacturing budget should include the cost of raw materials, direct labor, and manufacturing overheads. Many manufacturing firms prepare three sub-budgets that account for the three items mentioned: raw materials, direct labor, and manufacturing overhead.

Labor Budget

The labor budget includes the names and numbers of all positions within the company, and includes the salary, benefits, replacement, vacation, and pension contributions budgeted for each position. Some of the company’s labor costs may not be captured here, such as direct sales or direct manufacturing costs.

Overall this is a large budget component because for most companies, labor is a large part of the overall expenses.

Capital Budget

This is the manager’s plan to acquire fixed assets such as furniture, computers, and office space, to support the operations of a business. The capital expenditure budget lists equipment that will be scrapped within the budget period as well as replacement costs and acquisition prospects.

Plant capacity planning will play a role here. If the existing facilities are insufficient to handle forecasted capacity then new equipment and/or a plant may need to be acquired.

Cash Budget

Another budget that is normally performed once all of the other budgets are gathered and assembled is the cash budget. This is very important to highlight the flow of cash throughout the year to pinpoint when cash requirements may exceed existing cash resources.

If you find that you will be short on cash at a particular time, work can be performed now to plan for it. Excess cash forecasts can also be a problem: no one wants excess cash sitting unused if it could be invested and yield a greater return.

Understanding Where Your Budget Fits In

Your budget should flow down from your company’s plan, like this: