Question

The budget is classified broadly into two categories, operational and financial. Discuss the major steps in preparing these two categories of budgets.

Answer 1

What Is an Operating Budget?

An operating budget is a combination of known expenses, expected future costs, and forecasted income over the course of a year. Operating budgets are completed in advance of the accounting period, which is why they require estimated expenses and revenues.

Steps in Preparing an Operating Budget

Preparing an operating budget requires a balancing act of analyzing the existing data of your company's sales and expenses, and forecasting the numbers for the year ahead. While it is unlikely that your budget forecasting will be completely accurate, having an operating budget helps you figure out where to allocate funds, which departments are over- or under-performing, and how to better budget for the future. By breaking down the elements of profit and expense into digestible sections you will be able to prepare an operating budget.

Sales

A majority of your operating budget number-crunching will revolve around expenses, but once those are collected they will be compared to your total sales. You can break up your sales results by a quarter or by month, whichever works best for you. You can use a simple spreadsheet file to keep track and total your findings. Analyze your previous year to predict your sales for the next. Pay special attention to events that make your numbers vary. For instance, if you have a season that is more profitable than other seasons, then you can assume that there will be a similar percentage increase in sales next year at the same time. If you have a new product debuting that will have an expected jump in sales, reflect the expected percentage increase in that future month on your spreadsheet.

Cost of Goods

Use a similar prediction method to forecast what your goods will cost for future quarters or months. Account for expected fluctuations in sales, as that will affect your purchases for your goods. Once you have your totals for the expected cost of goods, subtract that total from the expected sales. Your sales total minus your cost of goods total is your gross margin. Now that you have this number you can use it against totals of all your other costs to predict your operating income.

Other Costs

Depending upon the size of your company, you will have any number of other operating costs to estimate. Some examples include payroll for employees, insurance for employees, overhead costs for maintaining a physical shop or warehouse, travel fees, and research and development costs. Record your previous expenses in the categories relevant to your business and use those numbers to predict the expenses over the course of the next year. Subtract that total from your gross margin to determine your operating income.

Taxes

Now that you have estimated your operating income, you can estimate your annual taxes. When you subtract your predicted taxes from your likely operating income you will discover your business's net income, the final step in the preparation of your operating budget. As you progress over the next fiscal year, compare your profits and expenses to those you predicted in your operating budget. If you did not use as much money as you expected in certain areas, move that money to other areas. If you are showing losses, you may need to consider layoffs or cutbacks on fringe benefits to compensate better next year.

WHAT IS FINANCIAL BUDGET?

A financial budget is predicting the incomes and expenses of the business on long-term and short-term basis. Right projections of the cash flow help the business to achieve its targets in the right way.

FINANCIAL BUDGET PLAN

The financial budget plan comprises of following steps:

• Calculate the expected inflow
• Calculate the expected outflow
• Set the targets
• Divide the expenses into different categories
• Keep the track of components in budget
• Set up the ledger

STEPS IN THE FINANCIAL BUDGETING PROCESS

Budgeting is a detailed process with several intricate steps leading up to understanding it at large. A step-by-step guide to the budgeting process is given as below.

1. Update budget assumptions

Budgets are always prepared on certain assumptions. Those assumptions could be related to the sales trends, cost trends or environmental conditions. Before embarking on preparing the budget, these assumptions must be thoroughly reviewed according to the recent environmental conditions.

2. Note Available funding

Limited funding can greatly hinder the growth projects of the business. Therefore, in the preparation of budgets adequate attention has to be given to the available funding as the availability of investable funds will determine the initiation of viable projects.

3. Step costing points

The business environment is subject to dynamism. Every day it is posed with challenges that can completely change its cost structure. Therefore, in the budgeting process certain factors that can affect the costing for the business should be closely considered. These factors should be identified beforehand in order to make the budget realistic.

4. Create budget package

In budget package, previous standards related to the budgeting process are taken in order to formulate a budget for the current period. Previous standards are updated according to the recent environmental conditions. Budget package is a kind of outline according to which budget has to be prepared.

5. Obtain revenue forecast

There is no denying the fact that sales budget is the most crucial budget of all. All the budgets are based on the sales budget. Furthermore, sales budget determines whether the business is generating enough revenue necessary for its survival. Therefore, adequate attention must be given to the preparation of sales budget by forecasting demand accurately.

6. Obtain department budgets

The department budgets will help to reach a budgeted expenditure for the budgeted period. Each department will prepare its own budget and then all of them will be combined to become a part of the master budget.

7. Validate compensation

Compensation plans are a significant component of the budgeting process. As compensation is subject to an annual increase, therefore, it should be prepared with great care. The approval for compensation increase should first be taken from the top management, and then it should be augmented in the budgeted compensation plans.

8. Validate bonus plans

In order to maintain the morale of the employees, bonuses are frequently given to out motivated workers. Bonuses act as an appraisal method. Bonus announcements that are not considered in the budgeting process can create havoc in the profits of the business. Therefore, any bonus plans should be taken into consideration beforehand. The top management should be consulted for any bonus plans.

9. Obtain capital budget requests

Capital expenditure ensures expansion of the business. It helps the business to avail the opportunities necessary for business growth. Any capital expenditure plans should be taken in advance, and they should be included in the budgeting process accordingly.

10. Update the budget model

Any changes in the assumptions of the budget model should be updated, and final budget should be prepared accordingly. A delay in this may lead to glitches later on that could cause confusion.

11. Review the budget

The budget should be reviewed thoroughly once it is prepared in order to correct any flaws. A little decimal placed wrongly can create quite an unbalance in the budget sheet.

12. Obtain approval

The budget should be presented to the top management. They will evaluate whether it has been prepared according to their requirements and finally l approve it if it does not need any changes.

13. Issue the budget

The budget should be formally issued after its approval. All the operations there and then will take place according to it.

IMPORTANCE OF BUDGETS

Budgets Set Targets

Budgets serve as a great tool for controlling and monitoring. They provide a coherent guideline according to which the business operations should be run. The budgets set targets for costs and revenues, targets that can then be achieved through a variety of ways.

Strategy Requires Funding

Budgets help to formulate the capital expenditure plans of the business. The available funding is always the first thing that is sought for in budget preparation. The available funding determines the kind of capital expenditure plans that a business can opt for. Furthermore, by knowing this in advance the business can decide upon the strategies that it can follow. Thus, budgeting greatly facilitates the formulation of strategies by outlining the available funding in advance.

Budgets Communicate Priorities

Budgets are a great way to communicate priorities. The allocation of budget to different divisions of the business says a lot about the priorities of the business. For example, if the business allocates huge amount of funding to sales department, it means that the business is laying strong emphasis on the sales and distribution of the project. While if a large amount of funding is given to research and development division, and then it implies that business wants to focus on the development of new products and excel in the market accordingly.

Control Spending

By accurately outlining the expenditures, the budgeting process helps to control the spending. Without a budget, a business will never be able to keep track of its expenditures and can ultimately face considerable loss. However, a budget provides them with vivid expectations through which they can always predict which way the business is headed.

Eliminate Turf Wars

By prioritizing the spending beforehand, the budgets help to eliminate the turf wars while deciding what projects to invest in. This helps particularly when Business divisions indulge in strong opinions about the allocation of funds. Otherwise, these arguments can distort the working environment to a great extent. Instead of working in collaboration, the business divisions start to work in opposite directions, which will ultimately harm the accomplishment of business goals.

Provides a Profit Margin

The budgeting process helps to form the pro forma financial statements. By developing these forecasted financial statements, a business can track its profit margins. This will determine whether it is profitable to run the business operations in future. If the business is not generating profit, the business will have sufficient time to adjust its revenue and costs beforehand. Profit generation is the most important factor due to which a business is running. Without generating profit, a business cannot hope to survive for long in the future.

Therefore, budget may seem like an added hassle but is an essential and core aspect of a business. It is through setting oneself a budget that the profit, income and savings can be categorically understood, saved and planned ahead. With a thorough and target based budget, each business becomes better equipped to analyze where the money comes from and also keep the record of where it goes. Creating a budget helps reduce the risk of unexpected losses because statistics can aid a business by predicting upcoming trends. Above all, it essentially allows them to be able to come up with newer schemes and strategies to induce a larger profit for the future. By properly and diligently following steps to understanding the set goals, individuals can learn how to work efficiently along the passage of time. It also helps them gain experience in their spending and allows them the margin to know what is saved and what overspent. Thus, it can be concluded that a budget is a highly useful tool when a business struggles with spending too much and receiving too little.