Basic Operational Budgeting Concepts in Financial Analysis
I. Objectives:
  • Know the difference between operating budgets and capital budgets

  • Know the components of, and how to create, an Operating Budget and its Sub-Budgets

  • Know the primary Budgets that comprise the Master Budget

  • Basic operational planning concepts

II. Operating Budget

Operational budgets are not the same as capital budgets. Capital budgets estimate the capital needed to complete a project, such as acquiring real estate or new equipment, or repairs that are unanticipated or extraordinary. Operating budgets provide reasonably good estimates concerning the volume and sources associated with:

  • the types and amounts of future expenses necessary to continue daily business, project, operations, such as equipment expenditures and salaries, and
  • future income generated by those operations and/or projects

Accounting procedures are typically used to identify, quantify, evaluate, and report a firm's financial information. These may include:

  • budgeting

  • financial statements, and

  • operation plans and forecasts

Of all of these, the most important tool is the budget. Budgets are used to strategically plan future business goals, as well as the financing that will be needed to achieve them.

  • Operating budgets facilitate planning of anticipated income and expenses for a specified budget period.

  • Operating budgets take into account seasonal differences.

  • Operating budgets encompasses the largest segment of the budgeting process.

  • Operating budgets are generally created on an annual basis to minimize time spent creating and managing capital resources.

A. Constructing and Using Budgets

The annual budget is a short-term budget based on estimated income and expenses. It is generally defined according to budget classification code (typical for government operations), functional and sub-functional categories, and cost accounts. The Annual Budget report provides:

  • estimated total values of resources necessary for optimum operation performance (including reimbursable work / services), and

  • estimated workload (total work units identified by cost accounts)


Many corporate, and most organization accounting departments, have some form of budget classification coding system, which generally determines the way the budget is recorded, presented, and reported. Budget classification code systems are widely used within government organizations in particular.

Effective systems classify revenues and expenditures according to administrative, economic, and functional classifications. Administrative and economic classification (codes) and their revenues/expenditures are distinct and independent of each other.

The budget classification is a decision-making, as well as an accountability, tool. It classifies expenditures and revenues, which are important for

  • overall performance analysis
  • efficient and uniform resource allocation, and
  • daily budget administration

The primary elements of a budget classification system are intended to show:

1. a comprehensive overview of all operations for a given period (a consolidated report of all operations)

2. overview and breakdown of individual department, divisions, sector, etc. operations' revenues and expenditures (ensuring efficient allocation of resources), and

3. consistency between components of the budget (ensuring current expenditures and past investment maintenance are included in the budget)


The operating budget discloses all of the firm's operational costs. This includes:

  • materials costs

  • labor costs

  • equipment and machinery costs

  • transportation and storage costs

  • utilities, and

  • administration, salaries, and supervision

Continued optimal operation and production depends on knowing the product's, item's, or service's cost. The operating budget focuses daily activity revenues and expenses, such as:

  • Sales (of the product or service)

  • Production (of the product or service), and

  • Support (general office and management)

Activities outside the daily operation routine must be planned for accordingly. However, they are not included in the operation budget.


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Operational budgets are typically created during the start-up phase of the business. As the business grows, which is usually fairly quickly in the first months, the operational budget may be expanded.

The Operational Budget should not be adjusted in the first months of the business, even though there may not be sustainable income while products or services are being manufactured, constructed, or offered, and expenditures and expenses for materials and equipment show a negative balance on the books. As income increases, the budget will balance, and eventually it will need to be expanded to include the additional income.

The Operating Budget is composed of a number of smaller budgets:

  • Sales Budget - the expected product sales and the anticipated selling price per unit (during the budget period).

  • Production Budget - the required number of units that must be produced to meet the expected sales.

  • Direct Materials Budget - the materials required to meet production expectations.

  • Direct Labor Budget - the labor required to meet production expectations.

  • Manufacturing Overhead Budget – production facility expenses (during the budget period).

  • General and Administrative Budget – expenses required to run the corporate office (during the budget period).

  • Cash Budget - cash receipts and cash disbursements (during the budget period). Also determines the firm's cash flows (during the budget period).


The all-inclusive Operational Budget begins with the Sales Budget. And many other budgets are based on the Sales Budget's data. The Sales Budget includes the projected quantity of units to be sold, or service(s) to be offered, and the asking price per unit.

Sales budgets are prepared quarterly with a comprehensive annual sales report. Monthly sales budgets are often prepared to track sales and compare them to expected sales projections.

SALES BUDGET = Expected Sales in Units x $ Sales Price


The Production Budget must be prepared before the Direct Materials Budget, Direct Labor Budget, and Manufacturing Overhead Budget can be completed.

The Production Budget indicates the total quantity of widgets (units) that must be produced. To effectively budget for annual production, the budget preparer must know:

1. the projected quantity of units that must be sold

2. the end-of-period level of inventory, and

3. the quantity of widgets (if any) in the inventory at the beginning of the year

The same information is required for quarterly budgets.

PRODUCTION BUDGET (NEEDS) = Budgeted Sales + Desired End Inventory In Units or Dollars


The Direct Materials Budget determines the (unit) quantity of raw materials anticipated for purchase to be used in product production. The quantity used is based on the number of units to be produced, taken from the Production Budget. The required level of end-of-period raw materials inventory, and the beginning inventory quantity of units, are also figures taken from the Production Budget.

The budgeted amount needed for the purchase of raw materials is quantitatively determined by multiplying the quantity of units to be purchased by the cost per unit.

DIRECT MATERIALS = Units of Raw Materials x Cost Per Unit

All budgeted raw material components used in production operations should be determined by repeating the above process.


The Direct Labor Budget shows the total direct labor hours calculated using the cost of the direct labor (number of units produced multiplied by how many hours spent to produce them), multiplied by the cost per labor hour.

TOTAL DIRECT LABOR = (Units x Direct Labor Hours) x Cost Per Labor Hour


The Manufacturing Overhead Budget indicates the expected fixed and variable overhead costs for the budget reporting period. Fixed and variable costs are separated.

Costs should be analyzed according to cost behavior. A predetermined overhead rate is typically applied. All overhead costs involving cash disbursements are paid in the quarter incurred.

Depreciation is a non-cash charge and, if included in manufacturing overhead, should be deducted from the total when computing expected cash payments.


The Selling Expenses Budget includes the variable and fixed selling expenses for the budget reporting period. Fixed and variable costs are separated. The variable expenses are typically based on sales dollars, such as those for sales commissions and delivery expense. Fixed selling expenses include sales salaries.


The General and Administrative Expenses Budget indicates the expected fixed and variable overhead costs for the budget reporting period. Fixed and variable costs are separated for the general and administrative areas of the firm. Salaries, rent expense, and office supplies are examples of fixed expenses.


Individual operating budgets are created for each operation by the assigned department/division manager. A budget coordinator provides actual expense reports for the current period, as well as for the prior period. The manager creates the new budget by combining most recent activity data with the historical data from the previous period. The budget coordinator collects all operating reports from all departments/divisions and combines them into a final comprehensive Operating Budget.

The following is a basic process for creating a comprehensive Operations Budget:

1. Expenditures - Identify expenses for the current period. Examine all expenditures for all business operations. Rent, storage, transportation, marketing, and administrative costs should be reviewed and included. Include any funds that were allocated and spent to keep the business in operation in the expenditures total.

2. Inventory Turnover - Identify production for the current period. Determine how many units are produced and sold during the current period. The units produced, minus those sold, indicates inventory turnover. Inventory turnover is important for trend analysis.

3. Value of Goods/Services – The value of goods or services expressed in cost per unit measure may be calculated by dividing expenses by production.

$ Expenses


4. Gross Income – This is the calculated revenue from the units sold, before expenses.

5. Profit Margin – The profit margin may be used to forecast future profits, when the calculated profit margin is positive. It is an indication to reduce expenses or increase costs, if the calculated profit margin is negative.

PROFIT MARGIN = Revenue Per Unit – Cost Per Unit

6. Analysis - The Operating Budget gives an overview of the performance of each operation sector during the period to which the budget report applies. Any variance between actual performance and operating budget must be explained and adjusted or accommodated, as necessary.

B. Earnings and Operating Income

The Operations Budget should clearly define the firm's earnings and income.

LARGER FIRMS' earnings and income include income from selling products and services, as well as from investors and shareholders.

SMALL BUSINESS' or INDEPENDENT CONTRACTORS' earnings and income may be generated exclusively from products or services sold.


Operating earnings measure profitability. It does not include non-operating expenses (interest and taxes).


Operating income is "Earnings Before Interest and Taxes (EBIT)". It is the realized profit from operations after deducting operating expenses (cost of goods sold (COGS), depreciation, amortization, and wages). EBIT is described as revenues minus expenses.

Operating income may be found by calculating the gross income, and

Gross Income = Revenue – Variable Costs

subtracting fixed cost operating expenses, depreciation, and amortization.

Operating Income = Gross Income – Operating Expenses – (Depreciation + Amortization)

C. Operating Expenses

Operating expense is a key component of a firm's operating income, which is an indicator of a firm's profitability.

Elements that affect operating expenses include:

  • pricing strategy

  • cost of goods sold (COGS)

  • cost of materials

  • labor costs, and

  • economic flexibility and proficiency of the firm's management

A business will invariably incur production expenses. This is especially true for a business that manufactures or directly produces a product or service. The Operating Budget is particularly beneficial in showing, and limiting, how much is allocated to certain production operations. Budgets monitor expense accounts to ensure that capital is appropriately used or invested and not wasted on non-essential items. It also helps ensure the firm does not excessively pay for economic resources used in the business. Often this results in procuring new vendors or suppliers to reduce cash outgo.

D. Operational Planning

Budgets are used to develop plans for future growth and expansion. Operational planning uses the Operation Budget to strategically map particular goals and objectives with the intent of increased profit. An operational plan is routinely used to justify operating budget requests. A typical strategic operational plan is a Five-Year Plan. This would normally require "five operational plans funded by five operating budgets."

Operational planning involves establishing milestones and conditions for goal achievement. The strategic plan must include details on

  • how the plan will be implemented

  • what plan components will be put into operation, and

  • when the plan components will be put into operation

Commercial applications of the strategic plan may be activated during a pre-determined operational period, typically within the fiscal year. Expenses may be mitigated accordingly. For example, if too much has been spent on production in relation to sales, the strategic plan may require different products that can be produced for less and sold for more, be made, to cover production fees.

Although budgets can assist in providing a financial road map for future business operations, many budget variances do not appear as negatives. Reserve accounts may be created so capital that has been saved on regular business expenditures may be deposited for designated new business opportunities. Budgeting for the future ensures capital is available when opportunities appear, and quick decisions for expanding operations must be made. The reserve account also serves as an operations safeguard during slow economic periods.