Operating Budget: Components and a Worked Example

An operating budget is the plan for the income statement: the revenue you expect, the direct costs of earning it and the expenses of running the business, by month or quarter for the year ahead. It is the budget managers use most often, because it translates strategy into numbers they are responsible for. This guide lists the components of an operating budget and walks through a complete quarterly example with the arithmetic shown. It is one piece of the full plan described in budgeting and forecasting and fits into the larger structure in the master budget.

Components of an operating budget

The operating budget does not by itself show cash. It works on an accrual basis (when revenue is earned and costs incurred). A cash budget is built on top of it. See what is a business budget.

A worked example

A hypothetical consumer products company budgets annual revenue of $4,700,000. Amounts below are in thousands of dollars.

Step 1: Revenue by quarter

Step 2: Cost of goods sold

Cost of goods sold is planned at 62 percent of revenue, based on standard unit costs and a supplier price list.

Step 3: Operating expenses

• Sales and marketing is budgeted at 12 percent of revenue.
• General and administrative costs are $150,000 a quarter (payroll, rent, finance and insurance).
• Other operating costs (software, travel, professional fees) are $45,000 a quarter.

Step 4: Operating profit

Check: 1,786 - 1,344 = 442, and 442 / 4,700 = 9.4 percent.

What the example shows

• Fixed costs create operating leverage. Revenue rises from $1,000,000 in Q1 to $1,350,000 in Q4, up 35 percent, while operating profit rises from $65,000 to $156,000, up 140 percent, because G&A and other costs do not scale with sales.
• The gap between the strongest and weakest quarters is large, so cash needs may vary even when the annual profit is healthy.
• Q1 earns a thin margin of 6.5 percent. A 10 percent revenue miss in Q1 ($100,000) would reduce gross profit by $38,000 and, since fixed costs hold, cut operating profit by roughly $26,000 after the $12,000 saving in variable selling costs, down to about $39,000.

Check the last point: a 10 percent miss means revenue of 900. Cost of goods sold at 62 percent is 558, so gross profit is 342. Sales and marketing at 12 percent is 108. Fixed costs are 150 + 45 = 195. Operating profit = 342 - 108 - 195 = 39. The budgeted figure was 65, so the shortfall is 26.

Sales budget by product

A sales budget is more useful when it is built by product line, with units and prices visible. Suppose the company sells two products.

This ties to the $4,700,000 used above. With units and prices in the budget, variance analysis can separate volume, price and mix effects later. See price-volume-mix analysis.

Production or purchasing budget

For a company that holds inventory, the sales budget leads to a plan for what to make or buy.

Units to produce or buy = Budgeted sales + Target ending inventory - Beginning inventory

Suppose Product A has budgeted sales of 30,000 units, a target ending inventory of 4,000 units and a beginning inventory of 3,000 units. Units to produce or buy = 30,000 + 4,000 - 3,000 = 31,000 units. If the standard cost is $62 per unit, the production or purchase budget for the year is 31,000 × $62 = $1,922,000. Note that this differs from the cost of goods sold for the year (30,000 × $62 = $1,860,000) by the $62,000 increase in inventory (1,000 units × $62), which is cash tied up in stock.

This is where the operating budget meets the demand plan: the target inventory should come from forecast accuracy, lead times and service goals, not from a guess. See demand planning and inventory optimization.

Building it in practice

1. Start with the sales plan, with owners from sales and marketing.
2. Set production or purchasing to meet sales and target inventory. This ties the operating budget to the demand plan. See demand planning and inventory optimization.
3. Cost the plan using current supplier prices and standard costs.
4. Collect department expense budgets from managers.
5. Consolidate and review against targets for margin and profit.
6. Iterate: if the result falls short of goals, adjust assumptions with evidence, not wishful thinking.
7. Approve and lock.

Presenting the operating budget

A good operating budget report shows monthly or quarterly columns, the full year, last year's actuals for context, percentage of revenue for each line, and notes on major assumptions. Keep the first page to one table.

Common mistakes

• Budgeting revenue without linking it to production or purchasing.
• Setting expenses as a flat percent of revenue when they are fixed.
• Ignoring the timing of big expenses like annual insurance or trade shows.
• Giving departments no say in their own lines.
• Using the operating budget as a cash plan.

Related guides

For the difference between this budget and the one for long-lived assets, see capital budget vs. operating budget. For how the operating budget fits with the cash, capital and balance sheet plans, see the master budget. The unit-level view of margins behind the 62 percent cost assumption is covered in unit economics.

FAQs

What is an operating budget?

A plan for revenue and expenses over a period, usually a year, showing expected operating profit.

What is included in an operating budget?

Sales, cost of goods sold, selling, general and administrative expenses, and any other operating costs, sometimes with interest and taxes.

What is the difference between an operating budget and a cash budget?

The operating budget is on an accrual basis. The cash budget shows when money moves in and out.

Who prepares the operating budget?

Finance coordinates, but department managers supply their own assumptions and estimates.

How often is it revised?

It is typically fixed for the year, with forecasts used to update expectations.