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Steps for preparing an operating budget

  1. Review prior period's data.
  2. Unless you are starting a new business or developing a new product (in which case there would be no data to review), you need to consider the actual results from the period just ended. The most recent past is a strong indicator of future progress.

    The more information you have about past events, the more effective your budgeted projections will be. For example, if to project future growth you only look at the income—which increased by, say, 10%—you won't know whether the increase was due to an increase in sales or a decrease in costs. But if you discover that the income was the result of an increase in sales and a decrease in the cost of materials, you will be better prepared to make reasonable assumptions about revenue growth and cost of goods sold for the following period's budget.

  3. Develop reasonable assumptions.
  4. After reviewing the data, you develop assumptions about the future. What do you assume sales growth will be for your products or services? On what basis? Will demand increase? Will economic or demographic or cultural factors affect your sales? What do you expect to have to pay your employees? Is there a tight labor market? Do you need to retain or employ more skilled workers? Or are you planning to downsize? Do you expect a labor strike during the next period? Questions concerning your expectations about the income and expenditures of the business need to be answered to the best of your ability.

    How do you develop your assumptions? Use the data from the past as well as all appropriate sources for information about the future. Read trade journals; subscribe to economic forecasting services. For sales assumptions, for example, talk with those closest to the scene—members of the sales force. For cost of materials, check with the people who do the purchasing in your organization. Consider your competitors' activities as well.

  5. Determine expected revenues. Here's where you put the equation together: Data + Assumptions = Projection
  6. Use the data you've examined and the assumptions you've developed to establish projections. You may want to establish a stretch budget that will be difficult, but not impossible, to achieve. Or you may want a less challenging but more attainable revenue target. Most important, though, is that your projections are reasonable—within the constraints of production capacity or a limited sales force on the one hand, and customer demand or changing economic conditions on the other.

    Expected revenues include not only the number of products you expect to sell, but also at what price you will sell. If you plan to increase the price, do you expect your customers to continue to buy at the higher price or resist the price increase?

    Note: If you manage a division or a product line and are given income targets by upper management, you may have to start at the bottom of the budgeted income statement and work your way up. In general, though, it's better to begin at the top—with sales and revenues.

  7. Calculate the expected cost of goods sold. Once you have determined the expected sales volume, you can calculate the cost of goods sold.
  8. When calculating the cost of goods sold, be sure to include all the costs, both direct and indirect. For example, using past data and assumptions about changes for each element, calculate costs such as the following:

    • cost of materials
    • labor costs
    • machine setups
    • machine run times
    • packaging costs
    • storage costs
    • cost of machinery
    • cost of production space

    Note: If you are selling a product your company manufactures, then you need to take into account beginning inventory.

  9. Calculate other expected costs.
  10. Calculate expected operating income.

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