A budget is the financial blueprint or action plan for an organization, division, business unit, or department. It translates strategic plans into measurable expenditures and anticipated returns over a period of time.
Organizations use different types of budgets for different purposes:
- An operating budget reflects day-to-day expenses and depreciation (the current portion of capitalized expenses). It typically covers a one-year period. Department, division, and unit managers are usually asked to develop an operating budget for their part of the business.
- A capital budget shows the planned outlays for investments in plant, equipment, and product development. It typically covers longer periods—3, 5, or 10 years. Managers throughout an organization may be expected to prepare or contribute to this type of budget.
- A cash budget addresses expected cash flows during the given forecast period, based on information from the operating and capital budgets. The company’s finance department typically prepares this. This type of budget is essential for ensuring the company has enough cash and credit (liquidity) to meets its expected cash outlays.
The operating budget captures how an organization plans to carry out its overall strategy day to day.
First, we need to understand that Capital budgeting is not the same as a capital budget. Rather, it’s the process of identifying the potential return on a given investment (ROI) in a capital asset to determine whether the investment makes sense (economically viable) and to compare alternative investment options to maximize value of money spent (investment) per ROI. Thus, capital budgeting is thus a key step in preparing a capital budget.
If many different departments are competing to have proposed investments funded, you may be asked to justify your proposals using capital budgeting techniques.
The four main techniques used are:
- Net Present Value (NPV) represents the current value of future cash flows, that is, it takes inflation into account. It tells you how much cash the investment will generate versus how much must be spent to make the investment, in current and future dollars. In determining NPV, you compute each year’s cash flow separately.
- Internal Rate of Return (IRR) is a percentage that is used to compare a potential investment against the hurdle rate to determine whether it’s worthwhile. The IRR is derived by dividing the estimated profit by the estimated expenditure. An IRR must exceed the hurdle rate in order to justify the investment. The higher the IRR, the more profitable the project.
- Profitability index (PI) represents the relationship between the costs of a potential project and its estimated benefits. To determine the profitability index, divide the current value of future cash flows by the initial investment. If the ratio is less than 1.0, the investment outweighs the expected returns. Conversely, the higher the index value, the more attractive the project.
- Payback period denotes the length of time it will take to recoup an investment or the break-even point (in years) on your chart. A period of 1 means it will take one year. This technique is used less frequently today because (a) it ignores the time value of money; and (b) it is biased toward products or services that generate most of their money on the front end.
Of the four techniques, NPV is most difficult to calculate, but is more accurate and therefore preferred by most companies.
Here is the steps to calculate an NPV:
- Prepare a schedule of estimated cash flows.This schedule identifies the capital outlays you want, the timing of those outlays, and the expected cost savings or revenue that will result from the investment. For substantial investments, consider annual cash flows over a period of several years. If an expense will be capitalized, the full outlay is recorded for the year in which it is incurred. Also record the expected tax savings that will result in subsequent years as capitalized items are depreciated.
- Use appropriate interest rates in your calculation, don’t sugar-coat your interest rate. Because NPV is the current value of future cash flows, you calculate it by dividing each future cash flow by the compounded interest rate and then adding up all of the discounted cash flows. You can create a spreadsheet (for situations in which the cash flows or the interest rates used are different from year to year) or use a financial calculator or app (if the cash flow and interest rate are constant throughout the period).
The NPV formula is:
In this formula, each CF represents a future cash flow, n is the number of years over which the cash flow is expected to occur, and i is the interest rate.
Some companies use the weighted average cost of capital, while others use a rate that reflects the uncertainty of the future cash flows of the project being evaluated. Check with your manager to find out how your company handles this question.
- Evaluate the NPV. A positive NPV indicates that the investment will potentially benefit the company. A negative NPV indicates a losing proposition.
Cost of capital is the cost of the funds used to finance a business. The cost of capital would depends on the method of financing used relative to the company financial standing. Most companies use a combination of debt (such as short-term notes or long-term bonds) and equity to finance their businesses. Such companies often derive their overall cost of capital from a weighted average of all capital sources. This is called the weighted average cost of capital (WACC), because each type of capital (common stock, preferred stock, bonds, other long-term debt) is weighted according to its proportion in the company’s capital structure. WACC is determined by the external market, not the company.
The WACC represents a “hurdle rate,” or minimum acceptable return rate, that the company would have to earn before the investment generates value. So it is extensively used in the capital budgeting process to determine whether the company should proceed with an investment.
The cost of capital sources varies from company to company. It depends on various factors such as a company’s
- Operating history
- Credit history
Newer enterprises with limited operating histories tend to have higher costs of capital than established companies with a solid track record. That’s because lenders and investors consider newer businesses to be a greater risk, and demand a higher return in compensation.
A capital budget shows a group’s or organization’s planned investments in capital assets (the spent budget then known as CAPEX, Capital expense). Organizations generally acquire capital assets to help generate profit or, if they are a nonprofit, to achieve their mission.
Examples of capital assets include:
- Furniture and fixtures
Capital assets are usually not liquid; that is, they can’t quickly be turned into cash. Organizations liquidate them only as a last resort; for instance, if a business is engaged in bankruptcy proceedings.
Depending on the type of business, capital assets may represent the bulk of a company’s owned assets. Equipment-heavy businesses, such as those involved in oil exploration or construction, are good examples of companies with large investments in capital assets.
Selling, general, and administrative (SG&A) costs are additional costs beyond those cost which directly associated with producing a product or service.
SG&A can include costs related to:
- Research and development
- Product design
- Customer service
- Administrative processes
To estimate SG&A costs, some companies consider how much they can afford: for example, “How much are we willing or able to spend on marketing, R&D, and so forth?” and also taking into account on current government tax policy on these spending to make sure whether the money budgeted shall be pre-tax money of post-tax money.
SG&A is also where companies tend to make spending cuts during tough economic times. A business might cut SG&A in the first or second quarter of the forthcoming budget period; for instance, by outsourcing marketing work or reducing the number of television advertisements it airs. It may then make up the cuts in a later quarter if business revives.
SG&A costs can vary depending on a company’s growth stage. For a startup, spending on marketing is more of a priority than it is for a mature well known company.
Still, there are some recognizable patterns that can help you estimate SG&A. For example, R&D as a percentage of SG&A cost tends to vary less than marketing or advertising expenditures do. That’s because R&D work is often done over a long time horizon and remains a stable percentage of a company’s sales. By contrast, decisions about how much to spend on marketing and advertising tend to change more quickly in response to changes in market opportunities and availability of technology such as social media. For example, cost per quality lead in Facebook ads are reported to be so much lower than traditional marketing media such as television and newspaper.
The cost of goods sold (COGS) is an expense calculated by companies that make tangible products they must hold in inventory, such as manufacturers.
- Other direct product costs
- Manufacturing overhead
A COGS estimate is based on the units of product (or hours of service) needed to maintain inventory for that period, so you must determine expected volume of sales as well as any planned changes in inventory. If inventories are depleted at the beginning of the budget period, the company will need to produce more to bring inventories up to normal levels. That will increase total direct production costs. Conversely, excess inventory will be sold during the period, reducing forecasted production costs.
In estimating COGS, also be aware of break points in production capacity that signal the need for additional outlays.
Typically, service-based companies don’t need to forecast COGS. However, like hotels and airlines, sell gifts or packaged snack foods, which they must inventory. Their COGS is the wholesale price of goods they resell.
Typically, cost can be divide into fixed and variable cost as well as cost overhead.
Fixed costs remain fairly constant in your business operation, regardless of production or sales volumes during the budget period.
Some examples of fixed cost usually include:
- Basic utilities (including electric and telephone service)
- Equipment leases
- Asset Depreciation
- Interest payments
- Administrative costs
- Marketing and advertising
- Indirect labor, such as salaried supervisory employees
Variable costs change in direct proportion to shifts in production or sales volumes during the budget period.
Some examples variable costs include:
- Raw materials
- Direct labor
- Energy (electricity, gas) used in manufacturing or production
- Sales commissions
- Income taxes
- Export taxes
- Duty payble
These estimates of the variable costs that will be incurred during the budget period depend on your group’s or organization’s plans. By understanding those plans, you can anticipate the need for resources (such as expanded capacity) and include them in your budget requests as well as fallback planning in the event of sudden cost increment which severely impact revenue and profit, since in our globalization era, a whole business model can be rendered obsolete in one night.
Corporate overhead costs
Operating budgets may include corporate overhead costs – costs associated with operating the organization that aren’t tied to individual products or departments. This figure typically includes the rent for the offices occupied by corporate headquarters, and salaries and expenses associated with corporate management.
How these costs are attributed to individual departments varies from one company to another. Some organizations may allocate overhead only to certain departmental budgets such as those that generate revenue.
A business budget functions as financial blueprint or action plan that a group or organization creates to ensure it has enough resources to achieve its desired goals. The budget also helps ensure that achieving those goals generates the desired benefits.
Therefore, a group or organization uses a budget to:
- Put all of its financial components into one coherent picture that shows its strategic and operational goals along with its financial health
- Align individual teams, departments, and business units behind the organization’s goals (for example, a company would budget more for sales and marketing teams charged with expanding the customer base in their region)
- Allocate resources wisely
- Communicate financial expectations
- Communicate goals to external stakeholders. Many companies declare their strategic and operational goals publicly to capital markets and then put those goals in their budgets
- Take corrective action when actual business results don’t match the budgeted target results; this might mean allocating more money to boost an effort or cutting funds if an activity or initiative is no longer worth pursuing.
- Make sure that they budget actually represent the organization goals, for example, in order to develop competent employees, sufficient budget shall be allocation for staff training and development.
A budget estimates expected revenues and expenses for a given future period while a financial forecast projects an actual outcome, such as quarterly revenues, based on historical data or projected analysis.
While organizations assess their budget on a regular basis, typically, once a year (or over a organization pre-set period) they revise forecasts when a change occurs in operations, inventory, or the business plan. This is to keep them ahead and monitor their progress and way forward accordingly.
Think of the budget as a plan for taking the business where it wants to go, and a forecast as a reflection of where the business is actually going.
These are the tools to steer your ship (organization) in the right way (forecast) with the optimum amount of fuel (budget).
A budget is a document that translates a group’s or organization’s strategic and operational plans into the expected resources required and returns anticipated over a certain period.
There are many types of budgets.