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Operating Budgets, Explained

What is an operating budget, and why does every business need one?

Every business, whether it's as big as Coca-Cola or as small as the local store, has to be aware of their financial details.

Imagine you run a business selling shoes. You decide you don't want the hassle of creating the shoes yourself, so you buy some pairs wholesale. Perhaps you aren't the most artistically gifted individual, so you hire a friend to design and make the shoes look pretty.

You now sell these shoes online, charging the same price you see on some other stores. You are content with the money coming in from sales, but you decide to run Instagram ads to boost the number of people visiting your website. Now you have enough money to pay your designer. Do you know how much profit you have?

An instrumental mechanism of every business is tracking the flow of money into and out of their business. They do this using many things, but the day to day calculations are done through an operating budget, which is what we will talk about today.

What is an Operating Budget?

Essentially, an operating budget outlines what money is needed to enable your business to run during a particular time period. It is a projection of what you expect your business will make in revenue and incur in costs, in an attempt to project the money available at the end of the time period.

What does an operating budget consist of?

The main elements of an operating budget would be the revenues generation per period of time (e.g. per month) and the expenses paid in that same time period. However, let us break down the finer details of what this may contain.

Revenue

This is the price per product multiplied by the volume of products sold. For the shoe selling business, this would be the number of shoes sold multiplied by the price of each pair.

Variable Costs

Variable costs are the costs that are dependant on revenue; they change based on the number of products sold. If you were to sell 50 shoes, you may have to buy 10 boxes of paint, which may cost up to $30 USD in total. However, if you are now selling 100 shoes, you may now need to buy 10 more boxes, for a combined variable cost of $60 USD. Variable costs often include things such as:

  • Cost of goods sold
  • Sales commissions

Fixed Costs

As one might guess, these are the opposite of variable costs; these are costs that your business must pay even if you do not produce or sell even one product. Examples of such costs are things like:

  • Rent
  • Insurance
  • Fixed employee salaries

Non-operating expenses

These are all the expenses that are incurred from business activities that are not part of the core operations. Some examples include paying interest on loans, as well as costs incurred in currency exchange.

Why should your business have an operating budget?

Tracking existing expenses

Operating budgets allow you to "follow the paper trail" of all the money coming in and leaving the business in a given time period. This allows a business to see the pattern in revenue and expenses. Crucially, this lets you to easily notice any deviations and begin identifying any problems that need to be fixed, saving you time and potential losses.

Planning

The importance of business planning can never be underestimated. If the business can track their monthly expenses, it then has the opportunity to allocate cash beforehand to pay out those expenses.

This ensures that staff and costs are paid regularly on time, and reduces the chances of a crisis when money does not flow in.

Furthermore, businesses can also plan for periods of reduced sales. For example, you may not expect your shoe business to sell well in the winter, unless you sell boots. By adjusting your expected revenue and variable costs, you can now see your upcoming expenses and make arrangements (such as overdrafts) to then cover them and ensure your business has suitable cash flow in the future.

Investor confidence

Who does not have faith in a well laid out plan? Showing potential or current investors your operating budgets and how well you have kept to them shows your ability to spend money wisely in future. This allows them to make a more informed choice, and may increase their perceptions of your business' future.

Operating Budgets with Causal

What do they look like?

Causal allows you to create simple models such as operating budgets, and visualise that data with ease. To show you an example, I built a dummy operating budget using test data.

Why should I use causal?

You might be asking yourself what the difference is between using causal and the traditional applications like spreadsheets for making your budgets. After all, your team, like most teams, are likely accustomed to working with spreadsheets. Below are just some of the many benefits of building models with Causal.

Speed

I think one of the biggest, if not the biggest things I noticed was how fast I could get things done. Once I had all my data set, it only took me about 15 minutes to build the above table (And it is only my first time using causal). Creating the same table using any other spreadsheet software would have taken me time that many of us just may not have.

One reason to explain the speed of using causal is how percentages work.

Figure 2 shows the formula I had to input in order to calculate the estimated growth rate of the volume of products sold.

All you have to type in your range, for example, “5 to 10%” and Causal will automatically convert that into a distribution chart and find a middle ground to work with. This makes it really easy to use estimate projections when calculating future expenses and revenue.

This also works for other formulas. Figure 3 below shows an example of the formula I used to calculate revenue by multiplying the volume of products sold with the price per unit. All I had to do was label the variable, then in the cell next to it type “Volume”, which would cause a drop-down list to show with all the fields that contain the word “volume”.

Once you click the field you want, you can change the time period of the field to either calculate using the current value in the field or the previous value in the same field.

In fact, even the table that I had made in Figure 1, barely took me 2 minutes. This is because Causal allows you to directly drag variables and will automatically generate tables based on them. This saves a ridiculous amount of time in formatting and creating the table itself, and then having to input and calculate the values.

What is more impressive, is that any edits in the original cells will be instantly reflected on your tables.

Comparisons and Scenarios

Figure 3 shows a chart generated through Causal, once again with a simple drag and drop. This makes visualising data incredibly simple and therefore enabling you to make informed decisions.

Furthermore, causal also allows you to add more variables to compare the data on the chart, and even shows periods of uncertainty intervals.

Suppose you do not like your projected numbers or something is about to happen which will shift your costs. Rather than creating a whole new table, or messing with your current table, Causal allows you to create scenarios.

This allows you to manipulate one or more variables and compare the changes in its impact between the scenario and the original figures. Figure 5 shows an example if a business decides to charge $300 instead of $100.

Note: For the sake of simplicity, only the impact of price change on income is noted here. Calculations on the impact on volume of sales is not included.

The most obvious thing to note is that the chart on the right of Figure 5 shows two different line diagrams, thereby showing the growth in net income if products are priced at $100 as opposed to $300. This makes it very easy to visualise how much a business could gain or lose from a particular decision.

One important thing to notice is that Causal highlights the other fields that have been impacted as a result of a change in price, namely the sales revenue and net income fields. This also saves a lot of time in adjusting for changes in your budget and makes it easy to visualise. You may also create numerous scenarios and filter which ones you want to see at a given time.

Conclusion

These are just some of the benefits of using Causal to do your financial modelling.

The speed, accuracy and UI make it easy to create charts and budgets. Being able to speedily create tables and charts make planning and tracking your cost data incredibly simple.

Lastly, the ability to generate scenarios and visualise their impact is perfect to show investors and other stakeholders to really show that you are keeping all avenues in mind.