Businesses need to be able to forecast the future to appropriately allocate resources. Four separate areas need to be budgeted for accurate measurements.
Budgets are an important part of strategy for a company. A business needs accounting to know where it has been, but forecasting is necessary to know the direction it is going.
The beginning step in budgeting should be related to volume. Every business needs to have some idea how much in the way of goods or services they expect to sell.
A manufacturer needs to know how many widgets they expect to produce, and in the same way, a hotel has to have some idea how many room nights they will sell.
Expenses and revenues will both follow from the expected volume, so every attempt should be made to have an accurate volume budget. It is not enough to simply take last year’s amount.
That may be an effective starting point, but consideration needs to be made on things that have changed. Is there a new competitor that will take away business, or can this company expand to new markets?
The second component is the revenue budget. Volume helps determine the amount of revenue available, but another component is what price can be charged and received for each items.
In the case of the hotel, the room nights may be budgeted at 3,000, but what price will they fetch? Will each night be the same, or vary based on the day of the week, or holiday periods?
Once the revenue is derived, the next step is to calculate the projected expenses. Expenses cannot be allowed to exceed the amount necessary to achieve the expected profit.
If expenses are greater than the revenue generated, many companies inflate the revenue expected, rather than make the hard choices to reduce expenses. This can be short sighted, since revenue is often out of a company’s control, but expenses generally can be achieved, though it may be painful.
The three items above make up the operating budget. There is a separate category of capital expenses, that is, items that have a useful life of greater than one year.
Capital items are usually budgeted separately, mainly because they are higher cost. The funds available are not commingled, but sometimes capital purchases are curtailed due to operating budget shortfalls.
Operating budgets are usually annual, but capital budgets are often prepared for multiple years and adjusted each year has necessary. A good capital budget is an important part of a proper long-range plan.