Determining your business’s actual operating expenses is essential when dealing with the industry’s dynamic nature. Although some costs might be obvious, it’s crucial to understand various cost categories to understand your finances fully. Creating an operational budget can help your business break down and understand the different cost categories.
An operational budget can provide your business with a breakdown of the true cost of your operating expenses. This article looks at the importance of an operational budget and how to use one to estimate your operating expenses.
The Importance of Creating A Budget
Creating a budget allows you to monitor operating expenses, plan for anticipated operational costs and changes and helps keep track of your spending. Without a budget, keeping track of your company’s performance may be impossible, resulting in overspending.
The budget you create is a spending plan for your business. This helps you identify cost categories, like direct and indirect costs, which enables you to keep track of how much you paying for business gas, rent, and insurance. A budget can allocate costs for various departments and analyse expenses related to labour costs, marketing and expenses, and costs related to transportation, supply management, and maintenance.
Creating a well-structured budget acts as a financial roadmap for your business. It should also be flexible and adaptable, allowing you to take proactive measures to prevent financial risks should your company face market disruption.
How To Calculate Costs Using an Operating Budget
Your company’s projected income and expenses over a specific period are outlined in an operation budget. All expenses related to maintaining and running your business are detailed in the operating budget. This covers the price of labour, supplies, and utilities, to name a few. While it sounds like an uphill task, building an operating budget to calculate your operational costs is relatively easy.
Identify Your Monthly Expenses
Carefully track your monthly expenses to fully understand the company’s financial health. Rent, utilities, and other necessary expenses are just a few cost categories that should be carefully evaluated during this process. Leasing costs for commercial or operational spaces are included in rent, the most significant fixed cost.
Your company can accurately determine its monthly rent commitment by carefully reviewing lease agreements and contracts. In the meantime, the operational infrastructure includes things like electricity, water, and internet contracts.
It is essential to carefully account for administrative expenses like office supplies, insurance premiums, and maintenance fees. Track invoices and receipts to determine the monthly amount needed for administrative processes.
Once you have identified the monthly expenses that keep your business operating, write down the total expenses.
How To Determine Inventory Costs
Your inventory turnover provides insight into how much inventory or products your business has sold and replaced during a specific period. To calculate your inventory turnover, determine how many units are produced and sold.
The formula is pretty simple to calculate:
- Inventory Turnover = cost of goods sold ÷ average inventory
- If the cost of goods sold is £500,000 and you typically have an inventory of £100,000, then your inventory turnover would be 5. This can easily be calculated by dividing the cost of goods by the inventory (£500,000 ÷ £100,000 = 5).
During this period, the inventory was turned over five times. Write down the number of units produced and sold.
Calculating the Cost Per Unit Measurement
The cost per unit refers to how much your company spends to produce one unit of a product. For example, let’s say you own a bakery and want to better understand the costs associated with every cake baked and sold at your bakery. In that case, you want to determine the cost per unit for every cake it produces.
Let’s say your bakery’s expenses (including the ingredients, staff wages, and electricity and gas utility costs) are £2,000 during a specific period, and the amount of cakes you produced during the same period is 200. To calculate the cost per measurement, divide the total expenses by the units produced.
- Cost per unit = Total expenses / Number of units produced
- £2000 / 200 equals £10 per cake
The bakery’s cost per unit for cakes is £10, meaning each cake costs your bakery £10 to produce. Your company can benefit from using this unit cost calculation when pricing products. This makes it easier for you to know the actual cost of production and ensures that the selling price will provide a reasonable and generous profit to cover all direct and indirect costs.
To determine the revenue, look at the number of units sold that you’ve written down earlier. Calculate how much money your business made from sales before deducting any costs. This will be the gross income for a unit.
Continuing with the bakery example, let’s say your bakery sells its cake for £20 each. The first step is to determine the number of cakes sold. In this case, your bakery sold 200 cakes. To calculate total revenue, multiply the selling price per unit (the number of cakes sold) by the number of units sold.
- Revenue = Selling Price per Unit × Number of Units Sold Revenue
- Example: £20 × 150 cakes Revenue = £3,000
The amount of £3,000 would be the total revenue generated from the cake sales before expenses. The next step would be to calculate the bakery’s or your business’s profit margin.
Calculate the Value of Your Profit Margin
To determine your profit margin, you need to subtract the cost per unit from the revenue per unit, giving you the value of your business’s profit margin.
Using the previous bakery examples:
The bakery sold 150 cakes for £20 during a specific period. The total expenses for the bakery were £2000. To calculate the profit margin, the formula would be:
- Profit = Total Revenue – Total Expenses
- £3,000 – £2,000 = £1,000
To show a profit as a percentage of total revenue, divide profit by total revenue and multiply by 100:
- £1000 ÷ £3000 × 100 = 33.33%
In this example, the profit margin is positive and can be used to predict future profits, and if the amount is negative, your company should increase costs and reduce expenses.
An operating budget can benefit your business and help manage your cash flow. This provides you with the ability to precisely evaluate the costs associated with managing your everyday activities. The costs, revenue, and earnings can function as measures that empower you to formulate choices about pricing, expense control, and strategies for expansion, ultimately guaranteeing consistent profitability.
Disclaimer: This content does not necessarily represent the views of IWB.