Preparing A Budget

Preparing a Budget

Preparing a budget in your business is one of the easiest tools available to CEO’s. By having a budget you can review how much you spent last year or quarter, and predict what you will spend this year or quarter. As implied, a budget can be made by year, month, quarter, or for any time interval that you deem relevant. There are two types of ways to make a budget, both giving you similar, but different results. The first is through Absorption Costing. The formula for this is:

Sale – Cost of Goods Sold = Gross Margin
Gross Margin – Selling and Administrative Expenses = Net Operating Income.

This may look easy enough, but there are a few things that are unique about this formula that need to be addressed. In Absorption Costing both Variable and Fixed Manufacturing cost are considered to be product cost, or in other words they are dependent on how many products you sell, not produce. Because of this you need to add both Variable and Fixed manufacturing cost together then divided that number (also known as the Cost of Goods Sold) by the total number of units produced to give you the total cost of production per unit. Then multiply that number by the actual number of units sold. This will give you the cost of everything you sold. The difference between what you produced and what you sold (or the leftovers) will be put into an inventory account for next period. This will give you the Net Operating Income of your company; however this will overstate how much you earned in that time period. It does this because it considers Fixed Manufacturing cost to be elastic, which it isn’t. It is not as accurate, but it is used for external purposed to give the illusion that more money was made that actually was. This is not illegal; however it is not as accurate.

For internal purposed accountants use Variable Costing. The formula for Variable Costing is:

Sales – Variable Cost = Contribution Margin
Contribution Margin – Fixed Expense = Net Operation Income

Like Absorption Costing this looks easy, but has a few tricks to it. First we need to explain the new variables. Variable Cost is a combination of Variable Manufacturing Cost and Variable Selling and Administrative Expenses. Fixed Expenses are a combination of Fixed Manufacturing Cost and Fixed Selling and Administrative Expenses. In Variable Cost only the Variable Manufacturing expense is considered a production cost. So you must divide it by the number of units produced to give you the cost per unit, then multiply by total units sold. Once you have that number, add it to the Variable Selling and Administrative expenses and the rest is how it seems. This type of budgeting gives you a more accurate Operating Income. It is used for internal purposes because it shows potential vulnerabilities in the company that you wouldn’t want competitors to know.

These are just a few examples of budgeting, however using this can be of great advantage to your company. You can plan you allocation of monies better so that you aren’t wasting money and resources. It can help you to prove your stability if trying to obtain a loan, or countless other reasons. Overall a budget is and easy and affective tool for you.