The budgeting process for any company starts with a capital or master budget. The capital budget is a forecast for the company’s long-term financial achievements.

Top level management formulates the master or capital budget during the strategic planning process.

The capital budget is then passed on to the departments or divided into categories by functions e.g. manufacturing and marketing, etc. in general, the master budget can be divided into three categories:

  1. Financial budgets
  2. Operating budgets
  3. Special activity budgets

A Financial Budget is the estimation of all cash flows arising from capital activities. It includes all cash flows from operating activities, capital investments, and changes in equity.

Therefore, the financial budget is reflected through changes in the balance sheet, income statement, and statement of equity for the shareholders.

Financial budgets are long-term in nature, often connected with capital expenditures. Top-level management primarily makes the financial budgets, and then specific roles and tasks are assigned to departments to achieve the set goals.

For any business, there are three key financial decisions: Investment, Financing, and Dividend. All of these decisions require strategic planning.

For example, a business needs to invest in a positive NPV project, for that it will need initial financing. That financing can be sourced through cash balance, bank loan, or equity finance.

Either way, the decision will impact the cash flow for the business, financial budgeting includes all of these cash flows. Financial cash flows come from both operating and financing activities. So in a way, both operating and financial budgets are linked.

An Operating budget is an estimation of all cash flows arising from operating activities of the business. Operating activities make up for the largest portion of expenditure for any business and the most important factor in the unit cost calculation.

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Operating expenses and revenues directly affect the cost of goods sold, sales, and hence profits. So operating budget forms a crucial part in performance appraisal for a business.

Operating budgets form the basis of financial budgets, and hence an integral part of the master budget. Operating budgets can be divided according to operating activities depending on the business nature:

  • Manufacturing expenses
  • Raw materials and required labor
  • Sales and marketing expenses
  • Production budgets
  • Sales volume budgets and so on…

Operating budgets are primarily concerned with business operations efficiency. As business sales or revenue increases and expenses are controlled efficiently, profitability increases.

Total sales budgets, sub-divided into sales volume and sales price analysis, manufacturing budgets, and purchases are all integral components of operating budgets.

Operating budgets should be made for the short-term and often require revision. Revised budgets should then be compared for any variances with the original budgets. At the end of the budgeting period, the actual results should be compared with revised budgets.

This operating and planning variance analysis can help achieve operating efficiencies and make operating budgets realistic.

Both operating and financial budgets directly affect the cash flows or the cash budgets of the business. Cash budgets can be categorized as operating and financial activities.

Operating cash flows include:

  • Sales of products and services
  • Procurement of raw material and labor
  • Purchase of manufacturing machinery and tools
  • Marketing and sales expenses
  • Sale or purchase of current assets

Financial cash flows include:

  • Financing facilities such as bank loans
  • Interest payments on existing loans
  • Sale or purchase of capital assets such as land or property
  • Income tax and dividend payments
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Both operating and financial budgets provide valuable forecast and control measures to the management. However, both differ in the nature of time, expenses, and revenue streams.

Some of the advantages for both operating and financial budgets are:

Operating BudgetsFinancial Budgets
Estimate expenses and revenue from operating activitiesEstimate revenue and expenses from capital activities
Provides short-term analysisProvide long-term analysis
Concerned with operating efficiencies such as manufacturing, sales, and laborConcerned with capital and financial health of the business at large
Offers critical variance analysis in sales volume, sales price, etcOffers capital assets analysis on the balance sheet and income statement
Planning and operational variances help improve operating efficiencyProvides top management with in-depth analysis for all business activities such as Financing, investing, and dividend

The sequence of budget preparation often depends on the budget approach taken by management, e.g. in a bottom-up budget approach the operating budget will be prepared first.

However, both operating and financial budgets are closely linked, and a variance in one budget will cause a variance in the other.