Components of an Operating Budget for a Small Business

Learn the key parts and calculations to develop your operating budget

Small business owner doing inventory

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Budgeting is one of the most critical financial management activities when it comes to a small business's day-to-day operations. The master budget for a business is an overall financial planning document, and consists of two budgets: The operating budget and the financial budget.

The operating budget for a business is a forecasted, or predicted, financial statement of all the revenue and expenses it expects during a specified time period like a quarter or a year. The operating budget is usually broken down by category of revenue for each product the business sells. It is also broken down by types of expenditures it makes regarding every product. Most firms further break down their operating budgets by fixed and variable costs.

The operating budget uses forecasted numbers in the different budgets, or schedules, that comprise it. These forecasts are based on historical activity, input from the sales force, and other sources. The result of the development of the operating budget is the pro forma, or forecasted, income statement for the firm for the specified time period.

Below is a hypothetical example of the development of the operating budget for a small business, Masks and More, LLC.

Sales Budget

Most business owners and managers use what is called a "bottom-up" sales forecasting technique. In other words, they solicit sales figures from salespeople in the field since the latter will generally have the most knowledge of what sales will be in future time periods. These sales figures are then combined with other sources of sales information to form an aggregate sales forecast.

Other factors that go into the sales forecast include the general state of the economy, pricing policies, advertising, competition, and other factors. The sales budget may be slightly different from the sales forecast after it is adjusted according to the wishes of management. The sales budget also shows units sold as well as dollars.

The following is the sales budget for Masks and More, LLC.

Quarterly Sales Budget
  1 2 3 4 Year
Units 1,000 1,200 1,500 2,000 5,700
Unit Selling Price x $10 x $10 x $10 x $10 x$10
Budgeted Sales $10,000 $12,000 $15,000 $20,000 $57,000

Production Budget

After developing the sales budget, the next step in developing the operating budget is to put together the production budget. In our example, the owner of Masks and More must know how many masks to make during the budgeting time period.


The production budget tells the business owner how many units of the product to produce to meet sales needs and ending inventory requirements.

The formula to calculate production needed for each time period is:

Sales budget component

For Masks and More, LLC, if we assume 25 units were in beginning inventory and 50 units are desired in ending inventory and the sales budget shows that 1000 units are forecasted to be sold in the first period, the calculation for the production budget would be: 1,000 + 50 - 25 = 1,025 units.

The production budget is the only budget that is stated in units instead of dollars. The direct materials purchases budget, direct labor budget, and overhead budget convert the production budget into dollars.

To convert the production budget to dollars, go to the Ending Finished Goods Inventory step below. After all the calculations, the product costs $9.00 to produce.

So by doing the math, $9.00 X 1,025 = $9,225 in production costs for the first time period.

Direct Materials Purchases Budget

The direct material purchases budget pertains to the raw materials that the business needs for its production process. It states the amount and the cost of each type of raw material needed. The business's inventory policy helps determine the amount of raw materials kept in inventory.

The direct materials purchases budget for Masks and More, LLC is based on this equation:

Direct materials purchases budget

If the cost of raw materials is $2.00 per unit sold, then, based on the production budget for the first time period, the calculation for direct materials purchases would be: 1,000 + 50 - 25 x $2.00 = $2,050.

As a result, the per-unit cost is $2.00.

Direct Labor Budget

The budgeted hours for direct labor are determined by the relationship between labor and production. Assume that labor is paid $7.50 per hour and it takes 0.50 hours for one worker to work on one unit of the product at Masks and More, LLC. In that case, the calculation for the direct labor budget for the first time period would be: 1,000 X 0.5 hours X $7.50 = $3,750.

The per-unit cost, in turn, is $3.75.

Overhead Budget

The overhead budget is everything leftover from production that isn't included in the direct materials purchases and direct labor budgets. Usually, the direct labor budget drives the overhead budget. Overhead includes items such as rent or lease payments and utilities. In the case of Masks and More, LLC, the overhead each time period is $6.50 per unit.

Selling and Administrative Expenses Budget

The non-manufacturing part of the forecasted budget is selling and administrative expenses. These expenses have fixed and variable cost components. For example, sales commissions are based on sales volume and are variable. Utilities may be fixed. In this example, utilities are the only overhead item and are $300 per time period.

Ending Finished Goods Inventory Budget

The ending finished goods inventory budget is important because it gives the company the information it needs to calculate the per-unit cost of its product. This per-unit cost is calculated from the information gathered from the direct materials purchases budget, direct labor budget, and overhead budget.

In this example, the total cost of direct materials per unit is $2.00. The total cost of direct labor per unit is $3.75. To calculate the total cost of overhead per unit: $6.50 X 0.5 = $3.25.

In this calculation, 0.5 equals time per hour that a worker spends on the product.

This adds up to $9.00 per unit. In the sales budget in Step 1, there were 50 units of the product not sold, so your finished goods inventory would be $450.00.


While it seems to make sense to produce as many items for sale as possible, if production is greater than demand, the business will end up holding obsolete inventory.

The Bottom Line

The question is whether or not Masks and More, LLC is selling enough of their product to cover their production costs. In the sales budget step, the company expects to sell $10,000 in the first time period. In the next step, the production budget is $9,225 for the first time period. The bottom line is that the company can cover its production costs with $775 to spare.

An operating budget is a living document that should be actively used and not filed away. You can use an operating budget to tell you where to cut expenses if your production costs are greater than sales. The operating budget can be as detailed a report of your revenue and expenses as you wish. Use it to perform variance analysis to determine what causes discrepancies in production costs and budgeted sales.

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The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. eFinance Management. "Sales Budget." Accessed March 29, 2021

  2. Corporate Finance Institute. "Direct Labor." Accessed March 29, 2021.

  3. First Bank SBA. "How to Create a Small Business Operating Budget." Accessed March 29, 2021.

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