Create an Annual Operating Budget

Contributor
Sustainable Infrastructure Society
Introduction

An annual operating budget is a statement of the revenues and expenses you expect over twelve months. It’s one of the most important tools you can have. Every water system should complete the annual budget with care. An operating budget provides a reference point for your activities over the year and can help you manage challenging financial periods, such as when you are faced with unexpected expenses.

Operating expenses are generally shorter-term costs and include, for example, salaries, insurances, and consumable items. In comparison, capital costs are incurred for more tangible things such as buildings or new equipment. Capital costs are excluded from the annual operating budget process although the annul budget may include contributions to capital reserves. Operating revenues include the charges you make for supply of water to customers.

A new budget must fulfill the following three criteria: it must cover a fixed period; in this case one year. The budget must have a defined scope; in this case operating revenues and expenses. And the budget must be formally documented, typically by using electronic worksheets.

Your financial records showing past revenues and expenses, together with information from your five-year plan, will help you build a realistic operating budget for the coming year. An annual operating budget differs from a project budget, which is one that is allocated to a special project such as the building of a new treatment plant. Larger project expenditures are typically shown in capital plans, and not in annual operating budgets.

Steps in Preparing an Annual Budget

There are five main steps in preparing an Annual Budget:

  1. Decide how to prepare the budget
  2. Estimate your operating expenses for the year
  3. Estimate your operating revenues for the coming year
  4. Work out contributions to reserves
  5. Work out net revenues for the year

Each of these steps is outlined in the sections below. And for each step, there are tools, such as worksheets, available to you in the Resources and Tools section at the bottom of the page. 

1. Decide How to Prepare the Budget

There are two basic methods for preparing budgets: by either (a) using the previous year’s budget, or else (b) creating a green-field budget.

Based on Previous Year: Operating budgets are normally created by taking last year’s budget, working out what will be different this year, and modifying last year’s budget figures to accommodate this. For example, there were two operators last year, but the plant is planning to hire one extra at the start of this year. Therefore, this year’s budget will include extra cost for salaries, additional employment insurance, taxes, contributions, costs and fees.

Green-Field Budget: A green-field budget is created from scratch, with no past budget to help with an estimate of costs. This type of budget is harder to complete. You should identify the things that need to be done in the year to operate and maintain the system. It can be useful to create the green-field budget in stages by breaking things down into successive chunks of information. For example, the total budget can first be split into several sections: operations, maintenance and contributions to reserves. Operations can then be broken down into personnel, tools and materials, and consultants. Maintenance is then broken down into personnel, tools and materials, specialist trades, and consultants.

The annual budget should refer to your five-year plan. It is good practice for all water systems to prepare a Five-Year Plan. This shows the expenditures you plan to make in the next five years and may also refer to provisions for increasing revenues. Refer to your five-year plan when preparing the annual budget and include in the annual budget for any items from the five-year plan that should be accounted for in the current year budget.

2. Estimate Your Operating Expenses for the Year

Each year your system will have recurring costs, which you should divide into broad categories: Administration and Operations and Contributions to Reserves. The first category, Administration and Operations, includes things such as treatment costs, utilities, wages and maintenance. The second category covers the contributions you make each year to one or more Reserve Accounts, as outlined below.

The costs you incur each year for Administration may include wages and benefits, rent, insurance, fees, charges and taxes, and training. The costs for Operations may include utilities, maintenance, monitoring and testing, consumables, equipment, and other categories. Knowing what your costs are and understanding how they have changed in the past and can change in the future is a key to knowing how much money to collect from customers every year.

In budgeting, it may help to think of your expenses as including fixed costs and variable costs. Variable costs are those expenses in your water system that increase or decrease from month to month, for example, your cost for pumping water is determined by volume used. Fixed costs are those that are not generally dependent on the water volume you provide. These may include such items as rent, water testing, insurance, and so on.

3. Estimate Your Operating Revenues for the Coming Year

To achieve long-term financial sustainability, you will need to collect sufficient revenues from your customers each year to cover all expenditures. In this case sustainability means that:

  • you can operate your water system safely and securely for the long-term future,
  • you can provide for replacement of assets when needed, and
  • you can manage upgrading and expansion of the system if required.

Revenues will typically come from service fees, late fees, connection charges, interest and other sources. You may also obtain income from parcel taxes, although typically these are used as a contribution to your capital expenditure budget, rather than you annual operating budget.

4. Work Out Contributions to Reserves

It is good practice to set up reserve funds. Typically, these funds are for Operating ReserveAsset Renewal ReserveEmergency Reserve and Capital Reserve. Smaller water systems can maintain these accounts in “virtual” form by creating appropriate worksheets for internal use (i.e., your records show that the reserves are being held, but you do not have separate accounts for each reserve). Money in a reserve fund should only be used for the purposes specified. Your Asset Management Plan and your Long-Range Plan will provide information you can use in establishing contributions to reserves.

Account Purpose Target Amount ($)
Operation Reserve For unexpected operational expenditures, such as a large increase in pumping costs. X% of annual operating budget
Asset Renewal Reserve For systematic renewal / replacement of assets, such as reservoirs and pipes. Refer to your asset management plan
Emergency Reserve For emergency events such as damage of intake works by flood. Y% of annual operating budget
Capital Reserve For major upgrading of the system such as installation of filtration. Refer to your long-range plan

To help determine the amount that should be in your Operating Reserve, consider how much you might need in a worst-case scenario, where your annual revenues would be as low as could be and your annual expenses would be as high as could be. The difference between these two extremes should be the amount you aim to maintain in your Operating Reserve account.

5. Work Out Net Revenues for the Year

To work out your net revenues for the year, subtract your operating expenses and your contributions to reserves from your revenues. The result should be positive. If not, you should adjust revenues, expenses or contributions to reserves.

Many smaller water systems do not charge enough for the water they supply. This means that the are unable to earn revenues that exceed expenditures unless they cut corners in operations or fail to make sufficient contributions to reserves. Both can have detrimental effects. Insufficient money spent on operations can lead to problems such as health or safety concerns and failure to meet regulatory requirements. Insufficient money contributed to reserves may mean your system cannot renew items like pipes ands pumps when they have reached the end of their service life.

The following figure shows a summary worksheet for an annual operating budget:

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Resources

To help you create an Annual Operating Budget, you can complete Excel worksheets available at the Canadian Water Directory's Financial Best Practices web page.

  1. Click on this link to the web page to access the Excel worksheets: Financial Best Practices.
  2. Once on the web page, click on the worksheets listed under BMP C.
  3. Then click on the tab at the bottom named "C2 Currents Ops Budget".

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