Budgets and Budgeting

Budgets and Budgeting

A detailed explanation of how to budget, types of budgeting, the benefits, and the critiques of the budgeting process.

In the broadest sense, a budget is an allocation of money for some purpose. The word once used to mean "pouch" or "purse"; a budget therefore is "what's in the pouch." This article will focus principally on "formal budgeting" as practiced in corporations, sometimes called the "budget process."

Budgeting has always been part of the activities of any business organization of any size, but formal budgeting in its present form, using modern budgeting disciplines, emerged in the 1950s as the numerical underpinning of corporate planning. Modern corporate planning owes much to operations research and systems theory.

Modern formal budgets not only limit expenditures; they also predict income, profits, and returns on investment a year ahead. They have evolved into tools of control and are also used as a means of determining such rewards as profit-sharing and bonuses. Unless the budgetary process is managed with extreme skill and care, the very virtues of budgeting can turn into negatives and have, of late, emerged into a movement actively working to change this process.

BUDGETING AS PROCESS

In large corporations, budgeting is a collective process in which operating units prepare their plans in conformity with corporate goals published by top management. Each unit plan is intended to contribute to the achievement of the corporate goals. Unit managers prepare projections of sales, operating costs, overhead costs, and capital requirements. The budget itself is the projection of these values for the next calendar or fiscal year. Approved budgets then become the road-map for operations in the coming year. Ideally monthly or quarterly budget reviews track performance against the budget. At year / period end managers are judged by their performance against the budget.
By regularly consulting a budget, business leaders can compare actual figures and catch potential business shortfalls or other problems early. Budgets can also be instrumental in winning over investors, convincing banks your business is a good loan risk, or bringing on new partners or customers.
While budgets are developed bottom up, managers must strive to meet top-down business goals. Because performance is measured based on meeting or exceeding positive projections (of sales, returns, and profits).

 
BENEFITS AND COSTS

The single-most potential benefit of formal budgeting lies in ensuring that responsible managers take time each year (and then at fixed intervals throughout the year) in thinking about their operation by looking at all of its aspects. Budgeting creates a comprehensive picture of the future and makes both opportunities and barriers conscious. This foreknowledge then helps guide day-to-day activities.

TYPES OF BUDGETS

The two dominant forms of budgeting are traditional and zero-based. Business planning is usually a combination of the two. 

Traditional

Traditional budgeting is based on a review of historical performance and then the projection of such findings to the future with modifications. If inflation is high, for instance, cost trends of the last several years are projected forward but with adjustments both for inflation and for projected growth or decline in business activity. Historical sales patterns, using established trends in sales growth, are projected; new sales from planned new product introductions are then added.

Zero-based  

Zero-based budgeting is the creation of a completely new budget from the ground up. When using this method, the operation must justify and document every item of expenditure and income anew. Brand-new operations will utilize zero-based methods.

Performance budgeting

Performance budgeting is used as a third alternative. Under this method, the budget is fixed at the outset. The planning activity is to determine exactly what activities will be carried out using the allocated funds. Performance budgeting is sometimes used in the corporate setting when the advertising budget is arbitrarily set as such-and-such a percent to projected sales. The advertising function then uses performance budgeting to allocate the budget to various products and media.

For the small business, different types of budgets can be drafted to monitor various financial aspects of the business.

Operational budget  An operational budget is the most common type of budget used. It forecasts and tries to pretty closely predict yearly revenue and expenses for a business. This budget can be updated with actual figures on a monthly basis and then you can revise your figures for the year, if needed.

Cash flow budget - A cash flow budget details the amount of cash you collect and pay out. This is generally tallied on a monthly basis, but some businesses tabulate this weekly. In this budget, you track your sales and other receivables from income sources and contrast those against how much you pay to suppliers and in expenses. A positive cash flow is essential to grow your business.

Capital budget - The capital budget helps you figure out how much money you need to put in place new equipment or procedures to launch new products or increase production or services. This budget estimates the value of capital purchases you need for your business to grow and increase revenues.

SUMMERY

Budgeting

A budget is a quantitative plan used as a tool for deciding which activities will be chosen for a future time period. Budget is used to control the future activities of the business. In a business, the budgeting for operations will include: preparing estimates of future sales, expenses and cash collections and disbursements.  Following the types of budget:

Fixed budget:

Fixed budget is not adjusted to the actual result. Fixed budgeting is done after the fact (actual results).

Flexible budget:

Flexible budget is designed to change according to the actual results. It is usually prepared before the start of the budgetary period. Following are types of flexible budget:

1.       Rolling budget:

 A rolling budget is the budget for next period which is revised on an ongoing basis by comparing with actual results when the first period is expired.

2.       Zero-based budget (ZBB):

This budget is prepared from zero for every period. The following three steps approach to ZBB:

a)       Decision packages (i.e. activates that result in cost of revenues)

b)       Evaluate and rank (prioritize) packages

c)       Allocation of resources across packages.

3.       Activity-based budget (ABB)

a)      This budget is prepared on the activity (department, section, function) based.

b)      Budgeted activity cost = demand for activity x unit cost of activity.

c)      It is more detailed and accurate than traditional budget.

4.      Incremental budget:

This budget is based on what went in previous period. This approach result in modest changes and adjustment in previous period budget for next calendar period.

Problems encountered when using conventional budgets:

a)      These budgets invites “Gaming” of the system

b)      These budgets can be “Inflexable”

c)      These budgets are often “Imposed from top to down” in the company.

d)     These budgets have an indirect connection with the company’s stragety.

e)      These budgets are used for too many different purposes.

The rational for moving “Beyond” budgeting

Rapidly changing market trend, triggering the need for real-time response.

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