What is a Budget?
A budget is a formal statement of estimated income and expenses based on future plans and objectives. In other words, a budget is a document that management makes to estimate the revenues and expenses for an upcoming period based on their goals for the business.
In finance a budget is:
- a statement of the financial position of an administration (as of a nation) for a definite period of time based on estimates of expenditures during the period and proposals for financing them;
- a plan for the coordination of resources and expenditures develop a budget for her company;
- the amount of money that is available for, required for, or assigned to a particular purpose.
A budget is a financial plan for a defined period, often one year. It may also include planned sales volumes and revenues, resource quantities, costs and expenses, assets, liabilities and cash flows. Companies, governments, families and other organizations use it to express strategic plans of activities or events in measurable terms.
A budget is the sum of finances allocated for a particular purpose and the summary of intended expenditures along with proposals for how to meet them. It may include a budget surplus, providing money for use at a future time, or a deficit in which expenses exceed income.
What Does Budget Mean?
There are tons of different kinds of budgets from short-term and long-term to department specific. Management can make a budget for anything. The important thing to remember is these budgets are really just the management’s future goals and plans for the business written down in financial form.
For instance, if management were planning to purchase a new piece of equipment next year, that expense would show up in the budget. See what I mean? It’s just a written plan that details the financial goals of the company for a future period.
A budget is used to forecast the financial results and financial position of an entity for a future period. It is used for planning and performance measurement purposes, which can involve spending for fixed assets, rolling out new products, training employees, setting up bonus plans, controlling operations, and so forth.
At the most minimal level, a budget contains an estimated income statement for future periods. A more complex budget contains a sales forecast, the cost of goods sold and expenditures needed to support the projected sales, estimates of working capital requirements, fixed asset purchases, a cash flow forecast, and an estimate of financing needs. This should be constructed in a top-down format, so a master budget contains a summary of the entire budget document, while separate documents containing supporting budgets roll up into the master budget and provide additional detail to users.
Many budgets are prepared on electronic spreadsheets, though larger businesses prefer to use budget-specific software that is more structured and so is less liable to contain computational errors.
A prime use of the budget is as a performance baseline for the measurement of actual results. It can be misleading to do so, since budgets typically become increasingly inaccurate over time, resulting in large variances that have no basis in actual results. To reduce this problem, some companies periodically revise their budgets to keep them closer to reality, or only budget for a few periods into the future, which gives the same result.
Another option that sidesteps budgeting problems is to operate without a budget. Doing so requires an ongoing short-term forecast from which business decisions can be made, as well as performance measurements based on what a peer group is achieving. Though operating without a budget can at first appear to be too slipshod to be effective, the systems that replace a budget can be remarkably effective.
What’s the Purpose of a Budget?
Budgeting isn’t about depriving yourself; it’s about taking control of your money. Making a budget shouldn’t feel like a punishment. Remember, it’s a plan for all of your money — that includes money for fun stuff, too.
A budget doesn’t have to be rigid. In fact, it should change as your circumstances change — when you get a raise, for example, or become a homeowner. The idea is to make your budget as personalized as possible, leaving room to adapt. Surprises (and mistakes) will happen.
Why is Budgeting Important?
Budgeting benefits everyone, not just those who struggle financially. It encourages you to live within your means and put your money to work in the best way possible. Think of a budget as a steppingstone to your financial goals. It can help you:
- Understand your relationship with money. Tracking your income and expenses paints a clear picture of how much you have to save or spend. Once you spot patterns, you can identify where to make adjustments. Maybe you spend less than you earn (way to go!) but you’re paying for that subscription beauty box that you no longer need.
- Save enough for the future. A good budget coaxes you to earmark money for an emergency fund and savings goals like a vacation or retirement.
- Get — or stay — out of debt. Mapping out expenses in advance reduces the risk of overspending and can help you pay off debt you already have.
- Relieve stress. Budgeting isn’t a cure-all, but it can help you manage financial decisions and prepare for challenges.
Types of Budget
The budget of a company is often compiled annually, but may not be a finished budget, usually requiring considerable effort, is a plan for the short-term future, typically allows hundreds or even thousands of people in various departments (operations, human resources, IT, etc.) to list their expected revenues and expenses in the final budget.
If the actual figures delivered through the budget period come close to the budget, this suggests that the managers understand their business and have been successfully driving it in the intended direction. On the other hand, if the figures diverge wildly from the budget, this sends an ‘out of control’ signal, and the share price could suffer. Campaign planners incur two types of cost in any campaign: the first is the cost of human resource necessary to plan and execute the campaign. The second type of expense that campaign planners incur is the hard cost of the campaign itself.
Professionals employed in this are often designated “Budget Analyst”, a specialized financial analyst role. This usually sits within the company’s financial management area in general; sometimes, specifically, in “FP&A” (Financial planning and analysis).
The budget of a government is a summary or plan of the intended revenues and expenditures of that government. There are three types of government budget = the operating or current budget, the capital or investment budget, and the cash or cash flow budget.
Personal or Family Budget
A personal budget or home budget is a finance plan that allocates future personal income towards expenses, savings and debt repayment. Past spending and personal debt are considered when creating a personal budget. There are several methods and tools available for creating, using, and adjusting a personal budget. For example, jobs are an income source, while bills and rent payments are expenses. A third category (other than income and expenses) may be assets (such as property, investments, or other savings or value) representing a potential reserve for funds in case of budget shortfalls.
Other Types of Budget
- Sales budget – an estimate of future sales, often broken down into both units. It is used to create company and sales goals.
- Production budget – an estimate of the number of units that must be manufactured to meet the sales goals. The production budget also estimates the various costs involved with manufacturing those units, including labour and material. Created by product oriented companies.
- Capital budget – used to determine whether an organization’s long-term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing.
- Cash flow/cash budget – a prediction of future cash receipts and expenditures for a particular time period. It usually covers a period in the short-term future. The cash flow budget helps the business to determine when income will be sufficient to cover expenses and when the company will need to seek outside financing.
- Conditional budgeting is a budgeting approach designed for companies with fluctuating income, high fixed costs, or income depending on sunk costs, as well as NPOs and NGOs.
- Marketing budget – an estimate of the funds needed for promotion, advertising, and public relations in order to market the product or service.
- Project budget – a prediction of the costs associated with a particular company project. These costs include labour, materials, and other related expenses. The project budget is often broken down into specific tasks, with task budgets assigned to each. A cost estimate is used to establish a project budget.
- Revenue budget – consists of revenue receipts of government and the expenditure met from these revenues. Tax revenues are made up of taxes and other duties that the government levies.
- Expenditure budget – includes spending data items.
- Flexibility budget – it is established for fixed cost and variable rate is determined per activity measure for variable cost.
- Appropriation budget – a maximum amount is established for certain expenditure based on management judgment.
- Performance budget – it is mostly used by organization and ministries involved in the development activities. This process of budget takes into account the end results.
- Zero based budget – A budget type where every item added to the budget needs approval and no items are carried forward from the prior years budget. This type of budget has a clear advantage when the limited resources are to be allocated carefully and objectively. Zero based budgeting takes more time to create as all pieces of the budget need to be reviewed by management.
- Personal budget – A budget type focusing on expenses for self or for home, usually involves an income to budget.
Classification of Budget
Budgets classified according to 4 bases:
- Based on Time;
- Based on Condition;
- Based on Functions;
- Based on Flexibility.
Types of Budget Based on Time
Based on time factor budgets can be classified into two types:
- Long-term Budget, and
- Short-term Budget.
This budget is related to the planning operations of an organization for a period of 5 to 10 years. The long-term budget may be adversely affected due to unpredictable factors. Therefore, from a control point of view, the long-term budget should be supplemented by short-term budgets.
Example: Research and Development Budget, Capital Expenditure Budget, etc.
This budget is drawn usually for one year. Sometimes a budget may be prepared for a shorter period (like monthly budget, quarterly budget, etc.). Shortterm budgets are prepared in detail and these budgets help to exercise control over day-to-day operations.
Example: Material Consumption Budget, Labor Utilization Budget, Cash Budget, etc.
Types of Budget Based on Condition
Based on conditions prevailing, a budget can be classified into 2 types:
- Basic Budget, and
- Current Budget.
A budget that is established for use as unaltered over a long period is called Basic Budget.
This budget does not take into consideration changes occurring from the external environment which are beyond the control of management. This budget is more useful for top-level management for formulating policies.
A budget that is established for use over a short period and is related to the current conditions is called the Current Budget. This budget is adjusted to the current conditions prevailing in the business.
Types of Budget Based on Functions
Based on activities or functions of a business, budgets can be classified into 2 types:
- Master Budget, and
- Functional Budgets.
The final integration of all functional budgets by the Budget Officer provides the Master Budget. When functional budgets have been completed, the Budget Officer prepares the Master Budget.
Master Budget is the summary budget incorporating its component functional budgets, which is finally approved, adopted and employed.
Master Budget shows the operating profit of the business for the budget period and budgeted balance sheet at its close. This Budget portrays the overall plan for the budget period.
The master budget consists of several separate but interdependent budgets. The first step in the budgeting process is the preparation of the sales budget, which is a detailed schedule showing the expected sales for the budget period. An accurate sales budget is the key to the entire budgeting process.
If the sales budget is inaccurate, the rest of the budget will be inaccurate. The sales budget is based on the company’s sales forecast, which may require the use of sophisticated mathematical models and statistical tools.
We will not go into the details of how sales forecasts are made. This is a subject that is most appropriately covered in marketing courses.
The sales budget helps determine how many units need to be produced.
Thus, the production budget is prepared after the sales budget. The production budget, in turn, is used to determine the budgets for manufacturing costs including the direct materials budget, the direct labor budget, and the manufacturing overhead budget.
These budgets are then combined with data from the sales budget and the selling and administrative expense budget to determine the cash budget.
A cash budget is a detailed plan showing how cash resources will be acquired and used. After the cash budget is prepared, the budgeted income statement and then the budgeted balance sheet can be prepared.
Functional Budgets relate to functions of the business such as product sales etc. In other words, Functional Budgets are prepared in respect of various functions performed in a business.
Functional Budgets which are commonly found in a business concern are as follows:
- Sales Budget;
- Production Budget;
- Material Budget;
- Labor Budget;
- Production Overhead Budget;
- Administration Overhead Budget;
- Selling & Distribution Overhead Budget;
- Plant Utilization Budget;
- Cash Budget
- Research & Development Budget and more.
Types of Budget based on Flexibility
Based on flexibility budgets can be classified into two types:
- Fixed Budget, and
- Flexible Budget.
Fixed Budget (or Static Budget)
Fixed Budget is a budget which is designed to remain unchanged irrespective of the level of activity attained. This type of budget is most suited for Fixed expenses, which have no relation to the volume of output. Fixed -Budget is ineffective as a tool for cost control. Fixed Budget is based on the assumption that the volume of output and sales can be anticipated with a fair degree of accuracy.
Flexible Budget (or Sliding Scale Budget)
Flexible Budget is a budget which is designed to change by the level of activity attained.
This budget recognizes the difference in behavior between fixed and variable costs about fluctuations in output. This budget serves as a useful tool for controlling costs. It is more realistic, practical and useful than Fixed Budget.
A flexible budget that can be used to estimate what costs should be for any level of activity within a specified range. A flexible budget shows what costs should be for various levels of activity.
The flexible budget amount for a specific level of activity is determined differently depending on whether a cost is variable or fixed.
If a cost is variable, the flexible budget amount is computed by multiplying the cost per unit of activity by the level of activity specified for the flexible budget. If a cost is fixed, the original total budgeted fixed cost is used as the flexible budget amount.
Characteristics of a Flexible Budget
Flexible budgets take into account how changes in activity affect costs. A flexible budget makes it easy to estimate what costs should be for any level of activity within a specified range.
When a flexible budget is used in performance evaluation, actual costs are compared to what the costs should have been for the actual level of activity during the period rather than to the budgeted costs from the original budget.
This is a very important distinction — particularly for variable costs. If adjustments for the level of activity are not made, it is very difficult to interpret discrepancies between budgeted and actual costs.