Budget definition
/What is a Budget?
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.
Structure of a Budget
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. Budgeting software also contains controls that prevent a budget model from being tampered with by an unauthorized user.
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Construction of a Budget
Businesses typically create budgets in accordance with a specific timeline. It begins with decisions about which products and services will be offered, as well as whether sales will be made into new geographic regions. Next, sales estimates are made, based on historical sales information and estimates from the sales department. This information is then used as the basis for the development of a production budget, as well as estimates of the cost of goods sold and inventory levels. Other department budgets are then estimated, along with expenditure levels for research and development, as well as asset purchases. These budgets are then rolled up into a master budget, from which estimates are made for the financing requirements of the business over the span of the budget period. The outcome may be run through several iterations before a reasonable budget model is created.
Static vs. Flexible Budgets
Most organizations use a static budget, which contains fixed amounts of revenues and expenses over the term of the budget. These budgeted amounts are used for variance analysis throughout the budget period, even if the actual circumstances change. A smaller number of organizations use a flexible budget, where you plug in the actual revenue figure for a reporting period, and that changes certain budgeted expenses, such as the cost of goods sold and commissions. A flexible budget is more useful over the full term of a budget, since it flexes with the actual levels of sales experienced. Conversely, a static budget is frozen, and so may not be relevant if sales levels change dramatically over time.
How to Improve Budget Outcomes
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 is to use a flexible budget, in which variable costs within the budget are modified based on the actual sales levels experienced during a reporting period. Yet another way to improve budget outcomes is to aggregate line items within the budget. Doing so reduces the variances that can arise when budget amounts are defined too narrowly across too many accounts.
Operating Without a Budget
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. This approach is especially useful for a new business that has no historical performance trend lines upon which to base its budget estimates.
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