Budgeting

What is Budgeting?

Budgeting projects anticipated revenue and expenditures for a future period based on prevailing internal and external factors. A detailed statement of projected financial result is prepared by considering inputs from various levels.

It is a health check for the organization—it is essential for avoiding cash crunch or losses. The changes in incomes and expenditures are brought out by labor laws, inflation, market growth, and economic downturns. Budgeting is done by top-level management in the top-down approach; other levels implement it. In the bottom-up approach, inputs from various levels are sent to top management.

Budgeting Explained

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Budgeting is done by individuals, families, groups, companies, and the government—to plan, monitor, and control finances. It is everywhere; homemakers use it to manage their monthly expensesExpensesAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital.read more and savings; the government relies on it to run the nation.

Anticipated revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more and estimated expenditure are the two crucial components. Anticipated revenue is the potential cash inflow that a person, business entity, or government might generate. On the other hand, estimated expenditure is the cash outflow that an individual, firm, or government expects to make in the upcoming period. 

It can be approached top-down or bottom-up. In the top-down approach, top-level management estimates costsEstimates CostsCost estimate is the preliminary stage for any project, operation, or program in which a reasonable calculation of all project costs is performed and thus requires precise judgement, experience, and accuracy.read more and gradually moves down levels. Ultimately, the top management prepares the breakdown of spending and passes it down for implementation. In contrast, in the bottom-up approach, managers prepare department-wise reports based on team inputs and past experiences. They then send it to top management for approval.  

Types of Budgeting

Following are different types of budgets prepared by individuals, businesses, and governments.

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• Personal Budget: An individual or family plans their monthly earnings Earnings Earnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.read moreand expenses to ensure that they don’t run out of cash before the next paycheck.
• Corporate Budget: It is a plan to maintain cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more, operating cash, and emergency fundsEmergency FundsAn emergency fund is a source of money that you refrain from spending and store away safely to use in the time of need. Since it is readily available for withdrawal, savings invested in the emergency fund act as a savior during unforeseen circumstances. The emergencies can be a sudden job loss, emergency medical issues, or big losses in the financial market.read more efficiently. It comprises sales, material, production, and factory overheadsFactory OverheadsFactory Overhead, also called Factory Burden, is the total of all the indirect expenses related to the production of goods such as Quality Assurance Salaries, Factory Rent, & Factory Building Insurance etc. read more.
• Government Budget: A financial plan prepared by the federal government accounts for the estimated national revenue for a particular financial or fiscal yearFiscal YearFiscal Year (FY) is referred to as a period lasting for twelve months and is used for budgeting, account keeping and all the other financial reporting for industries. Some of the most commonly used Fiscal Years by businesses all over the world are: 1st January to 31st December, 1st April to 31st March, 1st July to 30th June and 1st October to 30th Septemberread more. The revenue comes from taxes, fees, and grants. It also considers the anticipated expenditure over public services and infrastructureInfrastructureInfrastructure refers to fundamental physical and technological frameworks that a region or industry establishes for its economy to function properly.read more. There are two types of federal budgets—capital and revenue.
• Master Budget: It is a culmination of various lower-level budgets prepared for different areas of business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation.read more. It is a consolidated business plan. 
• Operating Budget: It is created at the beginning of a given period. It reflects the profit and loss accountingProfit And Loss AccountingThe Profit & Loss account, also known as the Income statement, is a financial statement that summarizes an organization's revenue and costs incurred during the financial period and is indicative of the company's financial performance by showing whether the company made a profit or incurred losses during that period.read more—accounts for fixed, non-operating, variable, and capital expendituresCapital ExpendituresCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more.
• Static Budget: It is mostly formulated by the government and non-profit organizations. It is rigid and does not allow variations depending on the activity of the institution. It is a prediction of revenue and expenses—based on anticipated values. The actual results may vary from the predicted values.
• Flexible Budget: It is a realistic approach adopted by businesses. A flexible plan considers changes in expenses and costs over the period and adjusts accordingly.
• Financial Budget: It incorporates assets, liabilities, and shareholders equityShareholders EquityShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period.read more. It charts a company’s short-term and long-term financial goals.
• Cash Budget: It is simply a cash flow prepared in advance. It documents anticipated payables and receivables for an upcoming period. It is prepared to ensure that the business has enough money to run the organization effortlessly. 
• Labor Budget: It is tailor-made for labor-intensiveLabor-intensiveLabor intensive implies those tasks which require a heavy workforce for accomplishment. In the production of goods and services, the industry is considered labour intensive if the manufacturing process relies more on human resource than machinery.read more firms. Businesses that are heavily reliant on employees need a systematic plan balancing revenue and wages.

Budgeting Methods

Different methods of preparing financial plans are as follows.

#1 – Incremental Budgeting

It is a traditional method; the manager takes the previous period’s budget as a benchmark. Further, the anticipated percentage change is either summed up or deducted to formulate the current budget. It includes adjustment for inflation, overall market growth, and other relevant factors.

#2 – Zero-based Budgeting (ZBB)

In this method, all the figures are reset to zero, and the manager begins with a fresh interpretation of all the items. The manager has to justify every new number with reasoning, in contrast to using figures from the previous accounting periodAccounting PeriodAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.read more. ZBB eradicates traditional expenditures that are no longer required. It is a strategic top-down approach re-evaluating every detail and decision.

#3 – Activity-based Budgeting

Operations or activities that generate cost to the business are identified. Ways of reducing costs are strategized. It is mostly used in mature organizations.

#4 – Participative Budgeting

Top-level executives often take the help of the managers and workers of different departments in designing the financial plan. It is a bottom-up approach.

#5 – Negotiated Budgeting

It has both top-down and bottom-up traits. Managers and employees together frame the financial plan, keeping in mind goals and targets—set by top-level management.

#6 – Value Proposition Budgeting

As the name suggests, every cost is re-evaluated and justified based on its impact. Unnecessary expenses are eliminated.

Budgeting Process

Given below are the seven steps of financial planningFinancial PlanningFinancial planning and analysis (FP&A) is budgeting, analyzing, and forecasting the financial data to align with its financial objectives and support its strategic decisions. It helps investors to know if the company is stable and profitable for investment.read more.

1. First, ascertain the goal of financial planning.
2. Next, interpret and compare historical data of revenues and expenses.
3. Then, devise a rough budget to direct the actions towards the objective.
4. Further, refine the findings to chalk down a final budget.
5. Prepare and submit a budget report.
6. Review the financial plan from time to time—detect loopholes.
7. Track the performance, taking the necessary corrective measures if required.

Example of Budgeting

The management of ABC Ltd. sets a new target for the sales team to sell 12000 units at a lower price for the year to increase the organization’s overall profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more. But the production unit cannot make 12000 units in a year. This could potentially cause frequent clashes between sales and production departments. If inputs from the production unit were considered in financial planning this problem could have been prevented.

On the other hand, if the sales team had achieved the target, sales personnel would expect a raise or incentive for their performance. However, due to lower production, incentives were not delivered. The management may have to spend more on wages without an increase in revenue. This is why companies need master budgets, integrating different departments.

Importance

Let us assume Ryan goes to a departmental store and picks a lot of stuff. At the billing counter, he realizes that he does not have enough cash. He ends up unloading items from his cart. This is where financial planning plays a role—saving people from potential embarrassment.

Let us look at some of its other benefits:

• Helps Attain Short and Long-term Goals: The financial planner can prepare for the future by foretelling the revenue and expenditure to achieve the desired objectives effectively.
• Decision-making: Business decisions are not taken blindly; they are based on proper research and planning.
• Avoid Cash Crunch: A person, firm, or government that efficiently plans and executes a financial plan can avoid financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more.

Frequently Asked Questions (FAQs)

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