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Budgeting

Updated on January 3, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

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.

Key Takeaways

  • Budgeting is a systematic approach, that predicts revenues and expenditures of an individual, family, group, business entity, or government. A realistic report helps businesses trace their financial performance. This is crucial for decision-making.
  • They are classified into personal, corporate, government, static, flexible, master, operating, cash, financial, and labor subtypes.
  • Incremental, zero-based , activity-based , participative , negotiated , and value proposition are different methods of budgeting.

Budgeting Explained

Budgeting

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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.  

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Types of Budgeting

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

Types of Budgets

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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:

Frequently Asked Questions (FAQs)

Why are budgets important?

Whether it is personal, corporate, or government finance, everything requires planning to actualize short-term or long-term goals. Anticipating revenue and expenditure helps track finances—prevents overspending and depleted emergency funds.

How is a budget prepared?

To formulate a financial plan, the manager first needs to define the goal. The next step is gathering and comparing the historical and present data. Then, the future revenue and expenses are predicted—based on the available data. Consequently, a realistic plan is drafted. Ultimately, a comprehensive report is submitted to the top-level executives.

What is the “50 30 20 budget rule”?

The “50-30-20 ruleu0022 recommends spending 50% of earnings (after-tax) on basic necessities. Of the remainder, the rule recommends spending 30% on leisure and 20% on savings.

This article has been a guide to what is Budgeting and its Meaning. Here we explain budgeting types, methods, processes, examples, and importance. You may learn more about financing from the following articles –

Reader Interactions

Comments

  1. Justina Thikan says

    Very clear definitions and easy to understand explanations for a non-financial person. The flow of thought is commendable.

    Thank you guys!

  2. Fakhar Ghumman says

    Thanks, very awesome style of conveying information, a lot I learnt from your website regarding accounting and financing. keep it up. Regards

    • Dheeraj Vaidya says

      Thanks for your kind words!

  3. monica says

    Thank you for your insightful knowledge on the matter, it has brought me more understanding of budgeting.
    Monica

    • Dheeraj Vaidya says

      Thanks for your kind words!

  4. Titiksha says

    Thanks a ton for such a detailed article on this topic.

    • Dheeraj Vaidya says

      Thanks for your kind words!

  5. Titiksha says

    Thanks for a ton for such a detailed article on this topic.

    • Dheeraj Vaidya says

      Thanks for your kind words!

  6. Daodu Modupe says

    I am greatly impressed by your teaching style. I have gained tremendously from your wealth of knowledge in this field. Thanks a million times. Hope to read more of your write ups.
    Modupe, from Nigeria .

    • Dheeraj Vaidya says

      thanks Daodu :-)

    • Kenneth Giraffe says

      Thank you brother

  7. George stefen says

    Thanks for providing such a useful knowledge on Budgeting. As I also want to say I love reading blogs on finance, investment banking and many other topics related to financial management.

  8. Peyton cooler says

    Thank you for this blog. I must say this is the most relevant blog I have seen till now. Great job Mr. Dheeraj. Okay I have a question. Is budgeting and forecasting one and the same?

    • Dheeraj Vaidya says

      Thanks Peyton! Well both budget and forecast are similar and inter-dependent but they serve different functions and budget is a tool of control whereas forecasts, being statement of future events. You can refer to this article on Budgeting vs Forecasting for further details.

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