Budgeting

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21 Aug, 2024

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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.

What is Budgeting?

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 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 expenses and savings; the government relies on it to run the nation.

Anticipated revenue 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 costs 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.

Personal Budget: An individual or family plans their monthly earnings and expenses to ensure that they don't run out of cash before the next paycheck.
Corporate Budget: It is a plan to maintain cash flow, operating cash, and emergency funds efficiently. It comprises sales, material, production, and factory overheads.
Government Budget: A financial plan prepared by the federal government accounts for the estimated national revenue for a particular financial or fiscal year. The revenue comes from taxes, fees, and grants. It also considers the anticipated expenditure over public services and infrastructure. 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 operations. It is a consolidated business plan.
Operating Budget: It is created at the beginning of a given period. It reflects the profit and loss accounting—accounts for fixed, non-operating, variable, and capital expenditures.
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 equity. 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-intensive 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 period. 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 planning.

First, ascertain the goal of financial planning.
Next, interpret and compare historical data of revenues and expenses.
Then, devise a rough budget to direct the actions towards the objective.
Further, refine the findings to chalk down a final budget.
Prepare and submit a budget report.
Review the financial plan from time to time—detect loopholes.
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 profitability. 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 crisis.

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.