What is a budget?
A budget is a plan to allocate limited resources to enable an individual or firm achieve their long-term goals. Budgeting helps keep track of expenses and income over time and uses this information in planning for the future. It can be as simple as writing down or tracking spending, or it can involve many complex calculations on spreadsheets.
Budgeting can be done by individuals, businesses, families, churches, nonprofits and more. However they are all designed to help individuals use their scarce resources wisely so they can reach their goals in life while still having enough left over for emergencies or future investments. A budget may also take into account the time value of money as well as risks associated with making these decisions.
Types of budgets
Different types of budgets can have many different purposes depending on the type; being careful not only means understanding what a firm’s goals are but why they need to be met given these conditions. Sometimes a firm may want to control for the way in which it invests its funds; otherwise, it can make some investment decisions without this aim. Other times, however, firms will want to limit their investment choices because of their financial position or because of other operational goals that they have.
A common objective in all budgets is to have one that preserves or maintains resources and minimizes investments while maximizing cash flows. Minimizing investments while maximizing cash flows typically means choosing the least cost input with respect to cash flow (cash flow maximization). If a firm has multiple projects to choose from, it may need to minimize the investments in a project while maximizing the cash flow of the project. Budgets can be used not only for investment decisions but also for operational expenses.
For operational budgets, firms will want to determine what level of output or sales is most profitable for them to produce. For example, if a firm produces goods with short lifespans and must make new investments quite often, it may want to keep its inventory levels low so as not to have excess inventory put up for disposal. In this case, firms would be focused on reducing costs related to production because production costs are high relative to sales revenue and sales revenue would increase if more units were produced.
Budgets for businesses
Since a business’s budget is often used to inform the firm whether they should make an investment or not, they show that even if a firm is looking at the future, a business still needs to know what its financial position looks like today. It may also help the firm decide how it should take on risk and in what direction.
There are various types of budgets in organizations. The financial budget (also called the accounting budget), refers to the budget of a company that is prepared by an accountancy firm. The general ledger (GL) budget refers to the budgets that are prepared in order to show how the expenses of each department, division, or division all contribute towards the overall performance rating of a company. This type may be prepared according to some set standards, or it may be self-created. The operational budget is a simple financial statement that focuses solely on revenue and expenses during a specific period of time.
A functional manager often has his own idea of what should be included in his functional or departmental budget. This type may be prepared according to some set standards, or it may be self-created.
A non-functional manager may often have his own ideas in the non-functional or departmental budget. This type may be prepared according to some set standards, or it may be self-created.
The general budget is based on a financial goal for the company and usually does not depend on any of the individual departments and their budget needs. A management budget is formulated independently of any other budget and usually depends on the revenue and expenses of one specific department.
In most cases the budgets are designed with a view to establishing a future financial plan (e.g., revenue, cost of goods sold, expense.
In some organizations budgets are prepared every month; in others, every quarter or every six months. Sometimes there is a need to prepare budgets to be used for planning purposes only (e.g., fiscal year).
Budgeting facilitates decision making by providing information about the future that can be compared with the actual performance of the financial position during the same period of time and can be used as a prediction tool.
A budget should represent a goal, not an exact financial plan. The budget should also consider economic risks and should show clear actions required to achieve these goals.
The main role of budgets and also financial statements is to communicate. Any firm that uses a budget should also publish and communicate its financial status so that the employees are informed about the company’s planning, performance, goals, and risks. These communications should include a description of how the budget and financial status were put together.
A main objective of a company’s budget should be to maintain or increase its financial position, without which it cannot grow and develop. A budget should include forecasts for the current period and for future periods. This will help predict how well the company will do in future or during certain periods, based on past performance, what is needed for achieving the goals (revenue, profit, etc.
Budgets should be structured to enable the company’s management, employees and the board of directors to keep track of performance and the status of budgeted items. Each item in a budget needs to be related to something similar (i.e., every dollar spent on salaries is related to salaries).
Key Features of Organizational Budgets
- An item in a budget should be related to something similar in the past.
- A budget must have clearly defined objectives and measurable goals.
- A budget must be prepared by someone who is familiar with the department or division that he is planning for, and not by an outsider or someone who has no knowledge of this field (e.g., an accountant).
- A budget should not be too ambitious and it should consider the risks involved in achieving certain goals (e.g., if there are no profits for one year one may not increase profit for the next year, especially if there are major changes involved).
- All planned actions should be related to the “percentage” at which each item will increase or decrease.
- It is important that a company’s management and board of directors are aware of what the budget shows and their understanding of how this information is linked to the financial goal, expected cost efficiencies, etc.
- A budget should be prepared in good time before the actual period to enable it to be maintained or corrected if needed.
- A budget should not just show what action will be taken but what action is required on top of this action in order for it to be achieved (e.g., increases in sales and profitability).
- The following information should be included in a budget:
a. the amounts, including net income for each department;
b. amount of sales and cost of goods sold;
c. costs (e.g., salaries, cost of goods sold);
d. other costs (materials, depreciation and maintenance).
e. forecasted expenses and revenue;
f. profit or loss;
g. non-profit activities and whether these will be funded by the company’s management or by donations from outside sources.
h. if the budget can be altered, after the actual period.
- In case of major changes or losses the provisions in the budget should be made accordingly (e.g., profit may be reduced by a certain amount and only then may expenses actually rise).
- A budget must contain a section explaining how all budgets are prepared, how they are revised and what prevents various people from making unplanned changes (e.g., if there is a change in personnel, or if one department or another becomes larger or smaller than expected).
- Budgets should not just mention certain numbers but must show how the numbers are derived accordingly to derive predicted results for the current period, for future periods and from past performance (e.g., net income was $50,000 in January but the budgeted amount for February was only $40,000. This may be because of lower revenue or higher costs).
The budget process can be divided into three stages:
- The initial stage, which involves preparing a budget before starting any new project or implementing any change in activities (or if there is some uncertainty about what will happen).
- The intermediate stage, which involves updating the budget at various stages and after taking action based on actual performance.
- The final stage, which involves issuing a final budget that takes into account the results from the previous stages (e.g., when there is a change in personnel or if one department becomes larger than expected).