Budgeting Basics

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The purpose of this article is to draw attention to the basics of constructing and using a financial budget.

A budget is a tool that is intended to provide management with a control mechanism for monitoring the organization’s performance. The organization’s performance is evaluated on the basis of financial inflows (income) and financial outflows (expenditures).

Budgets are financial plans. These plans are based on key future assumptions concerning the “drivers” that will determine whether the particular organization will be successful. For example, one could argue that a key assumption within their budget, or financial plan, would be a certain level of sales activity (i.e. units sold) because units sold is a driver that affects sales revenue. And everyone would agree that an organization would need to realize a certain level of sales revenue to be successful.

Budgets are comprised of a set of “targets.” These targets can be both financial as well as non-financial in nature. Typically, financial targets would be, for example, any of the elements appearing in the organization’s financial statements. The payoff from tracking financial targets in a financial statement format and order is simple: it facilitates matching target performance with actual performance. This, in turn, generates variances that need to be identified and reconciled. Management should then evaluate the impact of various operational courses of action (including non-financial courses of actions) when constructing and modifying their budget.

The budgeting process is not intended to operate in a vacuum. The budget is intended, however, to be something that communicates to management key information that forms the basis for decision making. Budgets are in no way intended to be fixed in stone, so to speak. The budgeting function should include an ongoing, frequent budget review process. The review process is intended to ensure your company has an effective, adaptable budget that reflects moving variables within the company and its industry.

If a proposed course of action has been anticipated in the budget, then managers will feel confident in making a decision to go ahead. But if a proposed course of action has not been costed in the budget, then managers will understand that going ahead with the action will entail financial risk.

Note the following principles of budgeting, as noted by LeoIsaac.com, which have been suggested as rudimentary to the budgeting process. Failure to engage in such fundamental, sound budgeting processes would rank as one of the main reasons why companies and organizations fail:

  • Be conservative in your estimates, not overly optimistic.

    Try to build in a safety factor by tending to underestimate your income and overestimate your expenses. There will always be unexpected events; therefore, a common strategy in developing a budget is to insert an additional expense called “contingencies.” This creates padding to protect you from the unexpected.

  • Engage In Teamwork

    Skillful delegation is crucial for healthy financial management. The task of budgeting should be split and allocated among those individuals who have the best chance of knowing what expenditure is likely to be needed and what income is reasonable to expect.

  • Time and Patience

    Don’t rush it. A good budget may be worked on for several weeks, if not months, adding and changing figures as new information comes to light. In other words, do not be afraid to take lengthy periods of time to refine your budget to perfection. Plan ahead for this budget-shaping period to ensure your company gives the process enough time to work properly.

  • Documentation

    It is very important that the author(s) of the budget document every step of the budget-shaping process. This means putting their reasoning behind decisions in writing and striving to produce documents that can be read and understood by anyone. This documentation will also serve as valuable references for future budget planning projects.

  • Training

    Ensure people who have a significant role in the budgeting process have a reasonable understanding of the principles of budgeting and how it relates to the strategic and operational plans.

  • Sign-Off

    Ensure that all persons formally involved in the budgeting process agree to the final iteration of the budget.

Often there is some confusion between what a “business plan” is and what a “budget” is. Many have the misconception that the business plan and the budget are one and the same thing. Nothing could be further from the truth.

On one hand, the business plan is geared toward identifying the goals, objectives, and other elements that go into the organization’s strategic plan. The view of the business plan is strategic, in the sense that an organization’s “strategy” is something that will take multiple years to achieve. The strategic plan typically covers a span of time of greater than one year.

The budget, on the other hand, is typically a tool that has a lifespan of one year. Being “on budget” in the annual sense will hopefully have an additive effect and result in the organization’s overall strategy being achieved. It is the norm, however, that the business plan be reviewed and updated on an annual basis in order to regain control of any operational situation gone bad. Strategic plans, however, are typically not updated as frequently as the budget.

As mentioned earlier in this discussion, budgets are meant to be frequently reviewed and updated. During the budget update process there is a high degree of manipulation of budget assumptions that needs to take place. The use of spreadsheets to create and maintain the company’s budget, for example, is critical.

Excel is widely recognized as the spreadsheet program of choice to use for creating and maintaining budgets. Excel is especially known for its flexibility in the budget creation process and the relative ease with which the program can be used to create reports, detailed worksheets, and summary worksheets.

Perhaps the most widely used budget report is the “actual vs budget variance report” (“variance report”). This four-column report typically presents a column of actual results against a column of planned results (budget) alongside a column with the $ amount variance between actual and budget and lastly a column with the % variance between actual and budget. This report displays variances in a fashion that makes the budget review process easier and more efficient.