TYPES OF BUDGET

A budget is a projection or forecast of the financial performance of a business. A budget is a plan of action that is prepared in advance and expressed in monetary terms.

Managers of a business can use budgets to plan for the business as a whole or to plan for specific responsibility centers, departments, functions, projects, or business units.

Similarly, managers prepare budgets to use over a particular period. Most businesses make a budget annually, although, they can also make monthly, quarterly, or biannual budgets.

There are many benefits to making a budget for businesses. Businesses use budgets as a planning tool for the future. Similarly, they also use budgets as a monitoring and controlling tool to ensure the business follows its set plans and strategies.

Likewise, businesses use budgets to coordinate different business activities to achieve a common goal. Businesses can also use budgets to communicate the objectives of the business to its employees.

Businesses can choose to use different types of budgets. Some of the main types of budgets are listed below.

Fixed Budget

A fixed budget remains fixed regardless of the level of activity of a business. This budget is prepared based on the assumption that there will be no changes in the level of activity of a business.

Businesses use a fixed or standard level of activity as a basis for the preparation of this budget. Fixed budgets are very rigid and inflexible.

These budgets are usually used for short periods or for smaller projects where the level of activity is pre-determined. Businesses don’t use fixed budgets often.

Flexible Budget

A flexible budget, also known as a variable budget, is the opposite of a fixed budget. Businesses design flexed budgets to change according to the level of activity of these businesses.

Initially, businesses prepare flexible budgets with a fixed level of activity, though, once the actual level of activity of a business is determined, they adjust the budget accordingly.

For example, at the start of the year, the business may budget 10,000 units produced at $100,000 but in case the actual production is 11,000 units, the budget will be adjusted according to the 11,000 units, thus, making the production cost budget $110,000.

Rolling Budget

A rolling budget is a budget used by a business that is continuously updated in every accounting period once the previous accounting period has expired. Businesses that use rolling budgets will always have a budget that extends into the future.

These budgets are more accurate as they require continuous updates according to the needs of a business. Rolling budgets are more suited to fast-paced businesses where changes occur constantly and the budgets need to be revised accordingly.

Rolling budgets are mostly short-term budgets, thus, making them more reliable in times of uncertainty. However, these budgets are most costly as they require constant updates and may demotivate managers if they spend a large portion on budgeting.

Incremental Budget

An incremental budget is a budget that is prepared by the management of a business for the current year of the business based on the last year’s budget.

Incremental budgets are mostly utilized in stable businesses where adjustments for inflation are made to previous years’ budgets each year. Incremental budgets are the easiest budgets to make as they require minimal effort.

However, undetected mistakes in one period are likely to get carried over to the next period. Incremental budgets may also decrease some budgets that that departmental managers do not fully utilize in the previous period which can lead to unnecessary spending by the managers to ensure their budgets aren’t cut in the next period.

Zero-based Budget

Zero-based budgets are the opposite of incremental budgets. In zero-based budgets, a business prepares a new budget from scratch for every financial period.

The business does not consider the previous period’s budget when making the budget for the next period. The resources allocated to a particular expense or a particular department are justified for that particular period without considering any prior information during the preparation of these budgets.

Zero-based budgets are more accurate as compared to incremental budgets; however, these budgets can take a long time to make as everything businesses have to do everything from scratch.

Imposed Budget

An imposed budget, also known as a top-down budget, is a budget that is set by the higher authorities in business without letting the lower-level management or employees participate in setting the budget.

Imposed budgets can save quite some time for business as the senior management of the business will set the budget according to the strategies of the business.

Imposed budgets are better for achieving the overall goal of the business rather than the goal of a particular department or project.

Participative Budget

A participative budget, also known as a bottom-up budget, is the opposite of imposed budgets. All levels of management participate in the preparation of these budgets.

Participative budgets can improve the morale and motivation of the lower-level managers and employees as it allows them to set their own goals.

Managers are more likely to follow and accept these budgets as they get to participate in the making of these budgets. Participative budgets are more task and operation oriented rather than strategy-oriented.

Functional Budget

A functional budget, also known as an operating budget, is a budget which relates to specific functions within a business. Functional budgets are prepared for each function in a business and are part of the master budget of a business.

A business makes functional budgets for every function within the business, such as production budgets, sales budgets, purchase budgets, etc.

Master Budget

A master budget is a budget that consists of a summary of all functional budgets of a business. It gives an overall view of the business rather than a specific function within the business. The preparation of master budgets requires consolidating all the functional budgets of a business.

Master budgets mostly come in the form of a budgeted profit or loss account and a budgeted balance sheet of the business.

Conclusion

Budgets are plans or forecasts for the future period of a business. Businesses use budgets for many different purposes such as planning, monitoring and control, communicating, coordinating, evaluating, motivating etc.

There are many types of budgets that businesses may use. For example, they may use fixed budgets, flexible budgets, rolling budgets, incremental budgets, zero-based budgets, imposed budgets, participative budgets, functional budgets and master budgets.

TOP-DOWN BUDGETING

Budgets play an important role in financial planning and control measures. Budgets often represent quantitative measures of performance appraisals known as “targets”.

Deviation from these targets is measured through variance analysis. An organization can take many approaches consistent with its corporate governance set up in the budgeting process.

In large organizations with a more authoritative approach, budgeting is often planned at top-level management. The top-down budgeting is a process defined as:

“Budgeting plan defined by top-level management and communicated towards the middle and lower management for implementation”

As the name suggests, the top-level management decides for the performance metrics and budget targets. This type of budgeting approach suits larger organizations, where top-level management takes all the strategic decisions.

In this approach, top management evaluates the past performances using variance and deviation analysis, incorporates business objectives, and sets new targets. Operational and department managers are often ignored in this budget approach, which may sometimes lead to conflicts.

Operational and department managers receive set budgets often adjusted with historic financial data. Departments then make their detailed budgets for various activities such as material purchases, repairs, and maintenance, labor and energy, and so on.

The allocation of resources and department break-down of budgets is often inflation-adjusted. Also, special consideration is given to specific needs such as new machinery purchase, the launch of a new product, or staff hiring.

The Finance department reviews department budgets regularly, with adjustments made to ensure the total budget targets are achieved.

This approach offers great control to the top level management and makes performance measurement easier.

Some advantages of top-down budgeting include:

  • Budgeting is a complex and complicated job, top-down approach relieves operational and department managers from this cumbersome duty
  • Top-level management has access to the required information and resources to analyze and allocate budget in-line with business objectives
  • Operational managers are tasked with readily set performance targets
  • It offers an increased sense of control and performance measurement

However, the top-down budgeting approach often creates conflicts and has some limitations:

  • Operational and departmental managers find demotivation without participation in the budgeting process
  • The process may prolong and cause delays if the allocated budgets do not match with department needs
  • Top management uses historic data, budgets are set at the beginning of the period which may lead to outdated targets
  • It may cause conflict in the performance appraisal of lower staff

Performance and rewards are closely linked in any organization; however, managers should only be appraised for the controllable actions.

Flexibility and responsiveness can eliminate the friction between top level and lower management in the top-down budgeting approach. One positive aspect of this approach though is it challenges the limitations of department managers and operational staff, which can motivate them to achieve tough targets.

In financial terms, budgets are set as targets, too rigid, and tough targets may lead to demotivation and too easy targets to complacency.

Top management is concerned with business objectives at ideal levels of performance that can be difficult to achieve for operational managers.

Performance measurement can take both financial and non-financial metrics. The budget oriented approach concerns with rigid approach of achieving targets within the set limits.

In contrast, the profit-oriented approach often disregards the budgetary targets and focuses on profit targets.

The non-financial performance measurement may take several parameters for performance appraisal such as customer turnover, staff turnover, customer complaints, etc.

In conclusion, the imposing style of top-down budgeting offers great control to the top management; however, it demands flexibility to achieve effective results.

Increased participation and feedback can enhance the overall performance of the organization. Motivation and rewards are closely linked with performance measurement, so a higher level of participation would result in higher performance.

On one hand, it saves operational managers the time and resources required for the budgeting process. It also challenges them to achieve targets within the set parameters. For top management, the approach provides great control and a performance appraisal tool.

Operating and Financial Budgets

The budgeting process for any company starts with a capital or master budget. The capital budget is a forecast for the company’s long-term financial achievements.

Top level management formulates the master or capital budget during the strategic planning process.

The capital budget is then passed on to the departments or divided into categories by functions e.g. manufacturing and marketing, etc. in general, the master budget can be divided into three categories:

  1. Financial budgets
  2. Operating budgets
  3. Special activity budgets

A Financial Budget is the estimation of all cash flows arising from capital activities. It includes all cash flows from operating activities, capital investments, and changes in equity.

Therefore, the financial budget is reflected through changes in the balance sheet, income statement, and statement of equity for the shareholders.

Financial budgets are long-term in nature, often connected with capital expenditures. Top-level management primarily makes the financial budgets, and then specific roles and tasks are assigned to departments to achieve the set goals.

For any business, there are three key financial decisions: Investment, Financing, and Dividend. All of these decisions require strategic planning.

For example, a business needs to invest in a positive NPV project, for that it will need initial financing. That financing can be sourced through cash balance, bank loan, or equity finance.

Either way, the decision will impact the cash flow for the business, financial budgeting includes all of these cash flows. Financial cash flows come from both operating and financing activities. So in a way, both operating and financial budgets are linked.

An Operating budget is an estimation of all cash flows arising from operating activities of the business. Operating activities make up for the largest portion of expenditure for any business and the most important factor in the unit cost calculation.

Operating expenses and revenues directly affect the cost of goods sold, sales, and hence profits. So operating budget forms a crucial part in performance appraisal for a business.

Operating budgets form the basis of financial budgets, and hence an integral part of the master budget. Operating budgets can be divided according to operating activities depending on the business nature:

  • Manufacturing expenses
  • Raw materials and required labor
  • Sales and marketing expenses
  • Production budgets
  • Sales volume budgets and so on…

Operating budgets are primarily concerned with business operations efficiency. As business sales or revenue increases and expenses are controlled efficiently, profitability increases.

Total sales budgets, sub-divided into sales volume and sales price analysis, manufacturing budgets, and purchases are all integral components of operating budgets.

Operating budgets should be made for the short-term and often require revision. Revised budgets should then be compared for any variances with the original budgets. At the end of the budgeting period, the actual results should be compared with revised budgets.

This operating and planning variance analysis can help achieve operating efficiencies and make operating budgets realistic.

Both operating and financial budgets directly affect the cash flows or the cash budgets of the business. Cash budgets can be categorized as operating and financial activities.

Operating cash flows include:

  • Sales of products and services
  • Procurement of raw material and labor
  • Purchase of manufacturing machinery and tools
  • Marketing and sales expenses
  • Sale or purchase of current assets

Financial cash flows include:

  • Financing facilities such as bank loans
  • Interest payments on existing loans
  • Sale or purchase of capital assets such as land or property
  • Income tax and dividend payments

Both operating and financial budgets provide valuable forecast and control measures to the management. However, both differ in the nature of time, expenses, and revenue streams.

Some of the advantages for both operating and financial budgets are:

Operating BudgetsFinancial Budgets
Estimate expenses and revenue from operating activitiesEstimate revenue and expenses from capital activities
Provides short-term analysisProvide long-term analysis
Concerned with operating efficiencies such as manufacturing, sales, and laborConcerned with capital and financial health of the business at large
Offers critical variance analysis in sales volume, sales price, etcOffers capital assets analysis on the balance sheet and income statement
Planning and operational variances help improve operating efficiencyProvides top management with in-depth analysis for all business activities such as Financing, investing, and dividend

The sequence of budget preparation often depends on the budget approach taken by management, e.g. in a bottom-up budget approach the operating budget will be prepared first.

However, both operating and financial budgets are closely linked, and a variance in one budget will cause a variance in the other.

Incremental Budgets

Perhaps the most traditional approach towards budgeting is incremental budgeting. It starts the budgeting process with historic or past data, analyzes the variances, and makes adjustments for the future period. Apart from variances in previous budgets, any allocations for inflation in costs are also adjusted. As with any traditional budgeting approach, incremental budgeting is also prepared for yearly budgets. It’s a more static or rigid approach in nature, which calls for the achievement of targets within the set parameters or allotted resources. As historic forms the basis of incremental budgeting, it may be difficult to apply for new businesses or unique projects without past data.

Working Example:

Suppose Blue Water Co. produces two products P1 (500 units) and P2 (350 units). The total costs of production for last year were $ 650,000. Estimating 70% variable costs and 30% fixed costs. Product P1 consumed 60% of the variable costs and P2 consumed 40%. The management is planning for the next year budget with additional information:

  • All costs will rise by 3% due to inflation
  • Operational efficiency levels are likely to remain the same
  • Increased production is estimated as: P1 = 650 units and P2 = 400

Required: for product P2 the variable costs for the next budget with incremental budgeting approach.

Solution:

Previous Year costs: Variable Costs = 70% × 650,000 = $ 455,000.

Portion of Product P2 for variable Costs = 40% × 455,000 = $ 182,000.

Cost per unit for P2 = (182,000 ÷ 350) = $ 520.

Inflation Adjustment for next year = (520) × (1+3%) = $ 535.6

Total Variable costs for Product P2 = 535.6 × 400 = $ 212,240.

Budgeting serves various purposes to any business, most prominently control, performance measurement, and communication. Each budgeting approach has its benefits and limitation.

The traditional incremental budgeting approach offers several benefits such as:

  • One of the easiest approaches that do not require any special skills
  • Depending on the past data, only inflation or incremental adjustments are needed to prepare new budgets
  • Easier to understand and implement for the operational managers
  • Suitable for organizations with stable and consistent production levels

However, as with any theoretical approach this method also serves its limitations:

  • Operational managers take inflation or “incremental” adjustments for granted without justification
  • Does not challenge the operational managers to achieve targets beyond set goals
  • Does not emphasize on removing inefficiencies
  • As there is no detailed activity based scrutiny of the past data, previously held inefficiencies in operations may continue
  • Easier to manipulate for the operational managers if the rewards and performance are appraised on the incremental budget indicators

Budgets serve valuable purposes for any organization, for public service sectors the performance appraisals are often non-financial metrics. In such scenarios, an incremental budgeting approach may seem more feasible. It offers a simplistic approach and easier evaluations that suits the public sector organization as their key performance indicators are often qualitative in nature. However, the incremental budgeting approach does not suit rapidly changing manufacturing facilities, which have to adjust often to the market changes.

PROJECT BUDGETING PROCESS:

Every organization takes projects to achieve its objectives both financial and non-financial. For-profit organizations take projects to make profits; not-for-profit organizations take projects to create value.

Estimating and assessing the total costs and revenue attached to a project is the starting point for any project. A project budget can be defined as:

“Estimation of total project costs in every process, task and milestone till completion”.

Budget allocation for a project also depends on the nature and need of the project. For example, a revenue-generating project will need a reliable cost of capital rate to analyze the profitability of the project.

The cost estimations may also take several approaches to the total project budgeting process. Financial resources are a key component of any project, a realistic and well-planned budget can be the final difference between a profitable and failed project.

The project budgeting process can take several approaches; a step by step generalized approach can be listed as:

  1. Pre-planning: The first step in project budgeting should start with identifying the tasks, activities, and milestones for the project. The break-down of the project can help in detail cost estimations and resources in full.
  2. Cost estimation: project activities and resources should be assigned estimated costs. These estimates can take several approaches, we’ll discuss in detail below.
  3. Contingency planning: a fair share of the total budget should be allocated to contingency resources to avoid mishaps during the project completion. It also helps to meet any shortcomings in the pre-planning stage.
  4. Real-time management: this step involves real-time costs and expense management during the project activities. During this step, project cash flows also start, so this step gives project managers an idea of their pre-planned cost estimates too.
  5. Variances: during the project activities there can be positive or adverse budget variances. Operational variances can occur due to several reasons such as idle labor hours, machine inefficiencies, etc.
  6. Reconciliation: although, the final costs of the projects can be aggregated at the end of the project completion, however, reconciliation of costs can take place during the project.

The traditional project budgeting process requires all activity and milestone cost estimated before the project commencement.

Modern project budgeting with a more flexible approach such as activity-based budgeting adopts a flexible approach that continues the reconciliation during the project.

The most critical factor in project budgeting is the cost estimations of activities and resources. Resource estimates will depend on the nature of the project, and will include:

  • Human resources such as skilled and non-skilled labor
  • Machinery and equipment to complete the project
  • Raw material, transportation, packaging, marketing, and sales.
  • Contingency resources to avoid risks
  • Project-specific costs such as project insurance

Cost estimation is the most critical and often difficult task in the project budgeting process. A project manager can take several approaches to estimate project costs.

Activity-Based Approach:

In this approach, each project activity is identified separately and allocated the best-estimated cost. The total project cost then comprises the sum of all activity costs.

Any additional activities occurring during the projects cannot be predicted with this approach, however, can be managed with contingency planning.

Bottom-Up Approach:

From the operational level to the top-level each activity and resource is assigned a cost. This approach is the most detailed and time-consuming yet effective in project budgeting.

Parametric approach:

Projects are often based on set parameters, such as the launch of a new product. Project costs can be allocated on these set parameter basis to estimate the full project budget.

Analogous Approach:

If the project is new and no historic data is available, one way of cost estimation is to compare the project with similar other projects.

Standardized and updated activity-based project is often difficult to identify; however, this approach can offer a simple starting point.

Project budgeting offers management control and a performance measurement tool. The Project budgeting process has several advantages:

  • It offers the most critical planning tool for the project i.e. the financial planning
  • It offers management planning and performance controls
  • Cost estimation and resource allocation helps in project profitability analysis
  • Project budgeting can help in prioritizing different projects if the financial resources are scarce
  • The budgeting process helps to identify critical resources e.g. in an activity-based budgeting approach each activity is allocated costs separately

Pre-planned project budgeting offers great valuable insights to the management, however, there are some limitations attached with project budgeting:

  • Project budgeting is performed way ahead of the real-time commencement which may make the estimates obsolete
  • Project managers may feel a lack of motivation if the budget targets are set too high
  • It is inevitable to see variances in budgets, without careful contingency planning project budgets cannot achieve targets
  • Lack of comparable or historic data may make the project budget estimates unrealistic and difficult to implement

The Project budgeting process starts with the pre-feasibility study of the project. Careful and realistic cost estimations can lead to a well-defined project budget. A flexible and responsive approach towards project during the activities can reduce the variance gaps.

Budgeted Cash flow statement

Introduction:

Managing the cash flow of your business by budgeting is an important technique that you can adopt instead of spending a hectic time counting and remembering where all the money came from and went to.

The cash budget allows you to estimate all your revenues and expenses beforehand and works as a guideline to keep the cash in the check.

The major benefit we get from this is avoiding potential expenses or policies that might lead to losses.

In case, the prepared budget results in negative cash flow then we can alter and adjust our expenditures and revenues accordingly before any such expenses are even incurred.

This helps us maintain a stable financial position of the business and avoid losses.

A budgeted cash flow statement is not the same as the cash budget. The cash budget plainly exhibits how much cash will be received or spent during the year whereas the budgeted cash flow statement portraits the movement of cash.

It gives a detailed explanation of how current assets or current liabilities become a major reason behind the difference in quick ratio and a current ratio of accounting analysis and how a non-cash transaction may deceive or confuse the reader about the profitability and liquidity of the business.

Hence, in order to keep the records clean, a separate budgeted statement of cash flow shall be prepared to portray how the budget plan is affecting the liquidity of the business.

If, for example, a purchase of better quality material is resulting in better profitability but simultaneously the cash flow is negatively being affected then such a policy would only harm the business.

Since the budgeted cash flow statement has identified this before the policy was even implemented, the business can now try a different budget plan and stay clear of any such liquidity crisis.

How to prepare a budgeted cash flow statement?

As per the international accounting standards (IAS), a cash flow statement shall constitute of three main heads namely:

  • Operating activities: These are all the main trading activities that a business performs to generate revenue. Operating activities include all working capital and non-cash adjustments that are to be made to the operating profit earned by the company in order to convert it from the accrual basis of accounting to the cash basis of accounting.
  • Investing activities: Investing activities reports all the money spent on investments in fixed assets or money received from the disposal of such assets.
  • Financing activities: This involves the money that a company raises or obtains in order to fund/finance the company as well as any transactions regarding dividends. Examples include obtaining a loan, issuance of shares, income dividends, etc.

When preparing a budgeted cash flow statement, the first thing you need to know is the forecasted operating profit of the company.

This can be computed by preparing a budgeted income statement that reports the projected sales and expenses respectively.

Secondly, all the working-capital adjustments shall be extracted from the lower-level budgets i.e. the accounts receivable budget, accounts payable budget, the production budget.

After the budgeted net cash flow from operating activities has been derived, the company shall report any assets it plans to purchase at its fair market value expected at that time or plans to dispose of.

These transactions must be based on an investment appraisal analysis resulting in a positive net present value, indicating that the investment will be profitable for the business.

Finally, any expected financing activities shall be reported. For example, the company plans to purchase a plant by raising money from the issuance of shares.

The money received from this transaction shall be added to the financing activities section but deducted from the investing activities section.

Hence, the company shall estimate the market value of shares and fair market value of plants that will be in the future and report these transactions on the budget statement as per the future rates.