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.
1) 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.
2) 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.
3) 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.
4) 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.
5) 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.
6) 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.
7) 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.
8) 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.
9) 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.
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.