Budget Models

What is a Budget?

A budget is a financial plan of expected cash inflows and outflows that a business generates. A sound budget guides the business managers regarding the funds at hand and effective spending of the same. Having a tight budgetary policy is indispensable for any organization that wants to succeed. Without one, a business might as well be shooting in the dark. It is what sets the boundaries for any organization. It represents the maximum financial resources at their disposal using which they must achieve all business targets. Let us see about the budget model in detail.

The saying – “Failing to plan is planning to fail,” is very apt here. A business with great products, dynamic management, or a dominating client base may still fail if it does not mind its margins. Without a budget, a company is directionless. With a budgetary policy in hand, the firm will always be aware of the cash on hand and save itself from running into debt. Also, a realistic budget goes a long way in setting out the long-term financial requirements of the firm, enabling a firm to prepare in advance for contingencies.

Budget Template

A fundamental budget tableau consists of a list of very basic items. It gives a list of budgeted income and expenditure and compares them with the actual. Deviations in such figures are undesirable and must be reported to the management for corrective action. Overspending indicates gross negligence and a lack of control over expenditure. On the other hand, under-spending may mean that the company is not utilizing its resources to the fullest extent and thus remains unable to achieve its true potential.

Below mentioned is a suggestive budget template:

CATEGORYBUDGET AMOUNTACTUAL AMOUNTDEVIATION
Sales Revenue   
Other Income   
TOTAL INCOME   
EXPENSES   
Accounting Services   
Advertising   
Estimated Taxes   
Installation / Repair of Equipment   
Interest on Debt   
Inventory Purchases   
Loan Payments   
Payroll   
Professional Fees   
Rent/Lease Payments   
Utilities and Telephone   
Vehicle Expenses   
TOTAL EXPENSES   
TOTAL INCOME MINUS TOTAL EXPENSES   

The budgeted figures derived may be based on several assumptions. The expected turnover, forecasted growth, current demand, and the scale of operations are factors that influence the budgetary figures. A very simple and effective approach is to build upon the number of previous years to arrive at the current year’s forecasts. Along the way, some tweaks are made to adjust for factor-specific changes that have occurred in the current year.

Below mentioned is a derivation of a single line item :

Previous Year Purchase

(+/-) Adjustment for orders

(+/-) Adjustment for change in prices

(+/-) Adjustment for applicable taxes

= Budgeted Purchases

Budget Models

Types of Budgets

Various types of budgets include:

Zero Based Budgeting

As the name goes, zero-based budgeting starts from zero. It does not borrow from any prior budgets. It is a management-based budget. The only factors considered are leadership vision and priorities. Goals are set afresh for every new year, and the budgets are built accordingly. It represents a very dynamic and fast-paced form of budgeting. However, it may be a time-consuming process to start from scratch every year. Also, due to fresh revisions every year, the departments always remain uncertain of the funds that may be allocated to them. This may impact their productivity and consistency.

Static Budget

A static budget is one that remains fixed throughout the period under question, irrespective of the level of activity. The anticipated figures for expenses do not change with the change in the level of sales. For example, if a firm sets out its commission expenses to be $300,000. After that, the budgeted commission for the year shall remain $300,00 irrespective of whether the sales stand at $2 million, $5 million, or $10 million. Obviously, actual results will vary widely due to the lack of an all accommodative approach. A static budget is ideal for firms with predictable sales, such as utility companies and PSUs.

Flexible Budget

A stark opposite of static budgets, a flexible budget is designed to display the forecasted budget at various activity levels. Certain expenses being a direct function of sales are expressed as a percentage of the same. Sales commission, packaging, and material are examples of the same. Then there are fixed expenses that remain constant irrespective of the activity level. They are hard-coded into the budget and do not change. Examples include lease rentals, license fees, and salaries, among others.

Below is an example of a flexible budget at different activity levels:

Level of Activity 50%75%100%
Sales (A)  $7,50,000  $11,25,000  $15,00,000
Variable Expenses    
Material 15% $1,12,500 $1,68,750 $2,25,000
Labour10% $75,000 $1,12,500 $1,50,000
Power & Fuel12% $90,000 $1,35,000 $1,80,000
Commision 5% $37,500 $56,250 $75,000
Total Variable Expenses (B)  $3,15,000  $4,72,500  $6,30,000
Fixed Expenses    
Rent   $1,50,000 $1,50,000 $1,50,000
Licence Fees   $37,500 $37,500 $37,500
Total Fixed Expenses (C )  $1,87,500  $1,87,500  $1,87,500
Budgeted Surplus   $2,47,500 $4,65,000 $6,82,500

Rolling Budget

A rolling budget, also called a continuous budget, is a form of ongoing budget drafting. It involves extending the existing budget to keep adding newer layers. As soon as a reporting period concludes, the budget for the next period must be immediately prepared and added to the existing one. In this way, the company always has a budget that extends over a 12-month horizon. For example, a firm has a reporting period stretching from January to December. Now, when the budget for January expires, the firm must prepare and attach a budget forecast for the January month of the coming year. This way, it sits over a 12-month budget-stretching from February to January.

Budget Variance Analysis

A budget is only an estimation based on a number of assumptions. Its main aim is to provide a ballpark number. The management then strives to operate within those boundaries. Deviations in actual results are inevitable. It is, therefore, necessary to trace them.  Variance analysis and reconciliation of actual and budgeted figures are necessary to bridge the gap in operations. The results of such variance study provide valuable insights into the operational aspects, thus uncovering areas for improvement.

Let us go through a few types of variances:

Material Cost Variance

Measures the impact on total material cost due to the difference in actual quantity and cost of materials consumed.

= Standard Cost – Actual Cost

=(SQ*SP)-(AQ*AP)

Labour Cost Variance

Measures the impact on total labor cost caused by changes in the labor mix, wages, and actual hours from the budget.

=Standard Cost – Actual Cost

=(SH*SR)-(AH*AR)

Sales Price Variance

Measures the impact on revenue caused by actual selling price differing from the budgeted selling price. It is measured by tweaking the prices and referring to the actual quantity sold.

=Actual Sales-Budgeted Sales

=(AP*AQ)-(BP*AQ)

The following example  provides a brief understanding of the concepts of variance analysis:

MaterialLabour
 SQ (kg)SR($)AQ(kg)AR($) SH(hours)SR ($ per hour)AH(hours)AR ($ per hour)
A50025502.5Skilled20032103.2
B75037404Unskilled1001.51201.5

Material Cost Variance

A: (500*2) – (550*2.5) = $375 (Adverse)

B: (750*3) – (740*4) = $710 (Adverse)

Total = $1085 (Adverse)

Labour Cost Variance

Skilled: (200*3) – (210*3.2) = $72 (Adverse)

Unskilled: (100*1.5) – (120*1.5) = $30 (Adverse)

Total = $102 (Adverse)

Budgeting Vs Forecasting

Budgeting and forecasting are terms often used simultaneously. However, they are not interchangeable. There lie distinct differences between the two, discussed below:

  • A budget is a financial plan emphasizing the monetary constraints to be adhered to by an organization. A forecast is a futuristic outlook of important variables such as sales, profit, and consumer habits.
  • A budget is based on the existing scale of operations of the company and borrows from actual numbers of the previous year. A forecast is anticipation of predicted patterns based on various trends and correlation research.
  • A budget is a long-term statement generally involving annual updates. Financial forecasts are dynamic and active.  Therefore, regular revisions are important to maintain its authenticity.

The effective conciliation and coordination of budgeting and forecasting figures play a key role. It ensures that the company has set an appropriate goal for itself in terms of budget. And forecasting results keep the management assured of routing the company’s efforts in the right direction.

Read more on Budgeting vs. Forecasting



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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