Budget Models

What is a Budget?

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.

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 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:

CATEGORY BUDGET AMOUNT ACTUAL AMOUNT DEVIATION
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, the scale of operations are some of the factors which 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 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

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. For every new year, goals are set afresh and the budgets are built accordingly. It represents are very dynamic and fast-paced form of budgeting. However, it may be a time-consuming process to start from a scratch every year. Also due to fresh revisions every year, the departments always remain in an uncertainty of the funds that may be allocated to them. This may impact their productivity and consistency.

Static Budget

A static budget is one which remains fixed throughout the period under question irrespective of the level of activity. The anticipated figures of 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. Thereafter, 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 lack of an all accommodative approach. A static budget is ideal for firms with predictable sales such as utility companies and PSU’s.

Flexible Budget

A stark opposite of static budgets, a flexible budget is designed to display the forecasted budget at various levels of activity. Certain expenses being a direct function of sales are expressed as a percentage of the same. Sales commission, packaging, material are examples of the same. Then there are fixed expenses which remain constant irrespective of the level of activity. They are hard-coded into the budget and do not change. Examples include lease rentals, license fees, 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
Labour 10%  $75,000  $1,12,500  $1,50,000
Power & Fuel 12%  $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 [A-(B+C)]  $2,47,500  $4,65,000  $6,82,500

Rolling Budget

A rolling budget also called a continuous budget is a form of an 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 over 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 budgeted.
=Standard Cost – Actual Cost
=(SH*SR)-(AH*AR)

Sales Price Variance

Measures the impact on revenue caused by actual selling price differing from budgeted selling price. It is measured by tweaking the prices and referring to actual quantity sold.
=Actual Sales-Budgeted Sales
=(AP*AQ)-(BP*AQ)

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

Material Labour
SQ (kg) SR($) AQ(kg) AR($) SH(hours) SR ($ per hour) AH(hours) AR ($ per hour)
A 500 2 550 2.5 Skilled 200 3 210 3.2
B 750 3 740 4 Unskilled 100 1.5 120 1.5

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 as below:

  • A budget is a financial plan emphasizing on 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 an 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 efforts in the right direction.

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Standard Costing . CDN. October 2018. [PDF]
Last updated on : October 8th, 2018

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