What is Budgeting?

Budgeting is the tactical implementation of a business plan. To achieve the goals in a

business’s strategic plan, we need a detailed descriptive roadmap of the business plan
that sets measures and indicators of performance. We can then make changes along
the way to ensure that we arrive at the desired goals.

 .
Strategy into Targets and Budgets

There are four dimensions to consider when translating high-level strategy, such as
mission, vision, and goals, into budgets.

1. Objectives are basically your goals, e.g., increasing the amount each

customer spends at your retail store.

2. Then, you develop one or more strategies to achieve your goals. The

company can increase customer spending by expanding product
offerings, sourcing new suppliers, promotion, etc.

3. You need to track and evaluate the effectiveness of the strategies,

using relevant measures. For example, you can measure the average
weekly spending per customer and average price changes as inputs.

4. Finally, you should set targets that you would like to reach by the end
of a certain period. The targets should be quantifiable and time-based,
such as an increase in the volume of sales or an increase in the
number of products sold by a certain time.
 

Goals of the Budgeting Process

Budgeting is a critical process for any business in several ways.

1. Aids in the planning of actual operations

The process gets managers to consider how conditions may change and what steps
they need to take, while also allowing managers to understand how to address
problems when they arise.

2. Coordinates the activities of the organization

Budgeting encourages managers to build relationships with the other parts of the
operation and understand how the various departments and teams interact with each
other and how they all support the overall organization.

3. Communicating plans to various managers

Communicating plans to managers is an important social aspect of the process, which
ensures that everyone gets a clear understanding of how they support the organization.
It encourages communication of individual goals, plans, and initiatives, which all roll up
together to support the growth of the business. It also ensures appropriate individuals
are made accountable for implementing the budget.

4. Motivates managers to strive to achieve the budget goals

Budgeting gets managers to focus on participation in the budget process. It provides a
challenge or target for individuals and managers by linking their compensation and
performance relative to the budget.

5. Control activities
Managers can compare actual spending with the budget to control financial activities.
6. Evaluate the performance of managers
Budgeting provides a means of informing managers of how well they are performing in
meeting targets they have set.

Types of Budgets

A robust budget framework is built around a master budget consisting of operating

budgets, capital expenditure budgets, and cash budgets. The combined budgets
generate a budgeted income statement, balance sheet, and cash flow statement.

1. Operating budget
Revenues and associated expenses in day-to-day operations are budgeted in detail and
are divided into major categories such as revenues, salaries, benefits, and non-salary
expenses.

2. Capital budget
Capital budgets are typically requests for purchases of large assets such as property,
equipment, or IT systems that create major demands on an organization’s cash flow.
The purposes of capital budgets are to allocate funds, control risks in decision-making,
and set priorities.

3. Cash budget
Cash budgets tie the other two budgets together and take into account the timing of
payments and the timing of receipt of cash from revenues. Cash budgets help
management track and manage the company’s cash flow effectively by assessing
whether additional capital is required, whether the company needs to raise money, or if
there is excess capital.
 
 The Process

The budgeting process for most large companies usually begins four to six months
before the start of the financial year, while some may take an entire fiscal year to
complete. Most organizations set budgets and undertake variance analysis on a
monthly basis. Starting from the initial planning stage, the company goes through a
series of stages to finally implement the budget. Common processes include
communication within executive management, establishing objectives and targets,
developing a detailed budget, compilation and revision of budget model, budget
committee review, and approval.

Who is a Budget Head?

The person who is ultimately responsible for the framing and creation of the budget for a
project is known as the Budget Head for that project. The budget itself is a document
that lists the expected revenues and expenditures associated with a project.

The term project here encompasses a very large number of activities. Each of these
activities would, in turn, have a slightly different type of budget and correspondingly, a
Budget Head associated with it. However, broadly speaking, these activities can be
classified into three groups: Individuals, Companies, and Governments. These are
examined in the next section.

 
Individuals
An individual planning out the monthly spending for himself and his family based on the
family income and expenditure. In this case, the Budget Head could be the head of the
family who makes all the financial decisions for the family.

Corporations
A company planning out its business activities for the first quarter of the year based on
its expected earnings and expenditures. In this case, the Budget Head could be a
financial expert or an industry expert who works for the company.

Depending on the size of the company, the Budget Head might have a varying number
of people working under him. For example, a Budget Leader working for a small
business might work alone or employ just a handful of people, whereas a Budget Head
working for a large business might have an entire department of people working under
him. 

Governments
A government planning out its expenditures (public spending) and revenue for an entire
financial year. This is referred to as the government budget and is based on policies the
government intends to follow.

For example, in the United States, Republicans traditionally favor lower government
expenditure and lower government revenue (in the form of lower taxes), whereas
Democrats traditionally favor higher government expenditure and higher government
revenue (in the form of higher taxes). In the case of the government budget, there
usually exists an entire government department that works towards framing the budget.

Key Responsibilities of a Corporate Budget Head

Every decision a company makes is directly or indirectly influenced by its budget. Thus, it is no
surprise that the Budget Head of a company plays a very important role in its success or failure.
The Budget Head must have a keen understanding of the company and the industry it operates
in. It’s important that the company owners (shareholders) and the Budget Head share the same
goals for the company.

It is important to note that while the Budget Head is in charge of framing the budget, he or she
might not be in charge of ensuring that the budget is followed. This responsibility can fall on the
Budget Holder. In some cases, especially for large companies and governments, the Budget
Holder and Budget Head are two different individuals. It is essential for a company to ensure
that the Budget Head and Budget Holder have the same goals for the company.

Because a company’s future revenues and expenditures are unknown, the FP&A team has to
estimate these values while framing the budget. This is an especially difficult task, as there is
almost an infinite number of things that can affect the company and industry in the future. The
Budget Head must account for these uncertainties and take steps to minimize the risks for the
company while framing the budget.

The Budget Head must work closely with the Budget Holder and other people in charge of the
budget’s implementation. A budget that cannot be implemented is useless and serves no
purpose.

What is an Operating Budget?

An operating budget consists of all revenues and expenses over a period of time (typically a

quarter or a year) which a corporation, government or organization uses to plan its operations. 
An operating budget is prepared in advance of a reporting period as a goal or plan that the
business expects to achieve.

Components of an Operating Budget

The main components of an operations budget are outlined below.  Each business is unique
and every industry has its nuances, but these items are general enough to apply to most
industries.

#1 Revenue
Revenue is usually broken down into its drivers and components.  It’s possible to forecast
revenue on a year-over-year basis, but usually, more detail is required by breaking revenue
down into its underlying components.
Revenue drivers typically include:
 Volume (units, contracts, customers, products, etc.)
 Price (average price, per unit price, segment price, etc.)

 
#2 Variable costs
After revenue, variable costs are determined.  These costs are called “variable”
because they depend on revenue, and are often calculated as a percentage of sales.

Variable costs often include:
 Cost of goods sold
 Direct selling costs
 Sales commissions
 Payment processing fees
 Freight
 Certain aspects of marketing
 Direct labor

#3 Fixed costs
After variable costs are deducted, fixed costs are usually next.  These expenses
typically do not vary with changes in revenue and are mostly constant, at least within
the time frame of the operating budget.
Examples of fixed costs include:
 Rent
 Head office
 Insurance
 Telecommunication
 Management salaries and benefits
 Utilities

#4 Non-cash expenses
An operating budget often includes non-cash expenses, such as depreciation and
amortization.  Even though these expenses don’t impact cash flow (other than taxes),
they will impact financial reporting performance (i.e. the figures a company reports at
the end of the year on their income statement).
 
#5 Non-operating expenses
Non-operating expenses are those that fall below Earnings Before Interest and Taxes
(EBIT) or Operating Income.  Examples of expenses that may be included in a budget
are:
 Interest
 Gains or Losses
 Taxes
 

#6 Capital costs in an operating budget

Capital costs are usually excluded from an operating budget.  The term operating refers
to a statement of operations (income statement) which does not include capital
expenditures.

Most companies prepare a separate budget for capital investments.

 

Master Budget
What is Master Budget?

All the functional division of the organization prepares the budget for the particular
division. The master budget is the sum total of all the divisional budgets that is prepared
by all the divisions. Further, it also includes the financial planning, cash-flow forecast
and budgeted profit and loss account and balance sheet of the organization. It is the
goal of the organization to reach a level in a particular period. Normally master budget is
prepared for a year.

Sometimes, it may be misunderstood that master budget is one large budget of the
organization. However, it is not the case. Master Budget is the summary of the
divisional budget. It is a continuous financial plan.
 Steps to Prepare Master Budget

Sales Budget
The sales budget is the foundation of the master budget. All the procurements, staff
requirements and administration cost are based on the sales. First and foremost, the
number of units to be sold and price per unit are derived. On the basis of that, the value
of sales is calculated.

The sales budget is prepared based on considering the following factors:

 Market demand estimation
 Production capacity or an infrastructure facility
 Current supply facility
 Industry analysis

Market demand and production capacity are determined with the help of Marketing
division and production division respectively.

Production Budget
The production budget is mainly based on the sales budget. However, following factors
shall be considered;
 Inventory at the beginning of the year
 Inventory to be maintained at the end of the year
 Number of units manufactured
 Buffer stock to be maintained throughout the year

The production budget is divided into further three parts

 Direct material budget
 Direct labor budget
 Manufacturing overhead budget

If the company is not having manufacturing unit, we require a number of units to

purchase instead of the production budget.

Capital Asset Acquisition Budget

The plant, machinery, and equipment require periodical maintenance and replacement.
If the sales target is higher than the previous period, new plant and machinery also
need to be introduced. Therefore, careful planning of the capital asset has to be done.
A financial budget is an integral part of Master Budget.

Cash Budget
For all the divisional budgets, the organization requires cash. It needs to ensure that
during the year it does not run out of the cash due to poor planning in preparation for
the budget.
On the basis of the sales and production budget, it is derived that what is the expected
receipts and what are the expected payment. Receipt and payment cycle of the
customer and supplier need to be analyzed. At this stage, the organization decides
whether the external borrowing is required or not.

All the administration expenses such as interest on borrowing, staff cost, office rent,
legal expenses, office supplies etc. are to be considered while preparing cash budget.
Some factors also are dependent on the sales budget such as CEO’s salary based on
performance or the performance bonus to sales staff.

Budgeted Income Statement

On the basis of the above budgets, the budgeted income statement is prepared.
Budgeted Income statement includes following;
Particulars Amount

Budgeted Income –

Less: Budgeted Expenses –

Budgeted profitability –

Budgeted Balance Sheet

The budgeted balance sheet is prepared once the Budgeted Income Statement is
prepared. Budgeted balance sheet indicates following:

Particulars Amount

Budgeted Assets

Plants & Machinery –

Equipment –

Accounts receivables –

Inventory –

Total Assets —

Budgeted Liabilities

Share Capital –
 Retained Earnings –

Accounts payable –

Income tax payable –

Short term loans –

Long-term loans –

Total Liabilities —

All the divisional budgets are interrelated. A mistake in preparation for any budget leads
to a mistake in the master budget. Hence, it is recommended to prepare the budget
which is ambitious but achievable and not a fairy tale.

Applications of Master Budget

Important Planning Tool

The master budget is considered one of the most important planning tools for an
organization. While planning, top-level management discusses the overall profitability
and the asset and liability position of the company. For which, the master budget is
being used.

Measures Performance
Master budget measures the performance of the organization as a whole.  It helps in
departmental control and setting in departmental accountability. It helps in improving the
efficiency.

Interdivision Coordination:
The master budget is used for the interdivisional coordination amongst the divisions of
the organization. It helps and ensures that coordination with the other divisions is
properly made.

Advantages of Master Budget

Motivation to Staff
The master budget serves as a motivation tool on the basis of which the employees can
compare the actual performance with the budgeted performance. The Master Budget
helps staff in getting job satisfaction as well as a good contribution to the growth of the
business.

Summary of the Divisional Budget

Master budget works as a summary budget for the overview of the business owners and
the management. The master budget indicates how much the organization is earning
and what the expenses are incurred as a whole.

Planning in Advance
The master budget identifies the unusual problems in advance and fixes the same. For
instance, one of the company divisions is not performing well and the expenses incurred
are exceeding the set budget limit. This results in the lower profitability of the company.

Helps in the Achievement of Goal

The organization has short, medium and long-term goals. A master budget helps in
achieving the long-term goal of the organization. All the resources of the organization
are channelized and controlled for optimization of the profit.

Continuous Improvement
The master budget is a continuous process. Each year the organization prepares the
master budget and it works as a tool of analytics. The variances are identified and the
worked upon for better results on a continuous basis.

Disadvantages of Master Budget

Rigidity
The divisional staff is forced for the achievement of the target despite having practical
difficulties in achieving the same. It is because of the pressure from the top
management. This leads to low revenue estimates and higher expense estimates.
Managers may not consider new opportunities for the growth of the organization.

Difficult to Update
The master budget is not easy to modify. To add, alter or delete small change requires
a lot of steps in the entire budget. It includes lengthy descriptions and charts. Hence, a
master budget cannot be easily understood as a layman.