Budget / Budgeting
Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Copyright © 2011 by Marty J.Schmidt. Revised 14 January 2012.
The Meaning of Budget and Budgeting Terms
In business, a budget is a forecast or plan of an organization's income and/or expenses for a period of time into the future. Budgets are used in many organizations:
- To support funding requests (by describing how funds will be used).
- To control spending, to ensure that available funds are used according to plan and that spending stays within preset limits.
This item defines the term budget, in context with closely related budgeting terms, including:
• Budget | • Flexible budget |
• The Budgeting Concept
• The Definition of Capital and Operating Budgets
- Capital Spending vs. Operating Expenses
- Capital Budgets
- Operating Budgets
• Cash Budgets
• The Budget Cycle/Budgeting Process
• Zero Based vs Incremental Budgeting
• Budget Variance Analysis and Flexible Budgets
The Budgeting Concept
In its simplest form a budget is just a list of spending items and/or incoming revenue items, with a budgeted figure for each item. As time passes, the actual spending or revenue may be entered into the budget to compare with the budgeted figure. The difference between the two figures is called a variance.
A company's quarterly operating budget, for instance, may forecast spending for employee training. The annual training spending figure may be set first but for management and control purposes, this may be broken down further into monthly or quarterly figures. Two quarters into an annual budget cycle, the budget item "employee training" might look something like this:
A variance for each quarter is computed by subtracting budgeted spending from actual spending. The variance is typically presented both in currency units and as a percentage of the budgeted figure. A positive variance means that spending is over budget, and a negative variance means that spending is under budget. (Note that many people prefer to show overspending as a negative figure, by calculating spending variance instead as the Budget figure less the Actual figure.)
In the real business world, some variance between actual and budgeted figures is normal and expected. Large quarterly variances, however, call for either (1) adjusting the budgeted figures to represent the new expected reality, or (2) controlling actual spending in future quarters so that the yearly variance comes closer to zero. (For more on these options, see the section Budget Variance Analysis and Flexible Budgets below).
Most organizations practice budgeting with a budget hierarchy. That means that budgeting begins with high level budgets, such as the company wide (or organization wide) capital and operating budgets. In these high level budgets, budget items correspond closely to the revenue and expense items in the organization's chart of accounts. These are really categories of spending and incoming revenues. Lower level budgets may further divide higher level categories, or even represent single, specific revenue or spending items.
Here, for instance, are a few of the budget levels in one company's budget hierarchy:
In setting budget figures, senior management is responsible for authorizing spending amounts for high level categories (e.g., the "Marketing Budget" above). Middle and lower level managers in Marketing will be responsible for dividing the "Marketing budget into authorizations for categories such as market research and advertising.
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The Definition of Capital and Operating Budgets
At the top of the budget hierarchy in most companies and organizations stand two major kinds of budgets, a capital budget and an operating budget. These two kinds of budgets do not overlap: they handle distinctly different spending categories. Capital and operating budgets, moreover, are built through different budgeting processes, by different managers, and they use different criteria for prioritizing and deciding spending.
Capital Spending vs. Operating Expenses
Whether or not an expenditure qualifies as a capital expenditure (CAPEX) or as an operating expense (OPEX) depends on what is purchased, what it will be used for, and also upon the country's tax laws. Companies and organizations normally designate specific criteria that must be met for an acquisition to qualify as "capital," such as a minimum useful life (e.g., one year or more) and a minimum purchase price (e.g., $1,000).
The tax authorities also have a say in what may be considered a capital expense because capital items go onto the company's balance sheet as assets, and on the income statement they create a depreciation expense for each year of the asset's depreciable life. This depreciation expense lowers reported income (profit), thereby creating a tax savings for each of these years. Spending on operating expenses, by contrast, impacts reported profit and taxes on earnings only in the single reporting period they are incurred.
Deciding what can and what cannot be called a capital expenditure, therefore, often requires knowledge of local policy and local tax laws. Some expenditures for business start up costs, for instance, can be capitalized in the United States and some other countries, but not all countries. In some localities, the costs of professional services (such as systems integrations services) can, under some conditions be "bundled" into the full capital costs of acquiring assets (e.g., a large IT system).
Acquisitions that typically meet company and government criteria as "capital assets" typically include such things as purchased:
- Vehicles
- Factory machinery and production equipment
- Store equipment and furnishings
- Laboratory equipment
- Large IT systems (Hardware and/or Software)
- Buildings
- Office Furniture and Office Equipment.
Operating budgets, by contrast, address spending on predictable, repeatable costs for items or services that are not registered as capital assets and are not depreciated. That means the company charges the full amount against income during that reporting period, and takes all tax consequences for it during that period.
Operating budgets typically address spending for such things as:
- Employee salaries/wages and overhead
- Office space rental and utilities costs
- Employee travel and training expenses
- Marketing communication / advertising expenses
- Telephone and internet services
- Outside consultant fees
Note that there is also a major income statement category called "Operating Expenses," which appears beneath the gross profit line, and above Extraordinary Items and above Financial Income/Expenses. (i.e., income statement "Operating Expenses" do not impact reported gross profit or gross margin). When used in the budgetary sense, however, the term "operating expense" can include expense items above and below the income statement's Operating Expenses category. Wages for direct labor in product manufacturing, for instance, are planned in the Manufacturing operating budget, but they can appear on the income statement as part of "Cost of Goods Sold," not as an income statement "Operating Expense."
Capital Budgets
Capital budgets plan spending for capital expenditures (CAPEX), the acquisition of capital assets—usually long lasting, expensive acquisitions that go onto the company's balance sheet as assets. On the company's income statement, capital assets contribute to depreciation expense throughout their depreciable lives.
The capital budget typically results from a capital review process by which a company selects from potential, proposed mid-range or long-range capital asset investments.
When deciding which capital investments to make, companies usually use a combination of formal financial criteria, including net present value (NPV), internal rate of return (IRR), return on investment, and payback period. Potential investments are also evaluated with respect to strategic consistency and risk. And, because capital budgeting is designed to maximize value, investments should be undertaken only when expected returns are equal to or greater than the average cost of capital.
Capital budget planning is usually accomplished through an organization's Budget Office or through a Capital Review Committee, which establish their own criteria for prioritizing proposals and for setting the capital budget ceiling. As the above suggests, an entity’s capital budget and budgeting process are usually quite distinct from its operating budget and budgeting process. The two kinds of budgets represent different expenditures, are planned through different processes, use different criteria, and may involve different managers.
In order for a specific expenditure to be funded from a capital budget, its sponsors may have to justify it with a formal business case analysis, including estimates of NPV, IRR, payback period and other financial criteria. If the company has limited funds for capital spending, moreover, the potential capital expenditure may have to enter a competitive capital review process, where all requested expenditures are compared on the same financial criteria and only the most favorable receive funding.
Those who propose or request funding for capital expenditure will want to be sure they understand
- The organization's criteria for prioritizing capital expenditure proposals.
- The timing of the current and next capital budget cycles.
- The current or expected capital budget ceiling.
Operating Budgets
Generally, an operating budget is a budget covering operating expenses (OPEX) for normal operations. Operating expenses can be budgeted and accounted for on a monthly, quarterly, and/or annual basis. Operating budgets are usually fixed through a process different from that used on capital budgets (in some companies, all management above a certain level participate in the process). Operating budgets, once fixed, are usually not changed during the period—except maybe for emergency reductions following unexpectedly poor sales results or other disasters. In other words, operating budgets are more often treated as static budgets, rather than flexible budgets.
Operating budgets for a company or organization are especially likely to be organized hierarchically, as in the example near the top of this page. A company's overall operating budget, for instance may be partitioned into operating budgets for different departments (Manufacturing, Marketing, IT, Design Engineering, Customer Services, etc). Each Departmental budget may be further partitioned into budgets for different functions (.e.g., Marketing budgets for advertising, for advertising agency expenses, for marketing events, and so on).
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Cash Budgets
A cash budget is a tool for planning and controlling near-term spending, normally including both incoming cash flows (incoming revenues) and cash outflows (spending on expenses). In business, the cash budget serves a purpose similar to the check register used by individuals to track deposits and checks for personal checking accounts. From the cash budget, one can see immediately the level of cash on hand and how that will change with spending,
Cash budgets are typically planned with a series of months in view, although they can also show cash revenues and spending on a weekly, quarterly, or annual basis. The distinguishing feature of the cash budget is that it represents actual cash inflows and outflows in the period they occur. This contrasts with the system of accrual accounting which most companies use for their financial reporting, in which receivables and liabilities are reported for the period in which they are incurred, even though the actual cash transactions may occur in another period.
A small company's monthly cash flow budget may look like this example:
The example shows the cash budget as it stands in mid February. All figures for January are now history and will not change. "Actual" figures for February are current as of mid-month, but these may change by the end of the month.
This example includes forecast inflows and outflows, actual inflows and outflows, and a computed variance for each item. The variance is the actual figure less the budgeted, or forecast figure. With this convention, a positive variance means that inflows or spending were above the forecast amount, and a negative variance means the actual amount was less than planned. Notice in the example that actual cash on hand at the end of January (Cash income less cash expenses = $131,614) is carried over to February as actual starting cash for that month.
When large variances appear between forecast and actual inflows or outflows, the cash budget helps identify the source of the variances. In the budget above, for instance, the overall negative cash flow variance for January was not due to overspending in that month, but rather, the variance clearly results from product and service sales revenues falling below forecast. For future months, the manager's options are to either (1) take action to increase incoming revenues, (2) or to lower the forecast revenues and spending figures.
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The Budget Cycle/Budget Process
Companies and organizations typically develop and implement budgets on a periodic basis at fixed intervals. The norm in private industry is to produce a budget for each fiscal year. Some government organizations also prepare annual budgets, but two-year (biennial) budgets are also common in government. Although budgets are sometimes adjusted in "real time" (that is, they are treated as flexible budgets after start of the budgeting period they cover), such changes are exceptions to the normal rule, which is to keep the budget intact (static) once implemented.
In the period of time between issuance of one budget and the next, budget-related decisions and plans are referred to as the budget cycle, or budgeting process. In large companies, large educational institutions and non profit organizations, and in government organizations, the budgeting process normally extends across months, if not the entire period between budgets.
For those involved in the budgeting process, there can be many specific steps and requirements to meet, and the nature and timing of these vary widely among companies and organizations. Most large organizations in fact publish a description of their own budgeting process, budget calendar, and budget approval requirements on the internet. This information is sometimes publicly accessible, or it may be accessible only to employees with authorized access to it. In any case, anyone setting out to prepare a budget or budget request for the first time will normally begin by accessing this source.
Although specific steps and timing vary from organization to organization, the budgeting process everywhere almost always includes steps for:
- Assessing variances between actual and budgeted figures in the previous period's budget.
- Identifying and then prioritizing business needs and objectives for the forthcoming budgeting period.
- Identifying and evaluating
- Incoming revenue forecasts.
- Current trends or changes that may have budgetary implications, such as new mandates to reduce spending, expected changes in staffing levels, or changes in expected business volume.
- Risks or potential emergencies that could impact either incoming funds or spending needs.
- Ensuring that individual budget proposals within the complete budget package are prepared in consistent format, and that proposals competing for funds can be compared fairly.
- Ensuring that procedures and methods are in place for implementing the budget and monitoring actual spending and incoming revenues.
- Packaging and communicating budget requests to those responsible for reviewing and approving budget proposals.
In large companies and organizations the budgeting process is managed and "driven" by, a Budget Office. A Budget Office works with managers, department heads, and others who will seek budget approval, but also with the senior management, legislative bodies, and senior officials who will make budget approval decisions. The result is that all budget proposals are developed according to local policies and rules, and that the entire proposed budget package is reasonable and aligned with organizational objectives.
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Zero Based vs. Incremental Budgeting
Zero based budgeting is an approach to budgeting requiring that every expenditure be justified. In other words, each budget item starts with an assumed value of 0, with all changes above that having to be justified. This contrasts with the more usual practice of incremental budgeting, in which each budgeted item is started at last year's (or last term's) level, and the next period's level is planned as an increment (positive or negative change) to that level.
Advocates of zero based budgeting favor the approach because it is based on demonstrated needs and resources, not on historical spending levels, which arguably leads to more efficient allocation of resources. Zero based budgeting can be very effective, for instance, in detecting and eliminating inflated budgets, or budgets that reflect obsolete or wasteful operations.
Zero based budgeting also helps avoid a practice common under incremental budgeting, whereby managers approaching the end of the budget period ensure that they spend all funds budgeted to them, whether all such spending is necessary or not. Some managers believe that if they do not spend all of this period's budget, they will receive less in next period's budget (in some organizations, this belief is supported by historical fact).
In a large organization, however, zero based budgeting may call for very substantial research and analysis in order to justify every funding request—an investment in time and organizational resources that is not, in its own right, justified. In Incremental budgeting, formal justification (e.g., business case analysis) is normally required only for capital spending proposals or for significant increases in operating budget categories.
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Budget Variance Analysis and Flexible Budgets
A variance (difference between actual and budgeted figures) is a signal to management that revenues or spending did go according to plan. If the variance represents overspending, moreover, it is an indicator that there may be problems paying future expenses. Variance analysis attempts to find the reasons that actual figures were over or under budget so that either
- Corrective action can be taken to reduce variances in the future, (an exercise in static budgeting) or
- Future budgeted figures can be adjusted as necessary (the practice of flexible budgeting).
Confusion sometimes arises in variance analysis because two different conventions for calculations commonly used.
- Convention 1:
Incoming revenue variance = Actual – Budget Forecast
Expense spending variance = Actual – Budget Forecast
This convention is used in this encyclopedia and in many organizations. Under this approach, a positive variance always means the actual result was greater than the budgeted amount. - Convention 2:
Some organizations (such as the Project Management Institute), however, recommend using the above convention for revenue, but reversing the order for expense items:
Incoming revenue variance = Actual – Budget Forecast
Expense spending variance = Budget Forecast – Actual
Under this convention, positive variances are always "good things" (more revenue or less spending than expected), and negative variances are always "bad things.".
Obviously, anyone involved in budgeting needs to ascertain which convention is used locally.
In many companies, variance analysis is often an especially important issue in budgeting for two areas: (1) Direct and indirect manufacturing costs, and (2) sales revenues and sales costs. Revenues and costs in these areas are often difficult to predict accurately. Variance analysis for these areas is, in fact, a substantial and sometimes complex topic in the teaching of cost accounting. The simple example below is meant only to illustrate one kind of approach.
Variance analysis typically begins with variance reports at the end of each month, quarter, or year, showing the difference between actual spending and budgeted spending. As an example, consider a small manufacturing company's quarterly variance report for one budget item, "Manufacturing overhead." The variance report shows that Manufacturing overhead is $76,400 over budget for the quarter. The variance is 7.4% of the budgeted figure:
The Manufacturing overhead variance is a substantial percentage of a large budget item. Management will certainly want to know the reason or reasons for the variance, and then what can be done to prevent recurrence in the next quarters. The next step in variance analysis is to identify the components of the cost item (Manufacturing overhead), and sources of variance within them.
The table above lists six line item components. Note that some of these are fixed costs, and others are variable costs. Fixed costs are (in principle) independent of manufacturing volume and should be more predictable than variable costs. Nevertheless, management salaries (a fixed cost) were $2,000 over forecast. Why? It turns out that during the quarter, the four managers involved took a total of two weeks paid sick leave among them, requiring other management labor to cover for them. Insurance costs (another fixed cost item) were 5% over forecast. Why? Here, there was an unexpected increase in insurance premiums during the quarter. In general, variances in fixed costs can be traced to:
- Unexpected problems or emergencies
- Unexpected cost changes
- Underestimated need for utilization of fixed cost resources.
In the table above, however, two variable cost components of Manufacturing overhead cost stand out with strikingly large variances: Hourly wage costs (9.6% over budget) and utilities costs (24.2% over budget). The hourly wage variance draws attention, especially, because it represents a very large component of the overall Manufacturing overhead variance.
Hourly wages are a variable cost item because they depend on manufacturing volume (units produced). Note, however, that two variable factors also contribute to total hourly wage costs: Labor hours per unit, and the cost of labor (here, $ per hour). In fact, Hourly wage costs are the simple product 3 factors:
Hourly wage cost = (Units manufactured) * ( Labor hours per unit ) * (Labor cost per hour)
The table below shows how actual figures for these factors compare with forecast:
Adding 100% to each of the variance figures, the unit variance is 105% of forecast, the hours per unit variance is 90% of forecast, and the labor cost per hour variance is 116% of forecast. These percentages, multiplied together, account for the actual labor cost:
Actual hourly labor cost = Forecast labor cost * 105% * 90% * 116%
= $690,000 * 105% * 90% * 116%
= $756,000
From this analysis, management may draw conclusions such as these:
- The positive variance in units is not a bad result. On the contrary, the higher unit count is probably associated with increased sales revenues and profits. However, if unit volume can now be forecast at higher figures in subsequent quarters, management may consider additional hiring so that the work can be done without extensive labor overtime.
- The efficiency gain in hours per unit is also a good result. Management will want to ask if this can be sustained or even improved further. If so, the change may be reflected in future budget forecasts.
- The positive variance in average hourly wage rates should move management to find ways to provide more labor hours at the standard rate rather than the much higher overhead rate. This hourly cost variance provides—along with the positive unit volume variance above—more evidence that management may want to consider additional hiring. .
Management can use the "Actual hourly labor cost" formula above to try out different proposed figures and variances, to see the impact on actual cost..
In addition, the very large variance for utilities costs (24.2% over budget) bears looking into in the same way, even though the actual spending figures are small compared to the wage cost variance. The same kind of analysis here, however, promises more complexity. Utilities costs will be the additive combination of phone costs, water costs, and electricity costs, Each of these, in turn, involves the product of price variances, efficiency variances, and usage variances.
A budget variance presents management with two alternatives: either adjust the budget in future periods, to conform more closely with revenue or spending realities, or take action to impact future spending and revenues so as to bring forecast and actual budget figures closer together. The former option (adjusting the budget) is called flexible budgeting. The latter option is an instance of static budgeting.
Most large organizations permit at least a limited level of flexible budgeting. Most managers responsible for lower level budgets (e.g., a department budget, or a budget for an operational area such as "Advertising") have the ability to adjust their own budgets "in real time" by moving budgeted levels from one category to another (except that movements from "capital spending" authorizations to "operating expense" cannot be done so easily).
However, if a manager needs to increase his or her overall spending budget total, that normally requires the use of a process called "emergency funding" or request for non-budgeted funds that is presented to the next higher management level. The next higher level may have a budget item where funds specifically are set aside for such contingencies. Or, upon demonstrated need, these funds may have to come from current assets, such as cash on hand or the sale of stock owned for investment purposes.
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