What it means
A budget is built line by line, normally starting with a sales forecast because almost everything else depends on volume. Cost of sales follows from that volume, fixed costs such as salaries, rent and software are added, and the difference between the two is the planned profit.
Its real value is as a control tool rather than as a prediction. Nobody expects a budget to be exactly right, but comparing actual performance against it every month surfaces problems while there is still time to do something about them.
Budgets are generally built one of two ways. Incremental budgeting takes last year's numbers and adjusts them, which is quick but carries forward old inefficiency, while zero based budgeting starts every line at nothing and requires each cost to be justified afresh, which is far more work but much better at removing spending nobody can defend.
Two variants matter in day to day practice. A rolling budget is re-extended every quarter so there are always twelve months in view, and a flexed budget restates the plan at actual sales volume so that cost managers are judged on cost control rather than on the sales team missing its forecast.
The most common complaint is that budgets encourage the wrong behaviour, particularly the year end rush to spend a remaining allowance so that it is not cut next time. That is really a symptom of how the budget is used in performance reviews rather than a fault of budgeting itself.
In practice
Real-world examples.
Example
A veterinary group builds its annual budget around 22,000 forecast appointments and hires accordingly. When bookings run 8% below plan by April, the practice manager freezes two vacancies rather than waiting for the year end to discover the shortfall.
Example
A software company adopts zero based budgeting for its non-payroll costs after three years of incremental increases. The exercise surfaces $180,000 of subscriptions to tools that no team could name an owner for, all of which are cancelled.
Example
A construction firm uses a flexed budget for site overheads because activity swings with the weather. When output falls 15% below plan, the flexed budget shows the site manager was actually $40,000 favourable on controllable costs, which the original fixed budget had disguised as an overspend.
Think of it
“Budget is a spending plan-knowing where your money goes.
Formula
Calculation
Budgeted profit = budgeted revenue - budgeted cost of sales - budgeted operating costs
Variance = actual result - budgeted result
A distribution business budgets revenue of $2,400,000 for the year, cost of sales at 40% of revenue, which is $2,400,000 x 0.40 = $960,000, and operating costs of $1,080,000. Budgeted operating profit is therefore $2,400,000 - $960,000 - $1,080,000 = $360,000, a margin of $360,000 / $2,400,000 x 100 = 15%.
The year actually delivers revenue of $2,280,000, cost of sales of $935,000 and operating costs of $1,100,000, giving actual operating profit of $2,280,000 - $935,000 - $1,100,000 = $245,000. The profit variance is $245,000 - $360,000 = -$115,000, an adverse result made up of $120,000 of missed revenue and $20,000 of overspend on operating costs, partly offset by $25,000 of favourable cost of sales.Case study
Seen in the real world.
This is an illustrative and entirely fictional example. Ravensworth Interiors, an invented commercial fit-out business, ran on an annual budget approved each December and never looked at again until the following December. Managers routinely knew by March that the plan was wrong, but nothing in the process allowed them to say so.
In one illustrative year, revenue ran 12% below budget from February onwards while headcount stayed at the planned level, because nobody had the authority to change a board approved number. By the time the year end accounts were produced, the company had made a loss of $310,000 against a budgeted profit of $400,000, a swing of $710,000 that had been visible for nine months.
The fictional fix was a quarterly rolling forecast sitting alongside the annual budget, plus a simple rule that any variance above $50,000 triggered a decision rather than an explanation. The following year the business hit a lower but achievable profit and, more importantly, knew where it stood in April rather than in the following January.
Watch out
Common mistakes.
- Treating the budget as a forecast of what will happen rather than a plan of what the business intends to make happen, then abandoning it the moment reality differs.
- Comparing actual costs at real sales volume against a budget set at planned volume, which blames cost managers for the sales team's shortfall.
- Building the budget in finance and handing it down, so the managers held to it never agreed the numbers and feel no ownership of them.
Questions
People also ask.
What is the difference between a budget and a forecast?
A budget is a fixed plan and target for the period, while a forecast is a regularly updated best estimate of where things will actually land.
How long should the budgeting process take?
For most small and mid sized businesses, six to eight weeks is plenty, and anything much longer usually means the numbers are stale before the year starts.
Should a budget be revised mid year?
Reforecast freely, but changing the approved budget itself removes the yardstick, so most businesses keep the original budget and track a separate current forecast.
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