Introduction to Budgeting

Introduction to Budgeting

You’ve probably heard the word “budget” around, as a restrictive measure so that people in governments or corporations don’t spend more than they should. But budgeting is not just about limiting spending; otherwise, businesses would miss opportunities or limit their production or in the case of personal finances, people would not take advantage of a great weekend sale. Budgeting should be acknowledged more as a financial planning tool that allows the entity to accomplish its goals rather than only serve as a restraint (which as we’ll see is why there’s flexible budgeting).

In Personal Finance

If you Google “budget” or “budgeting” you’ll notice that most of the results are geared towards personal finances. Apps and spreadsheets also include a budgeting option nowadays so you can establish what you consider reasonable to spend for each category. Even before the month ends you can see if you’re close to overspending or within the expected goal. Having a record by how much you overspent or underspent each month would allow you to adjust your budget accordingly depending on your budgeting strategy. If you’re overspending by the same amount or close to it every month it may illustrate that the problem lies with your planning and not necessarily with the spending itself. Maybe you didn’t really consider economics when setting your budget. There may be external factors why the range by which you overspent keeps increasing; prices for basic groceries going up so much that they neutralize any savings from lower prices in other categories or gas prices increments that they compensate for food being cheaper in a month. You notice then that despite your best efforts there are some budgets that you simply can’t limit (you can’t stop eating, public transportation doesn’t take you near your job so you need your car, utilities need to be paid, etc.) and that although not very fun to do there are some you can sacrifice (bars, movie tickets, travel…it hurts even to think about it) to compensate for increases in other budgets.

The same thing happens in companies, there are different budget categories. Some may be static and others may be flexible depending on the industry they are in and the company’s strategy. Research and Development budgets are usually one of the first to be limited or slashed by some companies to meet financial goals but on some companies they’re untouchable, especially if those companies rely on innovation to keep their market share or as part of the company’s strategy.

Defining Budget

Before proceeding to analyze the types of budgeting, the sources of information, how to calculate it, and how to analyze it I would like mention the definitions that serve as a good basis. These would be the ones provided by the Cambridge Academic Content Dictionary © Cambridge University Press.

1. A plan to show how much money a person or organization will earn and how much they will need or be able to spend.

2. The amount of money you have available to spend.
Types of budgeting

There are two types of budgeting: flexible and static.

A static budget isn’t modified for the determined periods (month, quarter, year) nor does it change depending on how other variables resulted throughout the period. While it could prove limiting if the company were it to use it exclusively as a guideline for expenses, it is also a useful tool for a company that wants to test how under control it has its forecasting process for income and/or expenses as well as the predictability of its operations in short term periods. With a static budget, the business can measure the variances between the amounts they established and the totals at the end of the corresponding period. By analyzing the differences between the estimates and the actuals, the company can study the positive and negative variances. Positive variances could be either due to earning more or spending less than expected, some insights that can be obtained for them are:

  • If the revenue is more than expected due to a continuous increase in sales or if its due to the time of year.
  • If the company spent less than expected due to efficiencies or because some projects didn’t come through.
  • If the differences were a consequence of underestimating or overestimating or were they truly because of lower disbursements and/or higher profits.

If the company ended up spending more or selling less than they had indicated, then the variances are considered negative.

  • Were rising costs the culprit? Were they fixed or variable?
  • Is there a decreasing tendency in sales or was it just a slow sale season?
  • Was there a problem with control or with forecasting?

It’s important to take into account the period in which the difference occurred, any noticeable trends based on variance analysis from previous months, quarters, year (depending on the comparable time frame you’re analyzing as you want month vs month, quarter vs quarter, year vs year, etc.), and the sources for the variances. If done right a static budget provides greater control and the ability to notice if there is a pattern in the difference between each time period (in an adjustable budget you may lose that tracking ability).

A flexible budget varies based on variable costs and volume for the chosen period. It’s recommended for longer time frames, for new operations, or when dealing with an unpredictable market. Changes are done both throughout the period (ex. receiving news or project that is expected to increase sales before the period is over) and at the end once all the necessary information is obtained. Adjustments should be done based on elements such as:

  • How sales and costs are influenced by what occurred in the time period that just finished or expected movements based on the season.
  • Any outside or inside factor that will affect any part of the operations that is variable.
  • To take advantage of efficiencies, tighter control, or increase profits not to enable a lax management style.

As you may have already noticed flexible budgets have many benefits but also a greater complexity and responsibility. If the budget will be changing before the end of the period, it’s important to have controls in place such as a process to record the changes accompanied by the necessary reasoning and backup.

This is only an introduction on the subject, so I may have missed a point or two that I’ll cover on future posts; however, please let me know any suggestions, questions, or examples that you would like to see.

Miguel Morales

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