How Budgeting Works for an Organization

Budgeting is the creation of a detailed financial plan that outlines the organization's expected revenues, expenses and capital expenditures over a specific period of time, typically a fiscal year. If an organization has a long-range plan, the budget extends beyond one year into the future.

Effective budgeting helps ensure the company aligns its vision with its goals and operations. It also helps the company allocate resources effectively, meet financial targets and maintain good financial health. Additionally, budgets provide a critical benchmark for evaluating performance, identifying variances and making informed decisions to pursue organization-wide objectives.

PART 1

The Purpose of Budgeting

Budgets serve multiple purposes, including planning, control and communication.

Planning

Budgeting formalizes and quantifies management’s financial plans for all aspects of operations. The planning aspect of budgeting provides guidance and coordination on who has what amount of money to spend, what they will spend it on, how much they will get in return and what the company can do with that money. As all organizations have resource constraints, budgets are critical tools for resource allocation decisions.

Control

The control process of identifying and analyzing discrepancies from the budget is referred to as variance analysis.

Variance analysis is a quantitative method used to assess the difference between planned and actual financial outcomes and determine why there is a difference. The deviation can be favorable (better than expected) or unfavorable (worse than expected).

While small variances from the budget are inevitable, large variances may be an early indicator of more serious problems, such as changes in economic conditions, a sudden change in product demand or a flaw in the forecasting method used to prepare the budget. Investigating the root cause of variances leads to new decisions for the company.

Communication

Budgets communicate to departments the financial goals for the planning period. They provide guidance on what each department must do to help achieve the goals and objectives stipulated by the strategic plan.

The communication aspect of budgeting also enables coordination and collaboration between departments and operating units. For example, if a company has investments planned, it needs to ensure that capital is ready.

PART 2

Budgeting Process

There are four primary steps to the budgeting process:

  1. Planning: Budget expectations estimate financial statement projections that reflect management’s goals for the period. They are created in concert with the business (which should own the assumptions and projections) and board-approved goals.
  2. Communication: Corporate-level budget expectations are disaggregated to various levels of management.
  3. Variance analysis: Throughout the year, as actual results overlay projections, FP&A analyzes variances from the budget to update the outlook and guide necessary adjustments in business activity.
  4. Feedback: Feedback and results are gathered to update the outlook for the next round of planning.

The first step in the budgeting process can be driven from the top down (senior management sets goals) or from the bottom up (divisional managers create detailed plans to meet high-level expectations). Sometimes, a mix of both is used (negotiated budgeting) to align senior management's targets with divisional needs.

Budgeting Process

PART 3

Types of Budgets

Budgets are created in a variety of ways, depending on the needs of management, the information required for analysis and the duration of the planning period.

The budget cycle typically begins with the creation of the master budget, the aggregation of expected income-generating activities, expenses, assets, sources of financing and liquid resources.

There are two primary components to the master budget:

  • The operating budget (also known as the profit plan) focuses on the revenues and costs or expenses from daily operational activity.
  • The financial budget adds a view to expected financing and investing activities and the cash position.

The financial budget consists of three budgets:

  • The capital budget outlines the expected cash flows and expense recognition of planned capital expenditures (e.g., new facilities and equipment).
  • The cash budget translates information from the operating budget (which may have GAAP accruals and recognitions) and capital budgets into sources and uses of cash.
  • The budgeted balance sheet shows the expected assets, liabilities and remaining equity, conditional on the results from preceding budgets.

Other types of budgets include:

  • Flexible budget: Based on actual sales volume, flexible budgets reflect the budgeted values for unit price, unit variable cost and fixed cost, but use the actual sales volume achieved in the period.
  • Incremental budget: Beginning with the prior budget or performance period, this method layers on an incremental percentage. This saves time and effort in developing an entirely new budget and spending plan.
  • Zero-based budget: The opposite of an incremental budget, the zero-based budget begins with zero expenses assumed and requires the business to justify every expense line anew.
  • Rolling budget: Also referred to as continuous budgets, rolling budgets present budget data for a fixed number of months or years by adding a month or quarter to the end of the budget period as each month or quarter ends.
  • Within-year budget updates: Combines the actual performance to date with the remaining budget as planned to arrive at an adjusted budget for the time period.

PART 4

What Is the Difference Between Capital Budgeting and Operational Budgeting?

The key difference between capital budgeting and operational budgeting lies in the timeframe and the nature of the expenses.

Capital budgets are for long-term, multi-year strategic investments. These are physical assets like property, buildings or equipment with long lives that are valued as assets on the balance sheet and depreciated or amortized on the income statement.

Operational budgets are for the day-to-day running of the business. They are classified as short-term expenses because they have a useful life of less than one year, like inventory to be turned into products, salaries and office supplies.

Role in the Budgeting Process

PART 5

Role of FP&A in the Budgeting Process

FP&A professionals typically own the budgeting process. They are tasked with developing financial forecasts, coordinating with various departments and consolidating input. Further, FP&A professionals are responsible for continuously monitoring actuals, analyzing variances and making recommendations for necessary adjustments, as well as preparing and presenting budget reports to senior management.

The organization looks to FP&A to offer insights and actionable recommendations and contribute to long-term strategic planning. By gathering feedback from the current budget cycle, FP&A is able to enhance future budgeting processes, ensuring accurate, efficient and strategically aligned financial planning.