What is a Budget?
There are various types of budgeting techniques including zero based budgeting, flexible budgeting, and rolling budgets which are discussed below.
A budget is a financial plan which a business sets itself, it lays out the target financial outcome the business is aiming for.
A business prepares budgets for accounting periods, usually a month or a year, and set out the intentions and financial objectives for the forthcoming accounting period. For example, suppose a business is aiming for electricity costs to be 10,000 for the next year, this would be classified as an annual budget of 10,000.
The purpose of the budget is to set a target for the business to aim for, without a budget the business is aimless, like starting a journey before deciding where you are going.
Budgets are often confused with forecasts. A budget sets out where the business wants to go, a target, something to aim for. In contrast, a forecast sets out where the business is going, which may be nowhere near the target set.
What is Zero Based Budgeting?
A budget shows the planned financial outcome of a business based on its current intentions and objectives and can be prepared using either the traditional approach or the zero based budgeting approach.
Traditional budgeting techniques involve using historical financial information (usually the previous years financial statements), and adjusting these for growth, inflation, and other known factors, to arrive at the next years budget. For example, if a particular expense last year was 50,000, the business might anticipate a 2% increase for the year and budget the expense for next year at 51,000.
In contrast, the zero based budgeting technique does not assume that the business will remain the same from one accounting period to another and allocates a zero budget to each expense until a case has been put forward to justify the allocation of a budget to it.
In order to undertake zero based budgeting, each year the business must consider what it is currently doing and where it plans to go. In the above example, zero based budgeting would consider whether the expense of 50,000 was needed at all, and whether and how the business could be changed to reduce the need for the expense.
Advantages of Zero Based Budgeting Techniques
Some of the advantages of zero based budgeting are as follows:
- Since every budget is set to zero, zero based budgeting techniques require consideration of all items.
- The business bases the final budget on its future plans and objectives.
- It avoids simple inflationary increases to expenses without due consideration.
- It eliminates waste and inefficiency resulting in cost savings.
Disadvantages of Zero Based Budgeting Techniques
Zero based budgeting also has its disadvantages including the following:
- It is time consuming as each year the budget starts from scratch.
- Zero based budgeting may require additional staff training.
- Conflicts can arise each year as each department attempts to justify its budgetary allocation.
What is a Flexible Budget?
The term budget usually refers to a static budget which is produced at the start of the accounting period. It is a financial statement of where a business wants to go, it shows the financial outcome for the business based on its current intentions and level of output. The static budget can be thought of as a planned route to a chosen target destination.
A flexible budget on the other hand, can only be generated at the end of an accounting period and is based on the static budget adjusted to reflect the actual level of output of the business.
The purpose of the flexible budget is to allow the business to make actual versus budget comparisons after adjusting for variations in output level.
Flexible Budgeting Techniques Example
Suppose a business had budgeted sales of 1,000 units at a selling price of 9.00 and expenses of 4.00 per unit together with fixed operating expenses of 3,000. At the end of the period, actual sales are 800 units at a selling price of 9.20 with variable expenses of 3.90 per unit and fixed operating expenses of 2,800.
Initially, the actual results are compared to the static budget with the following calculations:
Static budget: Revenue = 1,000 x 9.00 = 9,000 Variable expenses = 1,000 x 4.00 = 4,000 Fixed expenses = 3,000 Actual: Revenue = 800 x 9.20 = 7,360 Variable expenses = 800 x 3.90 = 3,120 Fixed expenses = 2,800
And are presented in table format as shown below:
When the actual unit sales (800) are above or below the static budget (1,000) the comparison of static budget versus actual is not particularly meaningful. In this case the actual sales are lower than the static budget and therefore actual revenue and costs are always likely to be lower then the static budget.
The flexible budget versus actual comparison overcomes this problem by adjusting the static budget based on 1,000 sales units to a flexible budget based on 800 sales units as follows:
Flexible budget: Revenue = 800 x 9.00 = 7,200 Variable expenses = 800 x 4.00 = 3,200 Fixed expenses = 3,000 Actual: Revenue = 800 x 9.20 = 7,360 Variable expenses = 800 x 3.90 = 3,120 Fixed expenses = 2,800
And are again presented in table format as shown below:
Using flexible budget techniques we can see that for the given level of actual output (800 units), revenue was above budget, and both variable and fixed expenses were below budget.
Rolling Budget Techniques
A rolling budget or continuous budget is one which a business updates on a regular basis.
For example suppose a business plans ahead for a 12 month period.
- The business prepares an original monthly budget for the 12 months January to December.
- At the end of January the actual results for the month are known and compared to the January budget.
- The original January budget is removed.
- The business reviews and adjusts the remaining 11 months February to December.
- A new budget month for January is added to the end of the original budget to create a new 12 month budget from February to January.
- The process is repeated at the end of each month.
Using rolling budgeting techniques the business always has a target plan for the next 12 months.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.