Running a business requires management to keep an eye on the finances, profitability, cash flow, and a multitude of operational activities that start with budgeting. A budget is a formal written plan that is based on an estimate of how the company will perform during a time period. There are a variety of budgets to consider, including financial budgets and operational budgets.
Budget preparation helps companies plan the coordination of activities across the entire company, establishes a basis for accountability, provides feedback on a variety of performance objectives, and helps companies analyze financial information to prevent potential problems. A well designed budget is a financial road map that can outline a clear trail of where the business wants to go and how to get there.
A budget is prepared to follow the accounting period of the entity. Budget preparation is typically an annual project established for an entire year, but can also be broken down into quarterly and monthly periods. An annual budget can also roll from year to year by adding a new month once one month is completed. This allows for a company to always be forward thinking and planning their forecast with adjustments made along the way.
The more detailed and frequent a budget is prepared; the better control a company has in monitoring inflows and outflows of cash, keeping a check on sales and expenses, and monitoring other performance targets. This can help prevent overspending and also indicate when a cash flow crisis may be looming. If a company does not have enough cash to pay its bills, it may need to secure a financing arrangement with a lender to borrow the funds needed to meet the goals of the accounting period. Some lenders have financing arrangements that require a company to maintain a minimum cash balance. Thus, furthering a need to keep an eye on the cash flow and keep their bank account adequately funded.
A budget is an estimate, but is based on input from a collective team within the company. A master budget is comprised of several budgets that interrelate and feed into each other. These budgets include a sales budget, purchases budget for a merchandiser or production budget for a manufacturer, general and administrative expense budget, cash budget, capital expenditure budget, and projected or pro-forma financial statements. A production budget for a manufacturer further requires a labor budget, materials and purchases budget, and an overhead budget. The team required to participate in budget preparation must be knowledgeable of the business's historical trends, and determine how to map these to the goals and benchmarks the company has.
Once a budget period has passed, it is important to evaluate the outcome by comparing the budget to the actual results. A difference between the budgeted amount and the actual result is called a variance. Both favorable and unfavorable variances should be investigated for useful feedback. Variances in sales targets could be favorable, meaning more sales occurred than anticipated. Variances in expenses are favorable if less is spent than budgeted. Understanding the reasoning behind a favorable variance can help the company determine how to reproduce efficiencies or successful sales strategies.
Unfavorable variances occur when sales revenue is lower than expected, or actual expenses are higher than planned. Determining the cause of these can indicate where spending may have to be trimmed back, where purchasing negotiations may need to be revised, or where an advertising campaign may be needed to boost sales.
Accountability is necessary for managing spending, but also helps improve business functions. Analyzing actual costs versus expected costs can indicate problems that can be caught early in the accounting period. Comparing budgeted data to actual results month to month, rather than waiting until the end of a year, may prevent a financial crisis from escalating. Many times the budget itself needs correction, and the formulas used to make the projections need adjustments.
The control established by preparing budgets, comparing actual results, and analyzing differences; helps management stay on target to reach company goals, forces accountability from everyone involved in the business, and provides valuable feedback about company performance. By setting a target with a budget and tracking the actual results; a company has a better chance of managing and preparing for downturns, maximizing success, and driving the company to efficiently stay on the road to success.