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What is Budgeting? What is a Budget?
Budgeting is the process of creating a plan to spend
your money. This spending plan is called a budget.
Creating this spending plan allows you to determine in
advance whether you will have enough money to do the
things you need to do or would like to do.
Why is budgeting so important?
Since budgeting allows
you to create a spending
plan for your money, it
ensures that you will
always have enough
money for the things
you need and the things
that are important to
A method of budgeting in which all expenses must be
justified for each new period. Zero-based budgeting starts
from a "zero base," and every function within an
organization is analyzed for its needs and costs.
An incremental budget is a budget prepared using
a previous period's budget or actual performance
as a basis with incremental amounts added for the n
ew budget period.
The allocation of resources is based upon allocations
from the previous period.
This approach is not recommended as it fails to take
into account changing circumstances.
Moreover it encourages "spending up to the budget"
to ensure a reasonable allocation in the next period.
It leads to a "spend it or lose" mentality.
Conflicts should be avoided if departments can be see
n to be treated similarly.
Managers can operate their departments on a consistent
The system is relatively simple to operate and easy to
The budget is stable and change is gradual
Co-ordination between budgets is easier to achieve.
The impact of change can be seen quickly.
Assumes activities and methods of working will continue in the same w
ay.No incentive for developing new ideas.
No incentives to reduce costs.
Encourages spending up to the budget so that the budget is maintained
The budget may become out of date and no longer relate to the level of
activity or type of work being carried out.
The priority for resources may have changed since the budgets were set
There may be budgetary slack built into the budget, which is never
reviewed-managers might have overestimated their requirements in the
past in order to obtain a budget which is easier to work to, and which will
allow them to achieve favorable results.
OR FLEXIBLE BUDGETING
A flexible budget is a budget that adjusts or flexes
for changes in the volume of activity. The flexible budget
is more sophisticated and useful than a static budget,
which remains at one amount regardless of the volume of
As with zero-based budgeting, the flexed budgeting
system gives its name away in the title as it involves
‘flexing’ the normal budget.
ADVANTAGES OF FLEXIBLE BUDGETING
Usage in variable cost environment. The flexible budget
is especially useful in businesses where costs are closely
aligned with the level of business activity, such as a retail
environment where overhead can be segregated and treated
as a fixed cost, while the cost of merchandise is directly
linked to revenues.
Performance measurement. Since the flexible budget
restructures itself based on activity levels, it is a good tool
for evaluating the performance of managers - the budget
should closely align to expectations at any number of
activity levels. It is also a useful planning tool for managers,
who can use it to model the likely financial results at a
variety of different activity levels.
Budgeting efficiency. Flexible budgeting can be used to
more easily update a budget for which revenue or other
activity figures have not yet been finalized. Under this
approach, managers give their approval for all fixed
expenses, as well as variable expenses as a proportion of
revenues or other activity measures. Then the budgeting
staff completes the remainder of the budget, which flows
through the formulas in the flexible budget and
automatically alters expenditure levels. This approach can
improve the efficiency of the budget formulation process,
especially when the management team is working its way
through a large number of iterations.
Formulation. Though the flex budget is a good tool, it
can be difficult to formulate and administer. One problem
with its formulation is that many costs are not fully
variable, instead having a fixed cost component that must
be calculated and included in the budget formula. Also, a
great deal of time can be spent developing cost formulas,
which is more time than the typical budgeting staff has
available in the midst of the budget process.
Consequently, the flexible budget tends to include only a
small number of variable cost formulas.
Revenue comparison. In a flexible budget, there is no co
mparison of budgeted to actual revenues, since the two nu
mbers are the same. The model is designed to match actual
expenses to expected expenses, not to compare revenue lev
els. There is no way to highlight whether actual revenues a
re above or below expectations.
Closing delay. You cannot pre-load a flexible budget into
the accounting software for comparison to the financial
statements. Instead, you must wait until a financial
reporting period has been completed, then input revenue
and other activity measures into the budget model, extract
the results from the model, and load them into the
accounting software. Only then can you issue financial
statements that contain budget versus actual information,
with variances between the two. These extra steps will delay
the issuance of financial statements.
Applicability. Some companies have so few variable
costs of any kind that there is little point in constructing
a flexible budget. Instead, they have a massive amount of
fixed overhead that does not vary in response to any type
of activity. For example, consider a web store that
downloads software to its customers; a certain amount of
expenditure is required to maintain the store, and there is
essentially no cost of goods sold, other than credit card
fees. In this situation, there is no point in constructing a
flexible budget, since it will not vary from a static budget.