What Is a Budget?

A budget is a formal statement of management’s plans for a specified method of

communicating the agreed-upon objective of the organization. A budget is an
estimation of revenue and expenses over a specified future period of time and is
usually compiled and re-evaluated on a periodic basis. Budgets can be made for
a person, a group of people, a business, a government, or just about anything
else that makes and spends money.

TYPES OF BUDGET

1. Incremental budgeting

Incremental budgeting takes last year’s actual figures and adds or subtracts a
percentage to obtain the current year’s budget.  It is the most common method
of budgeting because it is simple and easy to understand.  Incremental
budgeting is appropriate to use if the primary cost drivers do not change from
year to year.  However, there are some problems with using the method:

It is likely to perpetuate inefficiencies. For example, if a manager knows that

there is an opportunity to grow his budget by 10% every year, he will simply
take that opportunity to attain a bigger budget, while not putting effort into
seeking ways to cut costs or economize.

It is likely to result in budgetary slack. For example, a manager might overstate

the size of the budget that the team actually needs so it appears that the team is
always under budget.

It is also likely to ignore external drivers of activity and performance. For

example, there is very high inflation in certain input costs.  Incremental
budgeting ignores any external factors and simply assumes the cost will grow
by, for example, 10% this year.

 2. Activity-based budgeting

Activity-based budgeting is a top-down budgeting approach that determines the

amount of inputs required to support the targets or outputs set by the company.
For example, a company sets an output target of $100 million in revenues.  The
company will need to first determine the activities that need to be undertaken to
meet the sales target, and then find out the costs of carrying out these activities. 

3. Zero-based budgeting
As one of the most commonly used budgeting methods, zero-based
budgeting starts with the assumption that all department budgets are zero and
must be rebuilt from scratch.  Managers must be able to justify every single
expense. No expenditures are automatically “okayed”. Zero-based budgeting is
very tight, aiming to avoid any and all expenditures that are not considered
absolutely essential to the company’s successful (profitable) operation. This
kind of bottom-up budgeting can be a highly effective way to “shake things up”.

The zero-based approach is good to use when there is an urgent need for cost
containment, for example, in a situation where a company is going through a
financial restructuring or a major economic or market downturn that requires it
to reduce the budget dramatically.

Zero-based budgeting is best suited for addressing discretionary costs rather

than essential operating costs. However, it can be an extremely time-consuming
approach, so many companies only use this approach occasionally.

4. Master budget is the set of financial and operating budgets for a specific
accounting period, usually the next fiscal or calendar year. Master budget is
prepared quarterly or annually. The format of the master budget varies with
business nature and size. Operating budgets are used in daily operations and are
the basis for financial budgets. Operating budgets include the following: sales,
production, direct materials, direct labor, overhead, selling and administrative
expenses, cost of goods manufactured, and cost of goods sold. Financial budgets
include a budgeted income statement and balance sheet, cash budget, and
capital expenditures budget. Budgeted income statement and budgeted balance
sheet are also called pro forma financial statements.

5. Operating budget is the budget for income statement elements such as

revenues and expenses.

6. Financial budget is the budget for balance sheet elements. In other words,
financial budget deals with the expected assets, liabilities, and stockholders’
equity.
6. Cash budget is the budget for expected cash inflows and outflows during the
specific period of time. Cash budget consists of four sections: receipts,
disbursements, cash surplus or deficit, and financing section. The receipts
section lists the beginning cash balance, cash collections from customers, and
other receipts. The disbursements section shows all cash payments
(characterized by purpose). The cash surplus (deficit) section provides the
difference between cash receipts and cash disbursements. Finally, the financing
section examines in detail expected borrowings and repayments during the
period.

Static (fixed) budget is the budget at the expected capacity level. Because static
budget is fixed, it is usually used by stable companies. Also, this type of budget
can be used by departments with operations independent from capacity levels.
For example, operations of administrative and general marketing departments
usually does not depend on the level of production and sales and is rather
determined by the department’s management; as the result, static budget can be
used by such departments.

7. Flexible (expense) budget is the budget at the actual capacity level. Because
flexible budget is dynamic, it is commonly used by companies. Flexible budget
is adjusted to the actual activity of the company. It can be easily prepared using
a computerized spreadsheet (e.g., Excel). At first, the relevant activity range is
determined for the coming period. Next, costs that are expected be incurred over
the relevant range are analyzed. These costs are then separated based on their
cost behavior: fixed, variable, or mixed. Finally, the flexible budget for variable
costs at different points throughout the relevant range is prepared. In other
words, flexible budget matches expenses to specific revenue levels or activity
levels. For example, utility costs can be tied to the number of machines in
operation.

8. Capital expenditure budget is the budget for expected investments in capital

assets and long-term projects. It is usually prepared for 3 to 10 years.
Investments in capital assets include purchasing fixed assets such as plant, land,
buildings, machinery, equipment, and mineral resources. Long-term projects
might be undertaken to develop new products, expand existing product lines, or
reduce costs. Sometimes a capital project committee is created to overlook
capital budgeting processes. Such a committee is typically separate from the
budgeting committee.

OBJECTIVES OF BUDGET

(A)Redistribution of income and wealth: It is one of the most important

objective of the government budget. The government imposes heavy taxation on
a high income groups redistribute it among the people of weaker section in the
society. The government can provide subsidies and other amenities to people
whose income levels are low. These increase their disposable income and this
reduces the inequalities.

(B)Reallocation of Resources: Reallocation of resources in the manner such that

there is a balance between the goals of profit maximization and social welfare.
Government uses budgetary policy to allocate resources. This is done by
imposing higher rate of taxation on goods whose production is to be
discouraged and subsidies provided on goods whose production is to be
promoted.

There are some goods and services in which the private sector shows little
interest due to huge investment required and lower profits, like sanitation, roads,
parks etc. Government can undertake the production of these goods and
services. Alternatively, it can encourage private sector by giving tax concession
and subsidies.

(C)Economic Growth: Another purpose of the government budget today is to

study the generation of savings, investment, consumption and capital formation
to assess the trend of growth in the economy to improve the standard of living
of the people.

(D)Managing Public Enterprises: In the budget government can make various

provision to manage public sector enterprises and also provides them financial
help.

(E)Economic Stability: The government of the country is always committed to

save the economy from business cycles. Government budget is a tool to prevent
economy from inflation or deflation and to maintain economic stability. The
overall level of employment and prices in the economy depends upon the level
of aggregate demand during the time of deflation, deficit budgetary policy are
used to maintain stability in economy.

QUALITIES OF A GOOD BUDGET

1. The Budget Must Address the Enterprise's Goals. ...

2. The Budget Must be a Motivating Tool. ...
3. The Budget Must Have the Support of Management. ...
4. The Budget Must Convey a Sense of Ownership. ...
5. The Budget Should be Flexible

The advantages of budgeting

A budget is a comprehensive financial plan setting forth the expected route for
achieving the financial and operational goals of your business.  Budgeting is an
essential step in effective financial planning.  Even the smallest business will
benefit from preparing a formal written plan for its future operations.  However,
there are some advantages and disadvantages to consider:

The advantages of budgeting include:

Planning orientation. The process of creating a budget takes management away

from its short-term, day-to-day management of the business and forces it to
think longer-term. This is the chief goal of budgeting, even if management does
not succeed in meeting its goals as outlined in the budget - at least it is thinking
about the company's competitive and financial position and how to improve it.

Profitability review. It is easy to lose sight of where a company is making most

of its money, during the scramble of day-to-day management. A properly
structured budget points out what aspects of the business produce money and
which ones use it, which forces management to consider whether it should drop
some parts of the business or expand in others.

Assumptions review. The budgeting process forces management to think about

why the company is in business, as well as its key assumptions about its
business environment. A periodic re-evaluation of these issues may result in
altered assumptions, which may in turn alter the way in which management
decides to operate the business.
Performance evaluations. You can work with employees to set up their goals for
a budgeting period, and possibly also tie bonuses or other incentives to how
they perform. You can then create budget versus actual reports to give
employees feedback regarding how they are progressing toward their goals.
This approach is most common with financial goals, though operational goals
(such as reducing the product rework rate) can also be added to the budget for
performance appraisal purposes. This system of evaluation is called
responsibility accounting.

Funding planning. A properly structured budget should derive the amount of

cash that will be spun off or which will be needed to support operations. This
information is used by the treasurer to plan for the company's funding needs. •
Cash allocation. There is only a limited amount of cash available to invest in
fixed assets and working capital, and the budgeting process forces management
to decide which assets are most worth investing in.

Bottleneck analysis. Nearly every company has a bottleneck somewhere, and

the budgeting process can be used to concentrate on what can be done to either
expand the capacity of that bottleneck or to shift work around it.

BUDGETARY PROCEDURE AT DIFFERENT LEVELS OF

GOVERNMENT

STEPS IN THE FORMULATION STAGE (national level)

• Modeling of the economy (macroeconomic forecast: GDP, growth, inflation,

deficit, unemployment, etc.)

• Estimation of revenue (tax & non-tax, grants & loans, etc.)

• Determining expenditure ceilings for ministries/ departments/agencies (MDAs

then draw up budgets) • Release of the Pre-Budget Statement (parameters of
upcoming budget proposal – budget priorities & policies)

• Formulation & negotiation of ministry/department/agency expenditure

budgets

• Cabinet approval
STEPS IN THE FORMULATION STAGE II (subnational level)

• States receive block transfers & conditional grants from national Ministry of
Finance

• Expenditure ceilings determined for state departments

• State department expenditure budgets formulated

• Approval by State Cabinet

STEPS IN THE APPROVAL STAGE

• Budget tabled in national & state legislatures by Minister of Finance

• Committees review and scrutinize budget & revenue proposals and report to
the full legislature

• Amendments made (in countries where legislatures have amendment power)

• Budget voted into law by legislature

identify the composition of revenue and expenditure budget for recurrent and
capital items

Recurrent expenditure – all payments other than for capital assets, including on
goods and services, (wages and salaries, employer contributions), interest
payments, subsidies and transfers.

Capital expenditure – payments for acquisition of fixed capital assets, stock,

land or intangible assets. A good example would be building of schools,
hospitals or roads. However, it is important to note that much donor-funded
“capital” expenditure, though referring to projects, includes spending on non-
capital payments.