Organizations develop specific plans for saving and spending income and these plans, or budgets, are essential for developing spending and saving priorities. Properly preparing a budget also serves as a reference to check how well money is being managed during a period by allowing managers to see actual revenues and expenses compared to budgeted revenues and expenses. Corrective action can be taken earlier in a period when revenue shortfalls or expense excesses are identified.
The term "budget" can be dated back to medieval England, where it meant "leather purse" or "wallet." A budget allows businesses to meet specific goals by creating a system of saving and spending money efficiently. Simply defined, a budget is a plan for using corporate funds in a way that best meets the firm's wants and needs. The plan includes a recorded entry of expected income, expenses, and savings over a defined period of time.
A wide range of budgeting techniques exist, and although the fundamental purposes are similar, the specifics among various organizations are often different. One important aspect of budgeting is how organizations increase cash to finance ongoing operations and new opportunities. Large corporations, for example, may have the option of increasing cash by selling treasury stock (previously authorized shares of ownership that have never been offered for sale on the stock market). The liquidity of equity (stock) markets allows managers to implement these equity decisions fairly quickly to budget for projected needs. In addition, the debt-paying ability of large corporations is rated by several independent organizations. This creates a market for corporate debt, more commonly referred to as bonds. Corporations with favorable debt ratings have the ability to borrow money; that is, issue bonds, at lower interest rates than those with unfavorable debt ratings. Small businesses, in contrast, often do not have publicly traded shares of stock. Although these businesses can sell stock to investors, the process is more uncertain because the market for this type of stock is less liquid. Venture capital is also an option, but the number of small businesses seeking venture capital nearly always exceeds the amount of venture capital available. Also, debt-rating agencies do not rate the debt-paying ability of many small businesses, limiting the extent to which these businesses can raise cash through bond issues. Without a ready market for debt, small businesses must often turn to the less liquid forms of debt financing such as bank loans, in some cases at higher interest rates than would be available from established credit markets available to larger corporations.
Budgets allow businesses to better utilize the financial resources available to them. To begin with, budgets help businesses operate within their means; that is, over the long term, budgets assist businesses in spending less money than they earn. Next, budgets help businesses achieve their financial goals by planning for the future and organizing money into categories such as income, expenses, and savings. In short, budgets help a business avoid credit problems, better prepare for financial emergencies, and build better money management skills by creating a structured plan.
There are several steps that should be followed to successfully implement a budget. These include setting financial goals, planning budget categories, maintaining financial records, and balancing and adjusting the budget. Setting financial goals is the starting point in the budgeting process. Questions managers should asked include: "What do we want accomplished within one month, one year, or ten years?" "What new products or services do we want to offer in the short- and long-term and how can we finance these?" "Will my operating expenses increase with inflation, and how will we increase revenue to meet these additional expenses?" Clearly, there are dozens of questions managers should ask to cover all the categories of revenue, expense, and debt and equity financing in addition to these, but these questions provide a starting point to spur additional questions. The answers to these questions should help determine how income should be spent and saved, but in general, budgeting questions should revolve around estimates of income and expenses. Categories include fixed expenses such as rent, insurance premiums, and taxes; estimates of variable expenses such as utilities and wages; and estimates that allow for uncertainties.
One way to budget is by comparing estimated financial figures created before a budgeting period with actual experience at the end of the budgeting period. The initial estimates are called pro forma financial statements. The three primary types of financial statements are a balance sheet, income statement, and statement of cash flows. The balance sheet shows assets owned, liabilities owed, and owners' equity (owners' financial stake in the businesses). The income statement details profit and loss for a given period. The statement of cash flows helps managers see where cash came from and where it went. By comparing pro forma financial statements to end-of-period financial statements, managers can judge whether or not their budgets are in line with estimates. Adjustments can then be made for future budgeting periods.
A budget must meet certain characteristics to successfully manage money. The budgeting should be specific enough to provide the needed information. It should be realistic as well as flexible. When unexpected expenses arise, the spending plan should be able to handle these costs. A budget is not a permanent plan and should be realigned when circumstances occur that alter budget categories. The budget should be carefully planned and organized, yet clear enough to be communicated to organizational stakeholders such as lenders and owners.
Companies create budgets for a mixture of reasons. They can serve a variety of functions, and thus many techniques can be implemented to develop them. Budgets can be used as a means of forecasting and planning for the future. Their creation can also be used as a motivational tool. The plan can be used as a means of evaluation and control as well as a resource for information and decision-making. Many different approaches to the budgeting process in addition to preparation or pro forma financial statements and comparison to actual financial statements can be used depending on the desired function of the company. Breakeven analysis, for instance, estimates the amount of sales required to cover a new product's or new service's expenses. Payback periods are similar, but add to breakeven analysis' focus on needed sales by adding the length of time needed to achieve those sales. This tells managers how long it will take to recoup initial expenses. Another type of budgeting is capital budgeting, in which large the estimated revenue from capital projects such as purchase of property, plants, and equipment is projected. Additional techniques include such as parametric, partial, zero-based, and equity budgeting. Each of these may be applied to organizations' financial situations depending on the needs of the individual businesses.
Whatever technique managers use, the important thing is that budgeting is essential. Businesses without budgets can quickly find themselves short of cash not only for new products and services, growth and expansion, and improvements in capital projects, but also in simply meeting short-term needs such as payroll, insurance, and tax expenses. Budgeting is thus a key element in all business planning.
Revised by Scott B. Droege
Henry, David. "Loading Up on Junk." Business Week, 31 January 2005, 78–80.
Schick, Allen. "Twenty-Five Years of Budgeting Reform." OECD Journal on Budgeting 1, no, 4 (2004): 102–124.
U.S. Small Business Administration. Small Business Startup Guide. 2005. Available from < http://www.sba.gov/starting_business/startup/guide.html >.