Participative budgeting is a budgeting process under which those people impacted by a budget are actively involved in the budget creation process.
This bottom-up approach to budgeting tends to create budgets that are more achievable than are top-down budgets that are imposed on a company by senior management, with much less participation by employees. Participatory budgeting is also better for morale, and tends to result in greater efforts by employees to achieve what they predicted in the budget. However, a purely participative budget does not take high-level strategic considerations into account, so management needs to provide employees with guidelines regarding the overall direction of the company, and how their individual departments fit into that direction.
When participative budgeting is used throughout an organization, the preliminary budgets work their way up through the corporate heirarchy, being reviewed and possibly modified by mid-level managers along the way. Once assembled into a single master budget, it may become apparent that the submitted budgets will not work together, in which case they are sent back down to the originators for another iteration, usually with guidelines noting what senior management is looking for.
Because of the larger number of employees involved in participatory budgeting, it tends to take longer to create a budget than is the case with a top-down budget that may be created by a much smaller number of people. The labor cost associated with creating such a budget is also relatively high.
Another problem with participative budgeting is that, since the people originating the budget are also the ones whose performance will be compared to it, there is a tendency for participants to adopt a conservative budget with extra expense padding, so that they are reasonably assured of achieving what they predict in the budget. This tendency is more pronounced when employees are paid bonuses based on their performance against the budget.
This problem of budgetary slack can be mitigated by imposing a review of the budgets by those members of management who are most likely to know when budgets are being padded, and who are allowed to make adjustments to the budget as needed. Only by following this approach can stretch goals be integrated into a budget.
Budgetary planning is the process of constructing a budget and then utilizing it to control the operations of a business. The purpose of budgetary planning is to mitigate the risk that an organization's financial results will be worse than expected.
The first step in budgetary planning is to construct a budget. This is accomplished by engaging in the following tasks, which are presented in their approximate order:
It can be daunting to start the process of creating a budget, especially if you're not familiar with some of the common accounting and budget terminology you will encounter, so we have provided a glossary of terms covered here, located toward the bottom of the page under the In Summary section of the page.
It is important for organizations to create accurate and up-to-date annual budgets in order to maintain control over their finances, and to show funders exactly how their money is being used. How specific and complex the actual budget document needs to be depends on how large the budget is, how many funders you have and what their requirements are, how many different programs or activities you're using the money for, etc. At some level, however, your budget will need to include the following:
Fiscal year simply me "financial year," and is the calendar you use to figure your yearly budget, and which determines when you file tax forms, get audited, and close your books. There are many different fiscal years you can use. Businesses often use the calendar year -- January 1 to December 3@The federal government's fiscal year runs from October 1 to September 3@State governments -- and therefore state agencies and many community-based and non-profit organizations that receive state funding - usually use July 1 to June 3@Most organizations adopt a fiscal year that fits with that of their major funders. You'll want to prepare your budget specifically to cover your fiscal year, and to have it ready before the fiscal year begins. In many organizations, the Board of Directors needs to approve a budget before the beginning of the fiscal year in order for the organization to operate.
Disadvantages of Zero-Base Budgeting
The main downside of zero-base budgeting is the exceptionally high level of effort required to investigate and document department activities; this is a difficult task even once a year, which causes some entities to only use the procedure once every few years, or when there are significant changes within the organization. Another alternative is to require the use of zero-base budgeting on a rolling basis through different parts of a company over several years, so that management can deal with fewer such reviews per year. Other drawbacks are:
A static budget is fixed for the entire period covered by the budget, with no changes based on actual activity. Thus, even if actual sales volume changes significantly from the expectations documented in the static budget, the amounts listed in the budget are not changed.
A static budget model is most useful when a company has highly predictable sales and expenses that are not expected to change much through the budgeting period (such as in a monopoly situation). In more fluid environments where operating results could change substantially, a static budget can be a hindrance, since actual results may be compared to a budget that is no longer relevant.
The static budget is used as the basis from which actual results are compared. The resulting variance is called a static budget variance. Static budgets are commonly used as the basis for evaluating sales performance. However, they are not effective for evaluating the performance of cost centers. For example, a cost center manager may be given a large static budget, and will make expenditures below the static budget and be rewarded for doing so, even though a much larger overall decline in company revenues should have mandated a much larger expense reduction. The same problem arises if revenues are much higher than expected - the managers of cost centers have to spend more than the amounts indicated in the baseline static budget, and so appear to have unfavorable variances, even though they are simply doing what is needed to keep up with customer demand.
A common result of using a static budget as the basis for a variance analysis is that the variances can be quite substantial, especially for those budget periods furthest in the future, since it is difficult to make accurate predictions for more than a few months. These variances are much smaller if a flexible budget is used instead, since a flexible budget is adjusted to take account of changes in actual sales volume.
For example, ABC Company creates a static budget in which revenues are forecasted to be $10 million, and the cost of goods sold to be $4 million. Actual sales are $8 million, which represents an unfavorable static budget variance of $2 million. The actual cost of goods sold is $3.2 million, which is a favorable static budget variance of $800,0@If the company had used a flexible budget instead, the cost of goods sold would have been set at 40% of sales, and would accordingly have dropped from $4 million to $3.2 million when actual sales declined. This would have resulted in both the actual and budgeted cost of goods sold being the same, so that there would be no cost of goods sold variance at all.
Advantages of Zero-Base Budgeting
There are a number of advantages to zero-base budgeting, which include:
In short, many of the advantages of zero-base budgeting focus on a strong, introspective look at the mission of a business and exactly how the business is allocating its resources in order to achieve that mission.
and the actual amount. The budget variance is favorable when the actual revenue is higher than the budget or when the actual expense is less than the budget.
In rare cases, the budget variance can also refer to the difference between actual and budgeted assets and liabilities.
A budget variance is frequently caused by bad assumptions or improper budgeting (such as using politics to derive an unusually easy budget target), so that the baseline against which actual results are measured is not reasonable.
Those budget variances that are controllable are usually expenses, though a large portion of expenses may be committed expenses that cannot be altered in the short term. Truly controllable expenses are discretionary expenses, which can be eliminated without an immediate adverse impact on profits.
Those budget variances that are uncontrollable usually originate in the marketplace, when customers do not buy the company's products in the quantities or at the price points anticipated in the budget. The result is actual revenues that may vary substantially from expectations.
Some budget variances can be eliminated through the simple aggregation of line items in the budget. For example, if there is a negative electricity budget variance of $2,000 and a positive telephone expense budget variance of $3,000, the two line items could be combined for reporting purposes into a utilities line item that has a net positive variance of $1,000.
As an example of a budget variance, ABC Company had budgeted $400,000 of selling and administrative expenses, and actual expenses are $420,0@Thus, there is an unfavorable budget variance of $20,0@However, the budget used as the baseline for this calculation did not include a scheduled rent increase of $25,000, so a flaw in the budget caused the variance, rather than any improper management actions.
Most companies prepare just a single budget scenario, which is their best guess regarding how the next year will turn out. This scenario is based upon a range of supporting assumptions, any one of which can lead to diverging results - and usually does. So, though you may spend a considerable amount of time on that "mainstream" budget scenario, just that one version will not be enough to prepare you for what may - and probably will - happen.
It makes sense to add two more scenarios, one for the absolute worst case, where bankruptcy is looming, and one for the most phenomenal sales success. Sounds unlikely that either one will ever happen? If you don't plan for success, it never will happen, and bankruptcy scenarios are far more frequent than you might think. Consequently, it is useful to know what resources you'll need for a phenomenally successful year, and how deep you will have to cut to avoid bankruptcy. Is that enough scenarios? No.
There are gaping holes between the two opposite-extreme scenarios and the mainstream version. Realistically, actual results will fall into either of those two holes, so you should spend some time figuring out what you will do for situations that are somewhat above and below the mainstream scenario.
So the wer is - five budget scenarios. However, if some of your underlying assumptions are more likely than not to occur or to fail, then you may want to drum up some extra models just for those specific situations.
All of this talk of multiple models does not mean that you should spend an equal amount of time on each one. The mainstream scenario requires the most work, because it is (presumably) the most likely, with less work needed for the less likely ones. Nonetheless, you should at least spend time determining financial results at a high level for each scenario, and conceptualize what those situations will do to the company's operations.
In essence, a budget is a quantified expectation for what a business wants to achieve. Its characteristics are:
Conversely, a forecast is an estimate of what will actually be achieved. Its characteristics are:
Thus, the key difference between a budget and a forecast is that the budget is a plan for where a business wants to go, while a forecast is the indication of where it is actually going.
Realistically, the more useful of these tools is the forecast, for it gives a short-term representation of the actual circumstances in which a business finds itself. The information in a forecast can be used to take immediate action. A budget, on the other hand, may contain targets that are simply not achievable, or for which market circumstances have changed so much that it is not wise to attempt to achieve. If a budget is to be used, it should at least be updated more frequently than once a year, so that it bears some relationship to current market realities. The last point is of particular importance in a rapidly-changing market, where the assumptions used to create a budget may be rendered obsolete within a few months.
In short, a business always needs a forecast to reveal its current direction, while the use of a budget is not always necessary.
Incremental budgeting is budgeting based on slight changes from the preceding period's budgeted results or actual results. This is a common approach in businesses where management does not intend to spend a great deal of time formulating budgets, or where it does not perceive any great need to conduct a thorough re-evaluation of the business. This mindset typically occurs when there is not a great deal of competition in an industry, so that profits tend to be perpetuated from year to year.
There are several advantages to incremental budgeting, which are as follows:
A zero-base budget requires managers to justify all of their budgeted expenditures, rather than the more common approach of only requiring justification for incremental changes to the budget or the actual results from the preceding year. Thus, a manager is theoretically assumed to have an expenditure base line of zero (hence the name of the budgeting method).
In reality, a manager is assumed to have a minimum amount of funding for basic departmental operations, above which additional funding must be justified. The intent of the process is to continually refocus funding on key business objectives, and terminate or scale back any activities no longer related to those objectives.
The basic process flow under zero-base budgeting is:
The concept of paring back expenses in layers can also be used in reverse, where you delineate the specific costs and capital investment that will be incurred if you add an additional service or function. Thus, management can make discrete determinations of the exact combination of incremental cost and service for their business. This process will typically result in at least a minimum service level, which establishes a cost baseline below which it is impossible for a business to go, along with various gradations of service above the minimum.
Many organizations prepare budgets that they use as a method of comparison when evaluating their actual results over the next year. The process of preparing a budget should be highly regimented and follow a set schedule, so that the completed budget is ready for use by the beginning of the next fiscal year.
Here are the basic steps to follow when preparing a budget:
The number of steps noted here may be excessive for a smaller business, where perhaps just one person is involved in the process. If so, the number of steps can be greatly compressed, to the point where a preliminary budget can possibly be prepared in a day or two.
A flexible budget includes formulas that adjust expenses based on changes in actual revenue or other activities. The result is a budget that is fairly closely aligned with actual results. This approach varies from the more common static budget, which contains nothing but fixed expense amounts that do not vary with actual revenue levels.
In its simplest form, the flex budget uses percentages of revenue for certain expenses, rather than the usual fixed numbers. This allows for an infinite series of changes in budgeted expenses that are directly tied to actual revenue incurred. However, this approach ignores changes to other costs that do not change in accordance with small revenue variations. Consequently, a more sophisticated format will also incorporate changes to many additional expenses when certain larger revenue changes occur, thereby accounting for step costs. By incorporating these changes into the budget, a company will have a tool for comparing actual to budgeted performance at many levels of activity.
Advantages of Flexible Budgeting :
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.
Disadvantages of Flexible Budgeting :
Though the flex budget is a good tool, it can be difficult to formulate and administer. Several issues are:
There may also be a time delay between when there is a change in revenue and when a supposedly variable cost changes. Here are several examples:
Given the considerable amount of time required to maintain a flexible budget, some organizations may instead opt to eliminate their budgets entirely, in favor of using short-range forecasting without the use of any types of standards (flexible or otherwise). An alternative is to run a high-level flex budget as a pilot test to see how useful the concept is, and then expand the model as necessary.
Example of a Flexible Budget
ABC Company has a budget of $10 million in revenues and a $4 million cost of goods sold. Of the $4 million in budgeted cost of goods sold, $1 million is fixed, and $3 million varies directly with revenue. Thus, the variable portion of the cost of goods sold is 30% of revenues. Once the budget period has been completed, ABC finds that sales were actually $9 million. If it used a flexible budget, the fixed portion of the cost of goods sold would still be $1 million, but the variable portion would drop to $2.7 million, since it is always 30% of revenues. The result is that a flexible budget yields a budgeted cost of goods sold of $3.7 million at a $9 million revenue level, rather than the $4 million that would be listed in a static budget.
Many companies go through the budgeting process every year simply because they did it the year before, but they do not know why they continue to create new budgets.
What are the objectives of budgeting? They are:
Conversely, budgeting may not be of much use for a well-established business that has a consistent track record of performance. In this case, a better approach may be to manage the organization from a rolling forecast that is updated on a regular basis. Doing so reduces the work associated with financial predictions, and also allows the business to shift its operational focus on short notice.
A budget forecasts the financial results and financial position of a company for one or more future periods. A budget is used for planning and performance measurement purposes, which can involve spending for fixed assets, rolling out new products, training employees, setting up bonus pl, controlling operations, and so forth.
At the most minimal level, a budget contains an estimated income statement for future periods. A more complex budget contains a sales forecast, the cost of goods sold and expenditures needed to support the projected sales, estimates of working capital requirements, fixed asset purchases, a cash flow forecast, and an estimate of financing needs. This should be constructed in a top-down format, so a master budget contains a summary of the entire budget document, while separate documents containing supporting budgets roll up into the master budget, and provide additional detail to users.
Many budgets are prepared on electronic spreadsheets, though larger businesses prefer to use budget-specific software that is more structured and so is less liable to contain computational errors.
A prime use of the budget is as a performance baseline for the measurement of actual results. It can be misleading to do so, since budgets typically become increasingly inaccurate over time, resulting in large variances that have no basis in actual results. To reduce this problem, some companies periodically revise their budgets to keep them closer to reality, or only budget for a few periods into the future, which gives the same result.
Another option that sidesteps budgeting problems is to operate without a budget. Doing so requires an ongoing short-term forecast from which business decisions can be made, as well as performance measurements based on what a peer group is achieving. Though operating without a budget can at first appear to be too slipshod to be effective, the systems that replace a budget can be remarkably effective.
A fixed budget is a financial plan that does not change through the budget period, irrespective of any changes in actual activity levels experienced.
Since most companies experience substantial variations from their expected activity levels over the period encompassed by a budget, the amounts in the budget are likely to diverge from actual results. This divergence is likely to increase over time. The only situations in which a fixed budget is likely to track close to actual results are when:
Most companies use fixed budgets, which me that they routinely deal with large variations between actual and budgeted results. This also tends to cause a lack of reliance by employees on the budget, and in the variances derived from it.
A good way to mitigate the disadvantages of a fixed budget are to combine it with continuous budgeting, where you add a new budget period onto the end of the budget as soon as the most recent budget period has been concluded. By doing so, you gradually incorporate the actual results of the most recent period into the budget, and also maintain a full-year budget at all times.
Another way to mitigate the effects of a fixed budget is to shorten the period covered by it. For example, the budget may only encompass a three-month period, after which management formulates another budget that lasts for an additional three months. Thus, even though the amounts in the budget are fixed, they apply to such a short period of time that actual results will not have much time in which to diverge from expectations.
The fixed budget is not effective for evaluating the performance of cost centers. For example, a cost center manager may be given a large fixed budget, and will make expenditures below the budget and be rewarded for doing so, even though a much larger overall decline in company revenues should have mandated a much larger expense reduction. The same problem arises if revenues are much higher than expected - the managers of cost centers have to spend more than the amounts indicated in the baseline fixed budget, and so appear to have unfavorable variances, even though they are simply doing what is needed to keep up with customer demand.
The reverse of a fixed budget is a flexible budget, where the budget is designed to change in response to variations in activity levels. There tend to be much smaller variances from the budget when a flexible budget is used, since the model tracks much closer to actual results.
A business creates a budget when it wants to match its actual future performance to an ideal scenario that incorporates its best estimates of sales, expenses, asset replacements, cash flows, and other factors. There are a number of alternative budgeting models available.
The following list summarizes the key aspects and disadvantages of each type of budgeting model:
Of the budgeting models shown here, the static model is by far the most common, despite being unwieldy and rarely attained. A considerably different alternative is to use a rolling forecast, and allow managers to adjust their expenditures "on the fly" to match short-term revenue expectations. Organizations may find that the rolling forecast is a more productive form of budget model, given its high degree of flexibility.
Budgetary slack is the deliberate under-estimation of budgeted revenue or over-estimation of budgeted expenses. This allows managers a much better chance of "making their numbers," which is particularly important for them if performance appraisals and bonuses are tied to the achievement of budgeted numbers.
Budgetary slack may also occur when there is considerable uncertainty about the results to be expected in a future period. Managers tend to be more conservative when creating budgets under such circumstances. This is particularly common when creating a budget for an entirely new product line, where there is no historical record of possible results to rely upon.
Budgetary slack is most common when a company uses participative budgeting, since this form of budgeting involves the participation of a large number of employees, which gives more people a chance to introduce budgetary slack into the budget.
Another source of budgetary slack is when senior management wants to report to the investment community that the business is routinely beating internal budget expectations. This cause is less likely, since outside analysts judge a company's performance in relation to the results of its competitors, not its budget.
Budgetary slack interferes with proper corporate performance, because employees only have an incentive to meet their budget goals, which are set quite low. When there is budgetary slack for multiple consecutive years, a company may find that its overall performance has declined in comparison to that of more aggressive competititors who use stretch goals. Thus, budgetary slack can have a long-term negative impact on the profitability and competitive positioning of a business.
Budgetary slack is less likely to occur when a small number of aggressive managers are the only ones allowed input into the budget model, since they can set expectations extremely high. Slack is also less likely when there is no link between performance or bonus pl and the budget.
A rolling budget is continually updated to add a new budget period as the most recent budget period is completed. Thus, the rolling budget involves the incremental extension of the existing budget model. By doing so, a business always has a budget that extends one year into the future.
A rolling budget calls for considerably more management attention than is the case when a company produces a one-year static budget, since some budgeting activities must now be repeated every month. In addition, if a company uses participative budgeting to create its budgets on a rolling basis, the total employee time used over the course of a year is substantial. Consequently, it is best to adopt a leaner approach to a rolling budget, with fewer people involved in the process.
Advantages and Disadvantages of the Rolling Budget
This approach has the advantage of having someone constantly attend to the budget model and revise budget assumptions for the last incremental period of the budget. The downside of this approach is that it may not yield a budget that is more achievable than the traditional static budget, since the budget periods prior to the incremental month just added are not revised.
Example of a Rolling Budget
ABC Company has adopted a 12-month planning horizon, and its initial budget is from January to December. After a month passes, the January period is complete, so it now added a budget for the following January, so that it still has a 12-month planning horizon that now extends from February of the current year to January of the next year.
Continuous budgeting is the process of continually adding one more month to the end of a multi-period budget as each month goes by. This approach has the advantage of having someone constantly attend to the budget model and revise budget assumptions for the last incremental period of the budget. The downside of this approach is that it may not yield a budget that is more achievable than the traditional static budget, since the budget periods prior to the incremental month just added are not revised.
The continuous budgeting concept is usually applied to a twelve-month budget, so there is always a full year budget in place. However, the period of this budget may not correspond to a company's fiscal year.
If a company elects to use continuous budgeting for a smaller time period, such as three months, its ability to create a high-quality budget is greatly enhanced. Sales forecasts tend to be much more accurate over periods of just a few months, so the budget can be revised based on very likely estimates of company activity. Over such a short period of time, a continuous budget is essentially the same as a short-term forecast, except that a forecast tends to produce more aggregated revenue and expense numbers.
Continuous budgeting calls for considerably more management attention than is the case when a company produces a one-year static budget, since some budgeting activities must now be repeated every month. In addition, if a company uses participative budgeting to create its budgets on a continuous basis, then the total employee time used over the course of a year is substantial. Consequently, it is best to adopt a leaner approach to continuous budgeting, with fewer people involved in the process.
If continuous budgeting principles are applied to capital budgeting, this me that funds may be granted for large fixed asset projects at any time, rather than during the more typical once-a-year capital budgeting process that is prevalent under more traditional budgeting systems.