Budgeting : Purpose, Importance, Types, Process & Strategy
Last Updated : 16 Apr, 2024
What is Budgeting?
Budgeting is the process of outlining the estimated income and expenses over a specific period. The process involves planning, organizing, and controlling the financial resources of an organisation or an individual to achieve specific goals within a defined period. The objective of budgeting is to guide in making financial decisions and to ensure that available resources are used efficiently and effectively. It helps to navigate the financial performance and stability of the business and encourages to work towards achieving an end goal.
Geeky Takeaways:
- Budgeting serves as a roadmap for individuals and entities to provide an overview of the organization's financial position.
- It contributes to the overall financial stability of the business.
- Businesses compare their actual performance with the budgeted amount to track their performance.
- Budgeting helps in determining the area where the spending needs to be controlled.
Purpose of Budgeting
1. Allocation of Resources: Budgeting ensures that individuals and entities allocate their resources efficiently by utilizing their income wisely to meet financial objectives.
2. Tracking Expenses: Maintaining a budget helps to track the expenses and identify areas where spending can be optimized. Budgeting provides an outline to spend the money efficiently.
3. Saving: Individuals usually prepare a budget to allocate their limited resources in a systematic manner which eventually leads them towards saving a portion of their income.
4. Systematic Approach: Budgeting provides individuals and businesses with a systematic and organised approach to managing their finances.
5. Decision Making: It helps to make informed decisions according to the end goal of the business. Entities will sometimes be faced with large decisions that will impact their inflow and outflow of cash. With a budget, it would be easy to make better decisions.
6. Financial Stability: Preparing a well-planned budget helps in better planning and contributes to the overall financial stability of the business. A structured budget suggests a strategy to spend the money which reduces the financial stress of the business and provides a sense of security.
Importance of Budgeting
1. Setting of Goals: Budgeting involves planning. It serves as a roadmap to achieve the end goal of an individual or an entity. It prioritizes the objectives and provides a strategy to allocate the available resources accordingly. A goal can be to expand the business, save, generate more revenue, etc.
2. Financial Stability: Preparing a well-planned budget helps in better planning and contributes to the overall financial stability of the business. A structured budget suggests a strategy to spend the money which reduces the financial stress of the business and provides a sense of security.
3. Decision-Making: As said earlier, a budget is a roadmap to achieve the goal of the business, it also helps to make informed decisions according to the end goal of the business. Entities will sometimes be faced with large decisions that will impact their inflow and outflow of cash. With a budget, it would be easy to make better decisions.
4. Identify Income and Expenses: Identifying all the sources of income and categorizing all expenses ensures that a business has a comprehensive view of its financial inflows and outflows. It helps in determining the area where the spending needs to be controlled.
5. Coordination: It encourages managers to build relationships with the other parts of the organisation and understand how the various departments interact with each other. This maintains coordination among various departments in an organisation.
Types of Budgets
1. Operational Budget: An operational budget states the expected income and losses of a business over a specific period, generally a fiscal year. Its purpose is to focus on the core business activities. Operational budgets are used to predict the revenue and expenses of the business. A business can plan the strategy accordingly based on the operational budget.
2. Financial Budget: It is a budget that outlines the detailed plan on the income and expenses of a business or an individual and their financial goal over a specific period. It helps to provide a proper strategy for the utilisation of resources and to maintain financial stability. A financial budget focuses on the monetary aspect of an entity and helps in identifying various sources of income and ways to reduce expenses.
3. Master Budget: A master budget is a comprehensive financial plan that serves as a strategic roadmap by consolidating all smaller budgets within an organization to provide a comprehensive overview of the organization's financial performance. It is an essential tool for planning, coordinating, and controlling the financial activities of an entity.
4. Static Budget: Static budgets are those budgets that remain intact or unchanged during a fiscal year regardless of the actual performance of the business. These budgets serve as a benchmark against which actual financial results can be compared.
5. Flexible Budget: Unlike the static budget, a flexible budget is a budget that changes according to the level of activity or business condition. It helps a business to change financial plans depending on the fluctuations in production, sales, or other elements.
6. Sales Budget: A sales budget provides a detailed estimation of the sales revenue for a specific period. The budget is maintained by analyzing the historical sales data, market trends and other essential factors. It is one of the most important budgets as it affects inventory, production and operational decisions.
Budgeting Process
The process of budgeting includes the following steps:
1. Objective: The foremost step in creating a budget is to identify the ultimate goal of the business. It is one of the most important phases in this process. A business should set out the list of goals that are to be achieved whether short-term or long-term.
2. Historical data: A business needs to learn from its past performance. It must analyse its historical data to identify the trend in the performance of the business. Historical data helps in forecasting the position of the business and to identify threats and opportunities.
3. Relevant Information: Before preparing a budget, it is necessary to keep in mind every relevant data that has a direct impact on the end goal of the business. Information can be gathered by collaborating with different department heads of an organisation. It will help in calculating the estimated revenue.
4. Preparation: After analysing the previous record of the business and gathering all the relevant data. It is time to prepare the budget by estimating the income of the business, identifying fixed and variable expenses and adjusting figures as needed to align with financial goals. It is also necessary to determine the timeframe of the budget.
5. Communication: Once the budget is prepared, the organisation must communicate the budget to its stakeholders, its employees and other departmental heads. If the stakeholders raise any queries or issues with the budget, those queries must be considered and issues shall be sorted out.
6. Monitor: The last step is to finalize the budget with the approval of the stakeholders and closely monitor financial performance against the budgeted figures. Businesses should regularly review and compare the actual performance with the budgeted amounts.
Budgeting Strategy
1. Setting Clear Goals: The purpose of creating a budget is to meet financial goals, such as savings goals, and generate revenue now and into the future. Having clear objectives provides direction for your budget. It is one of the most important phases in this process.
2. Identifying Income and Expenses: Identifying all the sources of income and categorizing all expenses ensures that a business has a comprehensive view of its financial inflows and outflows. It helps in determining the area where the spending needs to be controlled.
3. Track Monthly Expenses: It is important to track expenses because it helps in reducing the irrelevant spending of money. Businesses prefer tracking their monthly expenses by using spreadsheets or other available software.
4. Saving Goals: A person or an entity should have a saving goal. Budgeting helps in allocating resources in a more useful and efficient way which helps individuals and entities to save money and reduce the cost.
5. Creating Emergency Funds: Funds are the part of the budget which are allocated to an emergency fund. It ensures financial safety for the business in uncertain situations.
Difference Between Static Budgets and Flexible Budgets
Basis | Static Budgets | Flexible Budgets |
|---|
Nature | Static budgets are those budgets that remain intact or unchanged during a fiscal year. | A Flexible budget is a budget that changes according to the level of activity or business conditions. |
Adaptability | Static budgets are not adaptable to changes in business conditions. Sometimes, they become less relevant for decision-making | Flexible budgets are adaptable to changes in production, sales, or other departments. They are useful in decision-making. |
Application | These budgets are useful in a business where the business conditions are stable and are not affected by external changes. | These are particularly useful in industries where activity levels may change due to various factors. |
Usage | Static budgets are used for performance evaluation by comparing actual performance with the budget. | Flexible budgets allow for a better understanding of the impact of volume changes on costs. |
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