Understanding The Budgeting Process: Complete Guide

Without a budget, a business can’t track how much of its revenue is profit. As a result, expenditures will be scattered and unclear. Without a budget, a business can’t determine its financial health. Not really.

A budget gives a detailed estimate of income and expenditures over the budget period. It allows businesses to identify potential dangers and areas in need of financial improvement, cut down unwanted expenses, provide data for forecasting, and so much more.

It can help fuel important business decisions, predict cash flow, and accurately predict profits.

Without a proper budget, a business sets itself up for failure, making it is an essential part of any business plan. And a proper budget requires thought, time, and effort.

Key Takeaways:

• The three types of budgets are operating budget, sales budget, and cash budget.

• The steps in the budgeting process are:

  • The preparation phase

  • The approval phase

  • The execution phase

  • The evaluation phase

• Budgets are important to companies because it can communicate objectives and evaluate departmental performance.

What Is a Budgeting Process?

In the simplest of terms, the budgeting process involves creating, approving, and implementing a budget. It is the financial planning a company undergoes to ensure that they maintain the expected profit margins.

• This can sometimes be a long, drawn-out process that drags out over months. For larger companies, it can be four to six months, sometimes longer. For smaller companies, it may only be one to three months from start to finish.

  Companies that have managed to streamline the budgeting process may not need nearly as long to create the budget for the upcoming fiscal year.

• A budget is more than just crunching a few numbers and planning to keep expenditures below a certain threshold. It is a plan for the company’s future.

• During the budgeting process, benchmarks will be set, priorities will be noted, and goals will be established. The budgeting process will give an overview of the revenue, profit, expenses, and more. All of it adds up creating a formal plan to achieve a business’s goals.

• By implementing a proper budget, a company can better evaluate its performance and determine whether or not they’ve met the goals of the budget period. They help a business answer some of these questions:

  • Is the business performing well?

  • Do they have the money to continue running?

  • To scale their operations?

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The Importance of Creating and Maintaining Budgets

A budget is more than just numbers. Creating, implementing, and evaluating the budget is an important aspect of a business’s financial health.

Budgets estimate and track income and expenses, but they also:

• Help to set and highlight priorities

• Communicate objectives and plans to departmental managers

• Evaluate departmental performance—both at the managerial level and below

• Control spending

• Validate expenditures

• Identify available funding and the need for additional funding

Types of Budgets

The budget a business creates during the budgeting process, the “master budget,” is a comprehensive compilation of many smaller budgets.

A master budget, often referred to as a comprehensive budget, combines all of the lower-level budgets — like the cash budget, the sales budget, cost of goods sold, and administrative budget — the cash flow forecasts, the budgeted financial statements, and the overall financial plan.

It can include everything from revenue and expenses, operating costs, sales projections, capital expenditures, and more.

The master budget will typically forecast an entire fiscal year and can be broken down into monthly or quarterly projections. The income statement, the balance sheet, and the cash flow statement can all be projected based on the master budget.

Some of the lower-level budgets that make up the master budget are:

1. Operating budget. The operating budget determines the income-generating activities, including both revenue and expenses, of the day-to-day operations. As the name suggests, an operating budget will focus on the operating costs.

   Like the master budget, an operating budget is a compilation of several smaller budgets. It can include sales costs like commissions, labor costs, material costs, manufacturing/production costs, and overhead costs.

2. Sales budget. The sales budget is a forecast of the total expected sales volume for the budget period. In the simplest of terms, it is the number of expected units sold multiplied by the expected selling price.

   Of course, there is a bit more to it than simple mathematics. A sales budget includes an itemization of the sales expectations, yes. But the expectations can be influenced by several factors, including previous sales, economic conditions, competitors, and material cost expectations.

3. Cash budget (or cash flow budget). A cash budget estimates the actual cash flow of a company. It can help project and track the inflows and outflows of cash.

   Like the other budget types, there is research and forecasting involved in creating the cash budget. Since the budgeting process involves estimating the payables and receivables, outstanding accounts can complicate the process.

   These complications can make the budgeting process for this particular budget type more difficult than others. To compensate for the past-due accounts, the company will need to include an allowance for doubtful accounts.

   The allowance for doubtful accounts will estimate the percentage of accounts receivable that are expected to go uncollected. It will take the total receivables on the balance sheet and update them to reflect only the amounts expected to be paid.

Components of a Business Budget

Several lower-level budgets will be compiled and collected to create the comprehensive master budget. But, every master budget will include some basic components.

The basic components of a business budget are:

1. Estimated revenue. This is the projected income for the fiscal year. This income should include only the profits made from the sale of goods. In addition, it will include a sales forecast and an estimation of the cost of goods sold (COGS).

2. Fixed costs. Fixed costs are any expenditures that remain static. For example, the rent for the office or warehouse, labor costs, and insurance premiums would all be considered fixed costs. While they may fluctuate slightly, these are typically the same amount each time a payment is rendered.

3. Variable costs. The opposite of fixed costs, variable costs are fluctuating expenditures. For example, cost of goods sold (COGS), commissions, utility costs determined by use, and part-time wages would all be considered variable costs.

4. One-off expenses. Unlike fixed costs or variable costs, which are made repeatedly, one-off expenses are a one-time cost. For example, equipment upgrades, software purchases, and unexpected costs will fall into this category.

5. Cash flow. Revenue is based on the sales numbers, but cash flow is the actual inflows and outflows of money. Therefore, you will want to understand the actual cash moving in and out when budgeting.

6. Profits. Understanding your profits is an extremely important part of running a business. It can help you determine how much you should invest, whether or not you require additional investments or loans, and how much your business is growing. To determine profit, you would subtract estimated costs from projected revenue.

The Most Common Approaches to the Budgeting Process

While there are many ways someone can approach the budgeting process, the two most common approaches are the “top-down” approach and the “bottom-up” approach.

1. Top-down approach. As the name implies, this budgeting process works from the top-level executives down. The budget is prepared entirely by senior management and relies heavily on company objectives.

   While lower-level management can use the budget to create its own departmental budget, there is little participation in the budgeting process outside top-level executives. Their involvement is more in implementation.

   Senior-level management will inevitably have more experience with the budgeting process and have direct knowledge of historical data, allowing for more accurate projections. In addition, it can save time since the mid-to lower-level management will simply be handed a budget to follow.

   However, there are certainly some disadvantages to this approach as well. For example, the lack of participation in the budgeting process may make the departmental managers less likely to see it succeed. In addition, there can be miscommunications or bloated expectations that lead to unrealistic budgets as well.

2. Bottom-up approach. Unsurprisingly, the bottom-up approach follows the opposite path. This budgeting process begins at the departmental level with the mid-to lower-level management before moving up to top-level executives.

   Each department creates its own master budget based on the general guidelines created by upper management that are passed up and combined to create a comprehensive budget for the company as a whole.

   While this is a more inclusive approach, it can also be more time-consuming. Due to the day-to-day involvement of the departmental managers, though, the bottom-up approach can produce more realistic and accurate budgets.

   In addition, their involvement in the budgeting process also affects their motivations; they are more likely to commit themselves to a budget that they believe is realistic.

The Steps of the Budgeting Process

By now, we understand that the budgeting process is the creation and implementation of a budget. There are many steps to the budgeting process—steps that may differ from business to business based on their approach—but four major phases.

Within each phase are many steps that will need to be completed to prepare a realistic, fully-fledged budget for the business.

1. The preparation phase.

   • Determine goals and objectives for the fiscal year

   • Obtain revenue forecasts and cost projections

   • Incorporate operating expenses and other expenditures

   • Review the budget

2. The approval phase.

   • Submit budget for approval

   • Obtain approval

3. The execution phase.

   • Issue the budget to each department

   • Implement the budget

4. The evaluation phase.

   • Examine monthly or quarterly financial reports

   • Examine year-end financial reports

   • Determine recommendations for the upcoming fiscal year

Author

Samantha Goddiess

Samantha is a lifelong writer who has been writing professionally for the last six years. After graduating with honors from Greensboro College with a degree in English & Communications, she went on to find work as an in-house copywriter for several companies including Costume Supercenter, and Blueprint Education.