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Budgets can be useful tools if developed and managed within a proper structure. Budgeting can also be used as an effective device to evaluate "what if" scenarios using computer spreadsheets. "What if" we change prices?" "What if" volume increases by five percent? Ten percent?" By running various "what if" scenarios, management can see the effect of various alternatives and can select the best course of action for achieving the company's goals.
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In developing budgets, two primary approaches may be used: Traditional or zero-based budgeting (ZBB). Traditional budgeting involves adding or subtracting a given percentage or amount to the preceding period's budget, or costs to arrive at the new budget. Zero-based budgeting requires that the budget be built up from a base of zero, examining and justifying each element in its entirety. One advantage of zero-based budgeting is that inefficiencies are considered and factored out (or in), whereas traditional budgeting tends to carry forward the past, inefficiencies and all. A combination of the two approaches is frequently used; focusing zero-based budgeting techniques on the expense side, excluding cost of goods sold and fixed costs.
The budgeting process starts with a definition of goals to be obtained during the budget period. A particular percentage of profit will be included as a goal. Similarly, a percentage of volume or sales growth may be stipulated, as could be market share.
Once the budget is finalized, it should be structured into a flexible format, which takes into consideration variations in sales volume and can also take into account variation in product mix. Various cost elements react differently to changes in volume. The result is that to analyze variances from a fixed budget can be difficult because of the combination of activity variances (volume), and price variances. A flexible budget is basically a formula applied to a fixed budget to show the impact of changes in budgeted activity level. In essence, a flexible budget is a means to convert the standard in the master budget to show how costs should behave at a different level of activity.
Budget variance analysis is performed to assess the cause(s) of deviations from the budget. Management is then able to institute corrective actions, where necessary, to address the causes of the variances.
It is critical that the budget reflects realistic goals and objectives. Equally critical is the necessity to link increased expectations to the resources necessary to achieve such increases.
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