If you dread “budget season,” you’re not alone. Learn how budgeting works and why it matters, so you can build effective budgets—and overcome that dread for good.
A budget is a document that translates a group’s or organization’s strategic and operational plans into the expected resources required and returns anticipated over a certain period. *
There are many types of budgets. For example:
- Operating budgets reflect a group’s or organization’s day-to-day revenues and expenses. They typically cover a one—year period.
- Capital budgets show planned outlays for investments in plants, equipment, and product development. Capital budgets may cover periods of three to 10 years.
- Cash budgets plot the expected cash balances an organization will have during the given period, based on information provided in the operating and capital budgets.
As a manager, you may need to prepare operating budgets for your group every year. Your organization’s finance department “rolls up” your operating budget and those created by your peers into a master budget for the entire organization.
You may also create capital budgets for investments you’re considering making for your group. As with your operating budgets, the finance department combines your capital budgets with other managers’ capital budgets to further build the master budget. The operating and capital budget information goes into the balance sheet and the company’s cash flow statement.
You probably won’t be preparing cash budgets unless you work in your organization’s finance department. That’s because this kind of budget is typically created by finance professionals. For that reason, this topic focuses on operating and capital budgets.
Here’s a diagram showing the information sources for various organizational budgets—and how the different budgets are connected. In a typical manufacturing company, for instance, the VPs of sales, procurement, and manufacturing, along with CFOs, country unit heads, and sales and marketing heads, contribute estimates for the operating budget. The CEO, CFO, division and business—unit heads, and plant managers and product managers provide estimates of planned capital investments for the capital budget.
How Departmental Budgets Coordinate with the Master Budget
Preparing a Budget. Pocket Mentor. Boston: Harvard Business School Publishing, 2009.
Why budgets matter
A budget functions as financial blueprint or action plan that a group or organization creates to ensure it has enough resources to achieve its goals. The budget also helps ensure that achieving those goals generates the desired benefits.
So a group or organization uses a budget to:
- Put all of its financial components into one coherent picture that shows its strategic and operational goals along with its financial health
- Align individual teams, departments, and business units behind the organization’s goals (for example, a company would budget more for sales and marketing teams charged with expanding the customer base in their region)
- Allocate resources wisely
- Communicate financial expectations
- Evaluate and motivate managers’ and employees’ performance (for example, managers and employees receive a bonus when their group meets the goals laid out in its budget)
- Communicate goals to external stakeholders. Many companies declare their strategic and operational goals publicly to capital markets and then put those goals in their budgets
Karl’s company’s investor relations team might tell analysts, “We expect earnings per share of $1.30 to $1.35”; “Our capital expenditures won’t exceed 10% of our revenues”; or “We plan to invest 5% more in R&D over the next three years.”
- Take corrective action when actual business results don’t match the budgeted target results; this might mean allocating more money to boost an effort or cutting funds if an activity or initiative is no longer worth pursuing.
Overview of the budgeting process
Typically, formulating a budget is an iterative process: Different groups prepare preliminary budgets. They then come together to identify and resolve differences. Coordination and communication between people at different levels of the organization and across functions are critical for arriving at useful budgets.
In an organization in which upper management defines strategic and operational goals, senior managers must communicate those goals to managers at all levels. Functional-area managers, business unit heads, and team leaders need to communicate their particular needs, assumptions, expectations, and goals to those who evaluate the departmental and functional budgets.
In addition, the different groups within the organization must listen to one another. For instance, if one division wants to achieve certain sales goals, then the production department needs to know that, so it can prepare to increase production capacity. If the company wants to introduce a new service, then the marketing department has to know about this early in its planning process. That way, marketing can include funds in its budget for developing effective advertising campaigns for the new offering.
Traditional and alternative approaches
There are many different approaches to the budgeting process. Some of them are traditional; others are designed for changing business needs (e.g., the need for real-time information or greater flexibility) and newer ways of working (more agile, less hierarchical):
Traditional budgets are generally easier to build, and they simplify the coordination of assumptions across departments. On the downside, their timing is frequently off: The periods they cover are either too long or too short to reflect real conditions. Moreover, traditional budgets can be simplistic or overly complicated, or inflexible or political.
Alternative budgets, such as zero-based budgets, try to deliver greater accuracy and functionality. But creating them and embedding them into company practice is a major undertaking. It can distract managers’ attention from their critical activities.
Types of costs
Whether your organization takes a traditional or alternative approach to budgeting, you need to distinguish between several types of costs when you build your budget: fixed, variable, and corporate overhead.
Fixed costs remain fairly constant, regardless of production or sales volumes during the budget period. Examples include:
- Basic utilities, including electric and telephone service
- Equipment leases
- Interest payments
- Administrative costs
- Marketing and advertising
- Indirect labor, such as salaried supervisory employees
Variable costs change in direct proportion to shifts in production or sales volumes during the budget period. Examples include:
- Raw materials
- Direct labor
- Energy (electricity, gas) used in manufacturing or production
- Sales commissions
- Income taxes
Your estimates of the variable costs that will be incurred during the budget period depend on your group’s or organization’s plans. By understanding those plans, you can anticipate the need for resources (such as expanded capacity) and include them in your budget requests.
Anna is the head of production for a book publisher. Her organization wants to increase sales volumes significantly. Anna includes in her budgets the expected costs for leasing additional computer equipment, renting more warehouse space, hiring extra administrative help in her group, and purchasing extra paper.
Corporate overhead costs
Operating budgets may include corporate overhead costs—costs associated with operating the organization that aren’t tied to individual products or departments. This figure typically includes the rent for the offices occupied by corporate headquarters, and salaries and expenses associated with corporate management.
How these costs are attributed to individual departments varies from one company to another. Some organizations may allocate overhead only to certain departmental budgets—such as those that generate revenue.
Fixed vs. flexible budgets
There are two basic kinds of operating budgets: fixed and flexible. A fixed budget is used where there are few or no variable expense elements. The manager must stick to the original amount budgeted for the particular budget period (barring a major unforeseen event, like a labor strike or a weather catastrophe).
A flexible budget allows the organization to adjust budgeted revenues and costs based on actual levels of activity, which can vary—sometimes greatly. For example, a manager with a flexible budget would be authorized to incur additional production costs to meet unanticipated demand. Flexible budgets are useful where managers have no control over the volume of output; they can spend what they need to meet customers’ needs without being penalized for the higher costs.FROM
How to Build a Flexible Budget
To build a flexible budget:
- Determine the relevant range of the activity that is expected to fluctuate during the coming period: the number of widgets manufactured, deliveries run, hours of contractor labor needed, and so forth.
- Analyze the fixed and variable costs that will be incurred over that range.
- Separate costs by type of activity, such as market research (for expanding to a new market) or distribution.
- Prepare a budget showing what costs would be incurred at various points throughout the range.
Demi, a marketing manager for a furniture retailer, is planning a marketing campaign for the next year’s new fall line. She’ll include in her budget the cost of an advertising agency’s services, the fees for freelance writers, and the labor costs for additional call center representatives to handle expected increases in call volume.
Flexible budgets are especially valuable for organizations operating in volatile business environments.
Tom is a supply chain manager for a steel manufacturer. Among other things, he is responsible for maintaining inventory at levels that support the sales plan. His company faces numerous uncertainties that could cause actual revenues and costs to differ markedly from those originally budgeted, including:
- Fluctuations in the supply and cost of raw materials, electricity, and natural gas
- Sudden changes in market demand for steel products, owing to a volatile global economy
- Intensifying competitive pressures from imports
- Changes in foreign trade policy affecting imports and exports
- New government regulations increasing environmental compliance costs
For this reason, when preparing his annual budget, he includes ranges for the quantity of raw materials needed for production, as well as for shipping and logistics costs for inbound materials and customer orders.
Limitations of budgets
Like any other management tool, budgets have limitations. For instance:
- They can be rigid. Startups as well as companies in fast-changing industries find budgets somewhat limiting. That’s because such enterprises can’t readily adapt their budgets to changes in their internal and external business environment.
- They’re time- and labor-intensive. The budgeting process takes considerable time and effort. One survey showed that budgeting takes up 20%-30% of senior executives’ time. * Because budgeting is so time-consuming, managers often must start developing new budgets before they’ve seen the impact of budgetary changes on the last period’s results.
- They can have unintended consequences. For example, when managers’ compensation is tied to their performance against budgets, the practice might trigger the wrong behaviors, such as budget padding (deliberately underestimating revenue or overestimating costs) or channel stuffing (shipping unfinished products to distributors to record more sales).
Caren, a marketing manager for a toy manufacturer, intentionally understates demand for the company’s products for an upcoming major holiday. That way, the revenues targeted in the budget will be low and easy to beat—and she can get a bonus. The company ties its production to this biased forecast and runs out of products to sell during the height of the holiday season. *
- They can foster counterproductive decisions. If budgets aren’t linked to an organization’s strategy-related spending, they can end up encouraging actions that undermine goals.
A cost-reduction mandate that results in across-the-board cuts can hurt important strategic initiatives or operations that contribute disproportionately to the company’s profits. As a result, high-performing units are penalized and underperforming ones are propped up. *
- They can encourage a use-it-or-lose-it mindset. Managers fear that if they don’t spend what’s left over in their budgets at the end of the year, their funding for next year will be reduced. * So they find something to spend the surplus on, instead of channeling those funds to resource-starved operations or projects elsewhere in the organization.
Once you understand the limitations, you can adjust your budgeting practices and expectations accordingly and derive more value from the budgets you create.