Budgets are an integral part of running any business efficiently and effectively. They serve as a plan of action for managers as well as a point of comparison at the period's end. So how do budgets work, and how can they be used to gauge where a business is going? In this article, we'll introduce you to budgeting and show you how businesses use them.

Business Budgeting

When most people think of budgets, they think of a typical household budget – given a certain amount of money, how much should be allocated to various expenses? This system usually works fine for individuals, but in the business world there needs to be a lot more involved. Determining how much to spend on various expenses is only half the battle. The other half is for a company to be able to effectively judge its spending financial performance. Regardless of the type of business, the ability to gauge performance using budgets is a matter of life and death in the business world.

Who Uses Budgets?

Nearly everyone uses budgets in some form. From the household budget to the multi-billion dollar government budgets, they're a pretty universal tool.

However, a company's budget is a bit more involved. Most companies will start with a master, or static, budget. A static budget is a budget with numbers based on planned outputs and inputs for each of the firm's divisions. It's the first part of budgeting, which determines how much a company has and how much it will spend. These are projected amounts and the company expects to stay within these limits. To figure out the numbers, managers make use of economic forecasting methods to determine a realistic static budget.

Changing Budgets

As you may have experienced with your own finances, expenses that are not part of the budget often pop up. However, the static budget acts as a guideline; it does not constrain the company to staying within those limits.

In other words, a budget is merely a tool that is used to help make business decisions. When it comes down to something that wasn't foreseen when the static budget was put together, companies can decide to spend more money or to spend more of it in a different area than originally planned, although the static budget will still act as a guideline. Budgets can always be changed.

Using a Budget to Evaluate Performance

So, what happens when the period's over? It's time to determine whether we fell in line with our planned expenditures. That's when a flexible budget is used. A flexible budget is a budget with figures that are based on actual output. It's then compared to a company's static budget to get variances (differences) between what level of spending was expected and what actually occurred.

With a flexible budget, budgeted dollar values (i.e. costs or selling prices) are multiplied by actual units to determine what particular number will be given to a level of output or sales. This yields the total variable costs involved in production. The second component of the flexible budget is the fixed cost. Typically, the fixed cost does not differ between the static and flexible budgets.

There are tons of variances that can arise in the static budgeting system. The two most basic are the flexible budget variance and sales-volume variance. The flexible budget variance compares the flexible budget to actual results to determine the effects that prices or costs have had on operations. The sales-volume variance compares the flexible budget to the static budget to determine the effect that a company's level of activity had on its operations.

From these two budgets, a company can develop individual flexible and static budgets for any element of its operations. For example, the static budget variance is the difference between the static budget and the company's actual results. The variances are always classified as either favorable or unfavorable.

If sales volume variance is unfavorable (flexible budget is less than static budget), the company's sales (or production with a production volume variance) will turn out to be less than anticipated. If, however, the flexible budget variance was unfavorable (the variance effects eventual cash flows negatively) this would be a result of price or cost. By knowing where the company is falling short or exceeding the mark, managers can do a better job of evaluating the company's performance and use the information to make changes to further streamline their processes.

Implementing Budgets

If you run your own business (or household), it's not hard to implement a flexible budget based on the business's numbers. You don't need to be an accountant: The math is simple and it's typically worth the effort in the end. After all, it's hard to know how you can make your company better and more cost-efficient when you don't even know where you're missing the mark.

The Bottom Line

Every major company in the world uses flexible budgeting – and you can bet that there's a good reason for that. So the next time you think about budgeting, think beyond the static budget that most people are familiar with. Understanding flexible budgeting can help you gain a wealth of information through the analysis that budget variances afford to those who use them.