The budgeting process is an essential element of strategic business planning that involves the development of the goals and objectives of the company; the formulation of specific department and overall organizational budgets; and the reporting and follow-up of budget variances and revisions. The goals and objectives of the company should, of course, be based on an assessment of the marketplace, the operational activities and strengths of the company, and the long-term business objectives of the stakeholders of the company. These goals and objectives are needed in order to give direction to the budgeting process. Operational objectives could include such things as controlling inventory levels and carrying costs and, if so, the budget should include all the indicators necessary to monitor inventory-related performance.
Analysis of variances is absolutely necessary to evaluate the integrity of the budgets as well as overall performance of organizational operations. By identifying and analyzing material variances, management can determine if the budget needs to be revised and/or other operational decisions are required. In order for the budgeting process to be most effective it should be done on a continuous basis as opposed to episodically or once a year so that the budget becomes a tool for regular feedback and improvement.
Fixed budgets are generally used in situations where the sales volume of the company is relatively stable and predictable. Fixed budgets are based on the estimated or standard unit costs, selling expenses and administrative expenses that correspond to a specific projected volume of sales. A fixed budget serves as a profit plan–assuming that the estimated costs and expenses are less than the projected sales revenues—and can be used as the basis for cash flow forecasting; however, the utility of a fixed budget depends heavily on the accuracy of the assumptions regarding sales volume. Accordingly, if the actual sales volume differs substantially from the projections, either due to unforeseen circumstances or faulty assumptions, then a fixed budget will immediately require modification—particularly if sales are depressed and cost cutting is needed in order to avoid substantial losses.
The alternative to a fixed budget is a flexible, or variable, budget. This type of budget is useful for controlling expenses and evaluating managerial performance. Development of a flexible budget begins with allocation of expense items to three different categories: fixed, semi-variable and variable. Each expense item has its own specially developed formula that is used to forecast costs and expenses based on the actual level of sales or production. Allocation of expense items and development of formulae can be a challenging process since it is often difficult to determine whether an expense is fixed or variable or choose whether the formulae should be based on sales or output. However, the time and effort invested in creating a flexible budgeting process is generally comparable to that associated with a fixed budget if one factors in inevitable modifications to the original fixed budget in light of actual operational performance. In fact, flexible budgeting is probably the preferred approach for smaller companies that are growing since there is bound to be unpredictability with respect to sales and output and the inherent flexibility lends itself to the management of change that is so necessary during the earlier stages of the company’s development.