The series aims to describe the fundamental aspects of forecasting and budgeting - planning process, the difference between forecast and budget and description of the basic types of budgets (fixed vs. flexible, static vs. continuous, incremental vs. zero-based budget and top-down or bottom-up budgeting process).
A significant part of the series consists of variance analysis, a description of planning techniques (e.g. time series) and responsibility centers.
This series logically follows our article series Strategic planning.
Forecast is a quantified prediction of the results that are expected to be achieved by the company in the future.
Budget is a quantified operational plan for the upcoming accounting period/s. It is financial plan which works as a kind of target.
According to the updates for the changed level of activity (usually sales volume):
According to the updates for the past/new periods:
According to the level which prepares the overall budgeted figures:
According to preparation technique:
Fixed budget is a budget that is not flexed with the changed production/sales volume or other significant variable. The variances between budget and actual are therefore usually great. But in practice, fixed budgets are used more widely than flexible budgets.
Fixed budget is useful mainly when:
Fixed budgets are not very appropriate for evaluating the performance of responsibility centers.
The opposite term to fixed budget is flexible budget.
Flexible budget is a budget that changes with the changed production/sales volume or other significant variable. Budgeted sales/revenues and variable costs are therefore flexed with the actual activity level, but fixed costs usually remain unchanged. Flexible budget shows how the financial plan/target would look like if actual (not planned) sales/production volume were used. The variances between budget and actual are therefore usually much lower than with fixed budgets. The condition of using this approach is splitting of all costs into variable and fixed components.
Therefore, flexible budgets are a kind of sensitivity analysis.
Rolling (continuous) budget is budget, which is continuously updated by:
if the original budget covered the period January – December 20x1 and January 20x1 is now over. January data will then be deducted and instead, January 20x2 will be included to the budget.
Term static budget refers to budget that is not updated, either in terms of rolling of periods (months) and the changed conditions and circumstances. It is therefore both an opposite of rolling budget or synonym to flexible budget.
If this style of budgeting is used, budgets are prepared from top-down direction, i.e. senior management sets the high-level budget (often just basic numbers) without collecting detailed information from operating staff. This total general target is then broken down into detailed budget.
The process is reversed to bottom-up budgeting.
The advantages and disadvantages of top-down budgeting can be derived from those described in term bottom-up budgeting.
If this style of budgeting is used, budgets are prepared from bottom-up, i.e. operating staff collects the detailed information from various departments/functions/other sources. Process usually has a budget coordinator – e.g. controller who aggregates/consolidates these lower-level budgets into the master budget which then is passed for management approval.
The process is thus reversed to top-down budgeting.
Negotiated budgeting is a budgeting style which combines top-down and bottom-up budgeting approaches. Negotiated budgeting can start by setting the general figures by top management. But compared to top-down budgeting, operational managers are given an opportunity to negotiate these figures. But it can also work vice versa – i.e. senior managements challenges or possibly adjusts the figures arrived through bottom-up budgeting.
Incremental budgeting is the traditional approach that comes out either from the actual results or previous budget and adjusts it for the expected changes.
It is the opposite approach to zero-based budgeting.
Zero-based budgeting is the opposite approach to incremental budgeting as it begins the budgeting process from zero. Therefore, no past results are considered and budgets “are built” from item to item from the very beginning. It is very lengthy process and therefore, zero-based budgets are not often prepared for the entire entity in just one budgeting period, but only a certain area/s are reviewed during a time and the next areas are left for the future periods. Zero-based budgeting is appropriate for costs that are not so easy to quantify – usually costs of support departments or costs (or revenues) for specific jobs and contracts.
The advantages and disadvantages of zero-based budgeting can be derived from those described in the article about incremental budgeting.
1. CEO appoints budget committee and budget coordinator.
Budget committee is a group of people that are responsible for budget preparation, review and approval. It is usually formed by senior managers including finance director. (26)
2. Review the system of responsibility (budget) centers – mainly whether they include all parts of the entity. Responsibility centers are important not only for budget data collection, but mainly for control purposes.
3. Set the basic budget assumptions such as expected inflation, exchange rate, interest rate, income tax rate etc.
4. Summarize the basic strategic points (new investments, diversification, etc.).
5. In cooperation with budget committee prepare/update budget manual and distribute it to all people involved.
Budget manual is a document that contains instructions for budget preparation. It is often used in large companies and facilitates the budget coordination process. It is usually prepared by budget coordinators (e.g. financial analysts or controllers) and approved by budget committee.
It defines mainly:
6. Define the principal budget factor – it is the key and limiting factor within the entity. Because it limits other operations, budgets containing principal factor shall be prepared first. It is usually sales, but others may be possible (e.g. raw materials if they are rare). Let’s suppose that principal budget factor is sales in the following text
7. Prepare sales budget (or collect it from sales manager or sales representatives). The following items should be determined for each product/service:
→ split by sales person, responsible manager or departments, products, geographic area, etc. – what is appropriate
8. Prepare production budget (or collect it from production manager):
→ split by responsible manager or departments, products, geographic area, etc. – what is appropriate
I. First determine whether there is sufficient production capacity available to be able to manufacture budgeted sales volume. If not, consider whether and how it can be resolved. If it cannot be resolved, production budget is in fact the principal budget factor and shall be prepared first instead of sales budget. If the capacity is higher than sales volume, the entity can for example consider reduction of prices (in order to sell more), strategy of diversification or other solutions mentioned below.
The limiting capacity factors are:
→ if actual machine capacity ≠ machine capacity required, make a decision to resolve it and adjust the relevant operational budget (e.g. capital expenditure budget or inventory budget). Possible decisions can be:
→ if actual labor hours ≠ labor hours required, make a decision to resolve it and adjust relevant operational budget (usually payroll budget). Possible decisions can be:
→ if available raw materials are not sufficient, consider for example possibility to purchase it elsewhere or using alternative materials (possible adjustment to purchasing budget).
II. Set the final production volume for each product and inventory budgets:
III. Set production prices (costs) – standard costing approach or pricing available from actuals is often used.
direct materials – consider:
direct labor – consider:
other direct expenses - production overheads –consider:
IV. Consolidate production budget
9. Prepare other relevant budgets (or collect them from relevant staff). The below stated budgets are not complete and the procedures are simplified.
→ prepare income tax budget – make the necessary adjustments to the tax base (not all expenses are tax-deductible, not all incomes are taxable etc.) and calculate current and deferred income tax. This step is interrelated with:
Therefore, these calculations should be made in several iterations.
10. Check all received budgets centrally – mainly for typical errors such as miscalculations, wrong totals, duplicities, incompleteness, missing interrelationships with other budget components, discontinuity or the variances from last actuals/past budget.
11. If there are any adjustments, they shall be communicated and at least send back for information to the original contributors.
12. Prepare preliminary master budget.
Master budget is the overall budget that summarizes lower-level operational budgets. It usually includes:
13. Review the master budget:
15. Obtain senior management approvals and distribute the master budget.
There are several approaches to planning (budgeting) that can be undertaken if uncertainty is a significant factor:
Scenario analysis is a prediction method under which several possible outcomes (variants) are worked out. It is often used during budgeting process and decision-making, mainly as a method of reducing uncertainty.
The most common scenarios are:
Sensitivity analysis (also called what-if analysis) is a technique which is used to calculate the output variable (e.g. profit, revenues or costs, NPV) under different assumptions (often different sales quantity, selling price, unit variable costs, etc.). It is used during budgeting process and in decision-making, mainly as a method of reducing uncertainty.
A kind of sensitivity analysis is preparation of flexible budgets.
Sensitivity analysis is a technique that can be used during scenario analysis.
Budgetary control is the process during which actual results are ascertained and compared with budgeted figures (variance analysis). The found differences are called variances (or deviations) and are usually further analyzed. A remedial action can be taken based on this analysis. The corrective action may be operational (e.g. if poor-quality materials are currently causing high-level wastage, it can be decided to purchase better-quality materials from different supplier) or can also result in adjustments of strategy.
The purpose of variance analysis is to ascertain the quantitative deviation between budgeted, forecasted or otherwise estimated figures and accounting actuals and analyze this deviation into bigger detail. It is a valuable control mechanism.
Factors to consider when deciding whether it is worth to investigate the variance:
In general, direct costs, revenues and margin variances can be split into:
Calculation: (actual unit price – budgeted unit price) x actual quantity
Interpretation: reveals how much the costs/revenues/margin changed as the consequence of the changed price (unit margin).
Calculation: (actual quantity – budgeted quantity) x budgeted unit price
Interpretation: reveals how much the costs/revenues/margin changed as the consequence of the changed quantity sold/produced.
More detailed variance calculations can be found here:
Techniques used for forecasting/budgeting can be differentiated into:
Time series represent a sequence of data for several time periods (hour, days, weeks, months, year). Independent variable is always time (axis x). Time series is used to predict future and it has several components:
Moving average is very simple method used to predict future based on the past results. It works well if there are no seasonal or cyclical elements included in the past data. It is calculated as an average of defined number ongoing periods.
Calculation of 3-month moving average for April: (255+260+279)/3 = 265
Calculation of 6-month moving average for July: (255+260+279+285+270+300)/6 = 275
Responsibility center is an object for which costs/revenues/capital expenditures are specifically collected and analyzed. Each responsibility center is usually managed and controlled by a separate manager.
The entity is often internally split into various types of responsibility centers for the purposes of smooth management, controlling and planning (budgeting).
Examples of responsibility centers:
Responsibility centers can be classified as: