Building the Business Case
Solution Matrix Ltd ®

Budget, Budgeting Process, and Variance Explained
Definitions, Meaning, and Budget Examples

Business Encyclopedia, ISBN 978-1-929500-10-9. Revised 2014-07-25.

Budget and budgeting terms defined, explained, and ilustratedA budget is a plan for spending items and incoming funds, with a figure for each item. If actual spending or funding differs from the planned figures, the difference is called a variance.

In business, budget can be defined as a plan for an organization's outgoing expenses and incoming revenues for a specific time period.  

Budgets are used in many organizations to . . .

  • Track and control spending.
    The purpose is to ensure that available funds are used according to plan, within preset limits and not exceeding available funds.
  • Support funding requests.
    The purpose is to justify the use of funds and to help plan future spending accurately by describing how funds will be used.

This item defines, explains, and illustrates the term budget, with examples, in context with related terms including capital budget, operating budget, cash budget, zero-based budgeting, and variance analysis.

Contents

• What is the meaning of the budgeting? What is a budget variance?
What are the differences between capital budgets and and operating budgets? 
     -  Capital spending (CAPEX) compared to operating expenses (OPEX).
     -  Capital budget defined
     -  Operating budget defined. 
•  What is a cash budget?
•  What is the budget planning cycle? What is the budgeting process?
•  What is zero based budging and how does it compare to incremental budgeting?
•  What is budget variance analysis? What is a flexible budget?

What is the meaning of budgeting? What is a budget variance?

In its simplest form a budget is a plan or forecast in the form of a list, showing spending items and/or incoming revenue items, with a figure for each item. As time passes, actual spending or revenue may be entered into the list to compare with the originally budgeted figure. If there is a difference between planned and actual figures, the difference is called a variance. 

A company's operating budget, for instance, may forecast spending for employee training. The annual training spending figure may be set first, for management and control purposes, but this can be broken down later into monthly or quarterly figures. Two quarters into an annual budget cycle, figures for budget item "Employee Training" might look something like this:

One budget item example

A variance for each quarter is found by subtracting planned spending from actual spending. The variance is usually presented both in currency units and as a percentage of the planned figure. Here, a positive variance means that spending is over budget and a negative variance means that spending is under budget.  However, note that this convention is not universally observed: some people prefer to show overspending as a negative figure by calculating variance as the planned figure less the actual figure.

In the real business world, some variance between actual and budgeted figures is normal and expected. Large quarterly variances, however, call for either (1) adjusting the forecast to represent the new expected reality, or (2) controlling actual spending in future quarters so that the yearly variance comes closer to zero. (For more on these options, see the section Variance analysis and flexible budgets below.)

Most organizations plan spending and revenue management with a budget hierarchy. That means that planning begins with high level budgets, such as the company wide (or organization wide) capital and operating budgets. In these high level plans, spending items and revenues usually correspond closely to the revenue and expense items in the organization's chart of accounts. Lower level plans may further divide higher level categories, or even represent single, specific revenue or spending items.  

Here are a few of the levels in one company's budget hierarchy:

Part of an organization's budget hierarchy

In setting planned figures, senior management is responsible for authorizing spending amounts for high level categories (for example, the "Marketing Budget" above). Middle and lower level managers in Marketing will be responsible for dividing the marketing budget further into lower level budgets for areas such as research, advertising, and events. Each of these areas may be further divided, as the chart suggests.

What are the differences between capital budgets and operating budgets?

At the top of the hierarchy in most companies and organizations stand two major kinds of plans, a capital budget and an operating budget. These do not overlap: they handle distinctly different spending categories. Capital and operating budgets, moreover, are built through different processes, usually by different managers, and they use different criteria for prioritizing and deciding spending.

     Capital spending (CAPEX) vs. operating expenses (OPEX)

Whether or not an expenditure qualifies as a capital expenditure (CAPEX) or as an operating expense (OPEX) depends on what is purchased, what it is used for, and also upon the country's tax laws. Companies and organizations normally designate specific criteria that must be met for an acquisition to qualify as "capital," such as a minimum useful life (e.g., one year or more) and a minimum purchase price (e.g., $1,000).

The country's tax authorities also have a say in what may be considered a capital expense.

  • Tax authorities specify which item categories appear on the balance sheet as capital assets. On the income statement, these items create a depreciation expense for each year of the asset's depreciable life. This lowers reported income (), thereby creating a tax savings. Spending on operating expenses, by contrast, impacts reported profit and taxes on earnings only in the reporting period they are incurred.
  • Tax authorities determine which expenditures for business start up cost, for instance, can be capitalized. In the United States and a few other countries, the costs of professional services (such as systems integrations services) can, under some conditions be "bundled" into the full capital costs of acquiring assets (for example, a large IT system).

Acquisitions that typically meet company and government criteria as capital assets typically include such things as purchased:

  • Vehicles
  • Factory machinery and production equipment
  • Store equipment and furnishings
  • Laboratory equipment
  • Large IT systems (Hardware and/or Software)
  • Buildings
  • Office Furniture and Office Equipment. 

Operating budgets, by contrast, cover operating expenses (OPEX), spending on predictable, repeatable costs for items or services that are not registered as capital assets and are not depreciated. That means the company charges the full amount against income during that reporting period, taking all tax savings for these expenses during that period. 

Operating expenses typically represent spending for such things as:

  • Employee salaries/wages and overhead    
  • Office space rental and utilities costs
  • Employee travel and training expenses
  • Marketing communication / advertising expenses
  • Telephone and internet services
  • Insurance costs
  • Outside consultant fees

Note that there is also a major income statement category called "Operating Expenses," which appears beneath the gross profit line, and above Extraordinary Items and Financial Income/Expenses. Income statement "Operating Expenses" category items thus do not impact reported gross profit or gross margin. When used in the budgetary sense, however, "operating expense" can include expense items above the gross profit line. Wages for direct labor in product manufacturing, for instance, are forecast in the Manufacturing operating budget and appear on the income statement above the gross profit lines as part of Cost of Goods Sold.

     Capital budget defined

Capital budgets forecast and spending for capital expenditures (CAPEX), the acquisition of capital assets—usually long lasting, expensive acquisitions that go onto the company's balance sheet as assets. On the company's income statement, capital assets contribute to depreciation expense throughout their depreciable lives.

When deciding which capital investments to make, companies usually use a combination of formal financial criteria, including

Potential investments are also evaluated with respect to strategic consistency and risk. And, because capital spending is planned to maximize value, investments should be undertaken only when expected returns are equal to or greater than the average cost of capital.

Capital planning is usually accomplished through an organization's Budget Office or through a Capital Review Committee, which establish their own criteria for prioritizing proposals and for setting the capital budget ceiling.

In order for a specific capital expenditure to be funded, its sponsors may have to justify it with a formal business case analysis, including estimates of NPV, IRR, payback period and other financial criteria. If the company has limited capital funds, moreover, the potential capital expenditure may have to enter a competitive capital review process, where all requested expenditures are compared, and only the most favorable receive funding.

Those who propose or request funding for capital expenditure should be sure they understand:

  • The organization's criteria for prioritizing capital expenditure proposals.
  • The timing of the current and next capital planning and spending cycles.
  • The current or expected capital spending ceiling.

     Operating budget defined (OPEX)

Generally, an operating budget covers operating expenses (OPEX) for normal operations. Operating budgets are typically developed through a process different from that used for capital budgets. In some companies, all management above a certain level participate in the process. Planned spending on operating expenses is usually not changed during the period—except possibly for emergency reductions following unexpectedly poor sales results or other disasters. In other words, spending plans for operating expenses are more often treated as static budgets rather than flexible budgets.

What is a cash budget?

A cash budget is a tool for planning and controlling near-term spending, normally including both incoming cash flows and cash outflows (usually for spending on expenses). In business, these serve a purpose similar to the checkbook register used by individuals to track deposits and checks for personal checking accounts. From the cash budget, one can see immediately the level of cash on hand and how that will change with spending,

Cash budgets are typically planned with a series of months in view, although they can also show cash revenues and spending on a weekly, quarterly, or annual basis. The distinguishing feature of the cash budget is that it represents actual cash inflows and outflows in the period they occur. This contrasts with the system of accrual accounting which most companies use for their financial reporting, in which receivables and liabilities are reported for the period in which they are incurred, even though the actual cash transactions may occur in another period.

A small company's monthly cash flow plan may look like this example:

Example of a cash budget

The example show the budget as it stands in mid-February. Figures for January are now history and will not change. "Actual" figures for February are current as of mid-month, but these may change by the end of the month.

This example includes forecast inflows and outflows, actual inflows and outflows, and a computed variance for each item. The variance is the actual figure less the forecast figure. With this convention, a positive variance means that inflows or spending were above the forecast amount, and a negative variance means the actual amount was less than planned. Notice in the example that actual cash on hand at the end of January (Cash income less cash expenses = $131,614) is carried over to February as actual starting cash for that month. 

When large variances appear between forecast and actual inflows or outflows, the cash budget helps identify the source of the variances. In the example above, for instance, the overall negative cash flow variance for January was not due to overspending in that month, but rather, the variance clearly results from product and service sales revenues falling below forecast. For future months, the manager's options are to either (1) take action to increase incoming revenues, (2) or to lower the forecast revenues and spending figures.

What is the budget planning cycle? What is the budgeting process?

Companies and organizations typically develop and implement budgets on a periodic basis at fixed intervals. The norm in private industry is to produce a plan for each fiscal year. Some government organizations also prepare annual plans, but two-year (biennial) budgets are also common in government. Although plans are sometimes adjusted in "real time" (that is, they are treated as flexible budgets after start of the planning period they cover), such changes are exceptions to the normal rule, which is to keep the forecast intact (static) once implemented.

In the period of time between issuance of one budget and the next, planning-related decisions and plans are referred to as the budget cycle or process. In large companies, large educational institutions and non profit organizations, and in government organizations, the process normally extends across months, if not the entire period between budgets.

For those involved in the budgeting process there can be many specific steps and requirements to meet, and the nature and timing of these vary widely among companies and organizations. Most large organizations in fact publish a description of their own process, calendar, and approval requirements on the internet. This information is sometimes publicly accessible, or it may be accessible only to employees with authorized access to it. In any case, anyone setting out to prepare a funding request for the first time will normally begin by accessing this source.

Although specific steps and timing vary from organization to organization, the budgeting process everywhere almost always includes steps for:

  • Assessing variances between actual and forecasted figures in the previous period's plan.
  • Identifying and then prioritizing business needs and objectives for the forthcoming period.
  • Identifying and evaluating:

Incoming revenue forecasts.

Current trends or changes that may have spending or revenue implications, such as new mandates to reduce spending, expected changes in staffing levels, or changes in expected business volume.

Risks or potential emergencies that could impact either incoming funds or spending needs.

  • Ensuring that individual funding proposals in the complete plan package are prepared in consistent format, and that proposals competing for funds can be compared fairly.
  • Ensuring that procedures and methods are in place for implementing the plan and monitoring actual spending and incoming revenues.
  • Packaging and communicating funding requests to those responsible for reviewing and approving budget proposals.

In large companies and organizations the process is managed and "driven" by, a Budget Office. This office works with managers, department heads, and others who will seek funding approval, but also with the senior management, legislative bodies, and senior officials who will make approval decisions. The result is that all budget proposals are developed according to local policies and rules, and that the entire proposal package is reasonable and aligned with organizational objectives.

What is zero based budgeting and how does it compare to incremental budgeting?

Zero based budgeting is an approach to budgeting requiring that every expenditure be justified. In other words, each potential spending item starts with an assumed value of 0, with all changes above that having to be justified. This contrasts with the more usual practice, incremental budgeting, in which each spending item is started at last year's (or last term's) level, and the next period's level is planned as an increment (positive or negative change) to that level.

Advocates of the zero based planning favor the approach because it is based on demonstrated needs and resources, not on historical spending levels, which arguably leads to more efficient allocation of resources. The zero based approach can be very effective, for instance, in detecting and eliminating inflated budgets, or those that include obsolete or wasteful operations.

Zero based budgeting also helps avoid a practice common under the incremental approach, whereby managers approaching the end of the budget period ensure that they spend all funds available to them, whether such spending is necessary or not. Some managers believe that if they do not spend all of this period's plan, they will receive less in the next period (in some organizations, this belief is supported by historical fact).

In a large organization, however, the zero based approach may call for very substantial research and analysis in order to justify every funding request—an investment in time and organizational resources that is not, in its own right, justified. Under the Incremental approach, formal justification (e.g., business case analysis) is normally required only for capital spending proposals or for significant spending increases in operating expense categories.

What is budget variance analysis? What is a flexible budget?

A variance (difference between actual and forecast figures) is a signal to management that revenues or spending did not go according to plan. If the variance represents overspending, moreover, it is an indicator that there may be problems paying future expenses. Variance analysis attempts to find the reasons that actual figures were over or under forecast so that either

  • Corrective action can be taken to reduce variances in the future, (an exercise in static budgeting) or
  • Figures for future spending can be adjusted as necessary (the practice of flexible budgeting). 

Confusion sometimes arises in variance analysis because two different conventions for calculations commonly used.

  • Convention 1:

    Incoming revenue variance = Actual – Forecast
    Expense spending variance = Actual – Forecast

    This convention is used in this encyclopedia and in many organizations. Under this approach, a positive variance always means the actual result was greater than the budgeted amount.
  • Convention 2:
    Some organizations (such as the Project Management Institute), however, recommend using the above convention for revenue, but reversing the order for expense items:

    Incoming revenue variance = Actual – Forecast
    Expense spending variance = Forecast – Actual  

    Under this convention, positive variances are always "good things" (more revenue or less spending than expected), and negative variances are always "bad things." 

Obviously, anyone involved in planning and analyzing spending needs to ascertain which convention is used locally.

In many companies, variance analysis is often an especially important issue in planning for two areas: (1) Direct and indirect manufacturing costs, and (2) sales revenues and sales costs. Revenues and costs in these areas are often difficult to predict accurately. Variance analysis for these areas is, in fact, a substantial and sometimes complex topic in the teaching of cost accounting. The simple example below is meant only to illustrate one kind of approach.

Variance analysis typically begins with variance reports at the end of each month, quarter, or year, showing the difference between actual spending and forecasted spending. As an example, consider a small manufacturing company's quarterly variance report for one plan item, "Manufacturing overhead." The variance report shows that Manufacturing overhead is $76,400 over plan for the quarter. The variance is 7.4% of the budgeted figure:

Variance analysis example in budgeting

The Manufacturing overhead variance is a substantial percentage of a large budget item. Management will certainly want to know the reason or reasons for the variance, and then what can be done to prevent recurrence in the next quarters. The next step in variance analysis is to identify the components of the cost item (Manufacturing overhead), and sources of variance within them. 

The table above lists six line item components. Note that some of these are fixed costs, and others are variable costs. Fixed costs are (in principle) independent of manufacturing volume and should be more predictable than variable costs. Nevertheless, management salaries (a fixed cost) were $2,000 over forecast. Why? It turns out that during the quarter, the four managers involved took a total of two weeks paid sick leave among them, requiring other management labor to cover for them. Insurance costs (another fixed cost item) were 5% over forecast. Why? Here, there was an unexpected increase in insurance premiums during the quarter. In general, variances in fixed costs can be traced to:

  • Unexpected problems or emergencies
  • Unexpected cost changes
  • Underestimated need for utilization of fixed cost resources.

In the table above, however, two variable cost components of Manufacturing overhead cost stand out with strikingly large variances: Hourly wage costs (9.6% over plan) and utilities costs (24.2% over plan). The hourly wage variance draws attention, especially, because it represents a very large component of the overall Manufacturing overhead variance. 

Hourly wages are a variable cost item because they depend on manufacturing volume (units produced). Note, however, that two variable factors also contribute to total hourly wage costs: Labor hours per unit, and the cost of labor (here, dollars per hour). In fact, Hourly wage costs are the simple product 3 factors:

Hourly wage cost = (Units manufactured) * ( Labor hours per unit ) * (Labor cost per hour)

The table below shows how actual figures for these factors compare with forecast: 

Example variance analysis

Adding 100% to each of the variance figures, the unit variance is 105% of forecast, the hours per unit variance is 90% of forecast, and the labor cost per hour variance is 116% of forecast. These percentages, multiplied together, account for the actual labor cost:

Actual hourly labor cost = Forecast labor cost * 105% * 90% * 116%
                                           = $690,000 * 105% * 90% * 116%
                                          =  $756,000

From this analysis, management may draw conclusions such as these:

  • The positive variance in units is not a bad result. On the contrary, the higher unit count is probably associated with increased sales revenues and profits. However, if unit volume can now be forecast at higher figures in subsequent quarters, management may consider additional hiring so that the work can be done without extensive labor overtime.
  • The efficiency gain in hours per unit is also a good result. Management will want to ask if this can be sustained or even improved further. If so, the change may be reflected in future spending forecasts.
  • The positive variance in average hourly wage rates should move management to find ways to provide more labor hours at the standard rate rather than the much higher overhead rate. This hourly cost variance provides—along with the positive unit volume variance above—more evidence that management may want to consider additional hiring.

Management can use the "Actual hourly labor cost" formula above to try out different proposed figures and variances, to see the impact on actual cost.

In addition, the very large variance for utilities costs (24.2% over plan) bears looking into in the same way, even though the actual spending figures are small compared to the wage cost variance. The same kind of analysis here, however, promises more complexity. Utilities costs will be the additive combination of phone costs, water costs, and electricity costs, Each of these, in turn, involves the product of price variances, efficiency variances, and usage variances.

A  variance presents management with two alternatives: either adjust the plan in future periods, to conform more closely with revenue or spending realities, or take action to impact future spending and revenues so as to bring forecast and actual figures closer together. The former option (adjusting the plan) is called flexible budgeting. The latter option is an instance of static budgeting.  

Most large organizations permit at least a limited level of flexible planning. Most managers responsible for lower level budgets (e.g., for a department budget or for an operational area such as "Advertising") have the ability to adjust their own plans "in real time" by moving planned levels from one category to another (except that movements from "capital spending" authorizations to "operating expense" cannot be done so easily). 

However, if a manager needs to increase his or her overall spending total above plan, that normally requires the use of a process called  "emergency funding" or request for non-budgeted funds that is presented to the next higher management level. The next higher level may designate funds specifically set aside for such contingencies. Or, upon demonstrated need, these funds may have to come from current assets, such as cash on hand or the sale of stock owned for investment purposes. 

By Marty Schmidt. Copyright © 2004-

 

The Business Case Guide Book

New Edition!
Business Case Guide

424 pages

3rd Ed July 2014!
Clear, practical, in-depth coverage of the case-building process and cost-benefit methods.

Business Case Guide: The standard source for industry, government, and non profit organizations worldwide.

 

Business Case Essentials
110 Pages

The complete concise guide to what belongs in your case and why. The trusted authority on business case analysis provides clear, practical, step-by-step guidance.

Essentials—The most frequently cited case-building guide in print.

 

Project
Progress Pro

Finish time-critical projects on time with the power of statistical process control tracking. The Excel-based system makes implementing project control charting easy to use—even for those without a statistical background.

Progress Pro—When projects simply have to finish on time.

 

Financial
Modeling Pro

A complete tutorial on building financial models for estimating costs, benefits, and business case results.

Modeling Pro—Live examples & templates for your own models.

 

Financial
Metrics Pro

Handbook, textbook, and live templates in one Excel tool. Comprehensive usage and implementation of ROI, IRR, Working capital, EPS, and 150+ more cash flow and financial statement metrics.

Metrics Pro features the Analyst Workbench & Chairman's View.

 

Business Case
Templates 2014

Integrated Word, Excel, and PowerPoint Template system designed to help you build a professional quality case quickly and easily.

Templates 2014—When you need a real business case.

The Premier Professional Training Seminars

Seminar Participants

Learn how to make your case.

Join more than 16,000 professionals worldwide who have mastered the 6D Framework in Basic and Master Class seminars.

Earn professional education credit while building your case!

Download case-building books and software when you register! Join the next class in...

   London
   New York City
   Kuala Lumpur

Twice Weekly Newsletter

Subscribe Free:
Business Case Newsletter