Budgets are the things you plan to do in order to make a profit for your business. Budgets will differ depending on your business type. There are four basic types of budgets used by businesses: (1) initial, (2) incremental, (3) activity-based and (4) pure revenue budgets. In this article, we will cover the first two basic types of Budgets. We will cover activity-based and pure revenue budgets in subsequent articles.
An initial budget is set during the planning process of an enterprise. The initial master budget consists of expenses and investment costs, less any cash flow generated by operations. Budgets may include one or more of the following sources: rent, overhead, utility, capital expenditures, investments, goodwill charges, prepaid expenses and depreciated costs. In addition to the above-mentioned sources, there may also be some special items that the company can charge for. The difference between the total cost of goods sold and the current value of the net worth of the firm usually represents the initial financing required to conduct operations.
Incremental budgets are designed to increase profits over time. Budgets are constrained through the existence of overspending. Overspending results in what is known as a negative amortization, which occurs when the amount of profit realized from sales is lower than the cost of capitalized interest and expenses over time. An example of an overspending budget cycle would be a business that sells products over time periods ranging from six months to five years. The firm will generate profits over the course of each of those six and five year periods, however, if those profits were realized faster than the six-year period, then the firm would face a negative amortization or negative cash flow problem.
Another of the common types of budgets is the forward budgeting cycle. Forward budgets are designed to achieve the most effective use of a company’s assets in the shortest time period. These types of budgeting methods often do not take into account any future uncertainties. A good example of this would be a company that intends to expand its production facilities overtime in order to reduce variable costs.
Variability is a by product of the ability to effectively forecast and plan. Most businesses are capable of being flexible in one regard while being somewhat less flexible in another respect. One area where a business may be less flexible is in the area of operating budgets. While it is possible to adjust the cost of goods sold or the operating budget in response to changing circumstances, changes to these variables will often require a simultaneous change to other business budgets. To avoid this kind of problem, it is often better to have all pertinent business budgets in place at the same time and review them periodically to make adjustments where appropriate.
One type of budget that is frequently reviewed is the production budget. The production budget is primarily set to cover the cost of materials used in the production of products that will be sold to customers. In some cases, it may also include a budget for raw materials used in the manufacturing of these products. This is a relatively static budget that typically only reverts to a level after a particular product has been launched into the marketplace.