Introduction: What Is a Budget?
Everyone has heard about the importance of having a budget for a business or for personal finance.
But exactly what is a budget? What is the purpose of a budget, and how does it apply to the business and personal finance worlds?
In this article, we will discuss the differences between the various types of budgets.
We will touch on the following:
- Budget definition: What is a budget?
- What is the purpose of a budget?
- Balanced budget definition
- Operating budget defined
- Cash budget definition
- Zero-based budgeting explained
Image Source: Budget Definition
What Is a Budget?
In simple terms, the definition of budget is a summary of estimated future income and expenses for a given period.
For a business, a budget definition can act as a roadmap that can be used to help carry out the strategic goals of the organization over the coming months and years.
Typically, businesses determine their budgets on an annual basis, further broken down into quarterly and monthly budgets. The master budget includes such items as a projected income statement and balance sheet.
In a larger business, each separate department will have its own budget definition as well, with detailed expense budgets showing detailed descriptions of office expenses, the cost of employee salaries and benefits, and any number of additional expenses, depending on the industry. The budgeting definition for every company may be different and will be dictated by many customized factors.
Finance groups will usually formulate a cash budget definition as well as operating and capital expenditure budgets.
As most businesses see a budget as merely a guide and not a blueprint to be followed exactly, there is usually some degree of flexibility in the budgeting definition. Department heads must, of course, justify additional expenditures. An effective and healthy cash budget can allow businesses to make shifts within departmental budgets while still maintaining the overall health of the business.
Typically, the annual budget definition for a particular business is not changed mid-year. Rather, changes in income and expenses are actualized while future months are maintained as in the original budget plan.
Budgets can also be used in terms of personal finance, although research shows that only a third of Americans actually prepare a household budget. The same rules apply, though most household budget definitions are less rigorous and are created month by month. Income and expenses for household budgets are usually easier to predict, and there are fewer stakeholders to please.
What Is the Purpose of a Budget?
In terms of what benefits a budget can have for a business, it boils down to a few key factors:
- Investors can forecast income, expenses, and profitability
- Management can make decisions based on a set of quantitative estimates from the budget definition
- Stakeholders can monitor and assess the performance of their business department by department
The key component to most businesses is making a profit.
Without a budget definition, it is impossible to decide whether the business will be profitable or not.
By sitting with members of the team, those creating the definition of the budget can get a sense of "buy-in" from each department to make sure the estimates that end up on the paper are clearly achievable and reasonable.
Making Better Decisions
What is the purpose of a budget? Well, without a budget, how would management make any decisions that impact the profitability of the company?
For example, if there is a budget shortfall, management needs to know that they will not be able to hire additional workers that month. Armed with the information provided by the budget, managers can either request more funds or else scale back workers until profitability and cash flow allows for expansion.
Without this key information provided by the budget, there would be no way to know the health of this business.
Image Source: What is a Budget?
Assess Team Performance
A regular budget definition, broken down by quarter and by month, allows for managers to assess the performance of their respective departments.
You want to be able to answer the question, “How’s business?” with a quantitative, numbers-based assessment.
When the budget definition is created, all stakeholders are consulted and can, therefore, be reasonably held to stand by their own metrics. If a particular department is underperforming, upper management can provide the necessary support to help prop up that department.
In a rare scenario, a budget can be changed mid-year in order to properly realign expenditures in order to provide for the most profitable outcome for the company as a whole.
This is to be avoided if possible, as determining a budget is a lengthy process and can take away from day-to-day business operations.
Balanced Budget Definition
A “balanced budget” is a phrase often heard when speaking of politics or very large corporations.
What is a balanced budget? All it means is that, for the given period, revenues are equal to or greater than expenses, resulting in a break-even or better profitability scenario.
For entities such as governments or nonprofits, this is often the goal. It is less common that a for-profit endeavor would speak openly about a “balanced budget definition” since most companies are interested in maximizing profits.
Amazon is a notable exception to the desire for a balanced budget definition, with the company being the most obvious big-time corporation seemingly unconcerned by low profitability.
A balanced budget definition can refer to a period in the past as well, after all expenses and revenues have been actualized. This is especially common in a government, where certain parties or individuals may want to take credit for helping to create a balanced budget.
Operating Budget Definition
Operating budget definitions are all about getting into the nitty-gritty of what actually powers the profitability of an organization.
For most companies, the operating budget is set by quarter and is highly scrutinized.
The operating budget focuses first on revenues. They will first and foremost look to get a solid reading of the sales and collections processes of the company. Without an accurate figure here, the company can get into financial problems very quickly. This is why an operating budget definition is highly important.
Next, the financial team will look at important metrics, such as the cost of goods sold, inventory and buying projections, and the associated operating and labor expenses.
In formulating an operating budget definition, planners need to be conservative or else run into issues with the cash budget.
Unlike the master budget, an organization may create multiple versions of the operating budget. This way, the company can be prepared in the event of unexpected gains or losses.
Having pre-defined scenarios in place can give management the ability to react quickly in a fast-moving marketplace.
Read on to find out more about the cash budget definition.
Cash Budget Definition
Cash is the lifeblood of business.
A cash budget details the intake and outflow of cash for a business or family.
The cash budget definition is a level more immediate than the operating budget and can truly make or break a business.
What is the purpose of a cash budget? A well-defined cash budget will ensure that a company doesn’t run into cash shortfalls, which can result in disastrous scenarios like missing payroll or defaulting on loan payment obligations.
It is very common for small, fast-growing businesses to buy inventory or hire staff on credit in the belief that future revenue will come in to help pay those bills.
With a well-built cash budget definition, startups can avoid such problems. The last thing a fast-growing startup needs is the bad reputation that can come with paying suppliers late or having to delay payroll.
This can also lead to undesirable emergency cash injections, which can be provided by investors but which often dilute the equity that owners or managers own in the company they have worked so hard to grow.
When asking the question, “What is a budget?” one of the main benefits is ensuring the presence of available cash.
Cash budget definitions are also used by individuals and families.
Some families like to institute such systems as the “envelope system,” wherein each budgeted monthly expenditure by category (e.g., clothing) is placed in cash in an envelope, to be used only for the purpose of paying for that category.
What is the purpose of a budget prepared this way? It reduces the urge to spend unwittingly on credit cards. It can also help to build financial discipline. If there is no money left in the envelope, there is no more to spend until the next month.
It is a common system to get out or stay out of personal debt.
Now, let’s talk more about personal finance budget definition.
Image Source: Purpose of Budgeting
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Zero-Based Budget Definition for Personal Finance
The zero-based budget definition is similar to that of the balanced budget – but with one exception. In a zero-based budget, you want every single dollar to be accounted for.
Every dollar has a destination. Even if it is sent directly to savings, zero-based budgeting requires that every dollar be spent in some way.
For instance, if a family expects $4,000 in income for the next month, their zero-based budgeting definition would reflect every penny of that $4,000 going to a different category.
It is a very popular personal finance system that is often combined with such ideas as the envelope system.
If, at the end of the month, there is money left over, the individual or family can either carry over the budget funds to the next month or else restate their next month’s budget to make sure that those dollars are spent.
A common budgeting problem that people face is that they don’t know where their money is going – they just look at their bank account around payday and see that it is hovering around zero.
With a zero-based budget definition, you can take control of your spending and make sure that you are comfortable knowing where each of your hard-earned dollars is going.
Conclusion: Without a Budget, There Is No Plan
For a business, a budget is an absolute necessity. A balanced budget and cash budget are key points of any successful business.
When forming a master plan and in drilling down to an operating and cash budget, it is imperative that all managers in an organization know the importance of a budget.
In discussing the question, “What is the purpose of a budget?” it is not merely a set of numbers dreamed up by owners to make sure that employees have something to aim for. It is a plan for the future of the company, but without a budget definition, there is no plan.
The budget dictates how fast the company will be able to grow and if it will be able to compensate employees, hire new ones or provide lower prices and better products for its customers.
For personal finance, it is the same thing. If you have a goal in your personal life, you must also have a plan. The concept of zero-based budgeting and the cash budget definition can help propel you out of debt and into financial freedom. And if you have larger goals, like buying a (bigger) house, providing college for your children or retiring early, you must formulate a plan to get there.
What is a budget? At its most basic, it is a plan for success.
After all, French writer Antoine de Saint-Exupery was correct: “A goal without a plan is just a wish.”
Successful businesses and individuals don’t just make wishes. They make plans.
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