Budget Construction: A Step-by-Step Guide
Definition
Budget
A financial plan that estimates income and expenses over a specific period, guiding decision-making and resource allocation.
- Just like any plan, budgets are essential for forecasting, controlling, and allocating resources effectively.
- Think of it as a roadmap for financial success.
The Budget Construction Process
1. Setting Objectives
- Before diving into numbers, a business must define its financial goals.
- These could include:
- Increasing revenue by 10%.
- Reducing costs by 5%.
- Allocating funds for a new project.
Hint
Clear objectives provide direction and ensure that the budget aligns with the business's strategic priorities.
2. Estimating Revenues
- Revenue estimation involves forecasting the income a business expects to earn.
- This requires:
- Market Analysis: Understanding trends, customer demand, and competitor actions.
- Sales Projections: Estimating the quantity of goods or services to be sold.
- Pricing Strategy: Determining the selling price of products or services.
Example
- A company expects to sell 10,000 units at $50 each.
- Its estimated revenue would be $500,000.
3. Estimating Costs
- We know that costs are divided into two main categories:
- Fixed Costs: Expenses that remain constant, such as rent and salaries.
- Variable Costs: Expenses that fluctuate with production levels, such as raw materials.
Example
If raw materials cost $20 per unit and the company plans to produce 10,000 units, the variable cost would be $200,000.
4. Allocating Resources
- Now that revenues and costs are estimated, resources must be allocated to different departments or projects.
- This involves:
- Prioritizing Needs: Ensuring critical areas receive sufficient funding.
- Balancing Trade-offs: Deciding between competing priorities, such as marketing vs. research and development.
Hint
- Avoid over-allocating resources to one area at the expense of others.
- A balanced approach is key.
5. Revising and Approving the Budget
- Budgets are rarely perfect on the first draft.
- They require:
- Review and Feedback: Involving department heads and key stakeholders.
- Adjustments: Revising estimates based on feedback and new information.
- Approval: Gaining final approval from senior management or the board of directors.
Hint
Regularly revisiting and updating the budget ensures it remains relevant and aligned with changing business conditions.
Types of Budgets
- Businesses typically use three main types of budgets:
- Income Budget: Forecasts revenue from sales and other sources.
- Expenses Budget: Estimates costs, including production, marketing, and overheads.
- Profit Budget: Calculates expected net income by subtracting total expenses from total revenue.
Note
Don't assume that meeting the budget always means success. Consider external factors that may have influenced results.
Practical Example: Ko Samui Ltd
Example question
Jojo Ltd, a manufacturer of stress balls, needs to construct its budget for the next year.
Solution
- Revenue Forecast: 40,000 stress balls at \$750 each = \$30,000,000.
- Cost Estimation:
- Materials: 45% of revenue = \$13,500,000.
- Wages: 18% of revenue = \$5,400,000.
- Fixed Costs: Rent = \$600,000, Research and Development = \$3,000,000.
- Profit Calculation:
- Total Revenue: \$30,000,000.
- Total Expenses: \$13,500,000 + \$5,400,000 + \$600,000 + \$3,000,000 = \$22,500,000.
- Net Income: \$30,000,000 - \$22,500,000 = \$7,500,000.
| Category | Amount ($) | Notes |
|---|---|---|
| Revenue | 30,000,000 | 40,000 stress balls at $750 each |
| Variable Costs | ||
| Materials | 13,500,000 | 45% of revenue |
| Wages | 5,400,000 | 18% of revenue |
| Total Variable Costs | 18,900,000 | |
| Fixed Costs | ||
| Rent | 600,000 | Fixed expense |
| R&D | 3,000,000 | Investment in innovation |
| Total Fixed Costs | 3,600,000 | |
| Total Expenses | 22,500,000 | Sum of variable and fixed costs |
| Net Income (Profit) | 7,500,000 | Revenue - Total Expenses |
Self review
- What would happen if Jojo Ltd's sales were 10% lower than expected?
- How would this affect their budget?
Hint
- Budgeting is not a one-time task.
- It requires ongoing monitoring and adjustments to stay aligned with business goals.
Self review
- Can you outline the key steps in constructing a budget?
- What challenges might arise during the process?
