Budgets usually relate to specific future periods of time, such as an annual reporting year or a natural business cycle. For example, a car producer may release the 20X8 models in the middle of 20X7. In such a case, the budget cycle may be more logically geared to match the model year of the cars.

There is nothing to suggest that budgets are only for one-year intervals. For purposes of monitoring performance, annual budgets are frequently divided into monthly and quarterly components. This is helpful in monitoring performance on a timely basis. Sometimes, specific amounts within a monthly/quarterly budget are merely proportional amounts of the annual total.

For instance, monthly rent might be 1/12 of annual rent. But, other costs do not behave as uniformly. For instance, utilities costs can vary considerably with changes in the weather, and businesses need sufficiently detailed budgets to plan accordingly. Major capital expenditure budgets may transcend many years. A manufacturer may have 10 facilities in need of major overhauls. It is unlikely they could all be upgraded in just 1 or 2 years; capital expenditure budgets may cover as much as a 5- to 10-year horizon.

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Continuous Budgets

Highway IllustrationComputer technology permits companies to employ continuous or perpetual budgets. These budgets may be constantly updated to relate to the next 12 months or next 4 quarters, etc. As one period is completed, another is added to the forward-looking budgetary information. This approach provides for continuous monitoring and planning and allows managers more insight and reaction time to adapt to changing conditions.

Continuous budgeting is analogous to driving a vehicle. A bad driver might focus only on getting from one intersection to the next. A good driver will constantly monitor conditions well beyond the upcoming intersection, anticipating the need to change lanes as soon as distant events first come into view.

 

Flexible Budgets

The discussion in this chapter has largely presumed a static budget. A static budget is not designed to change with fluctuations in activity level. Once sales and expenses are estimated, they become the relevant benchmarks. An alternative that has some compelling advantages is the flexible budget.

Flexible budgets relate anticipated expenses to observed revenue. To illustrate, if a business greatly exceeded the sales goal, it is reasonable to expect certain costs to also exceed planned levels. After all, some items like cost of sales, sales commissions, and shipping costs are directly related to volume. How ridiculous would it be to fault the manager of this business for having cost overruns? Conversely, failing to meet sales goals should be accompanied by a reduction in variable costs. Certainly it would make no sense to congratulate a manager for holding costs down in this case! A flexible budget is one that reflects expected costs as a function of business volume; when sales rise so do certain budgeted costs, and vice versa. The next chapter will illustrate a flexible budget.

 

Encumbrances

In working with budgets, especially budgets of governmental units, one may encounter an encumbrance. An encumbrance is a budgetary restriction occurring in advance of a related expenditure. The purpose of an encumbrance is to earmark funds for a designated future purpose. For instance, a department may have $100,000 budgeted for office supplies for the upcoming year. However, the department may have already entered into a $500 per month contract for copy machine repair services. Although $100,000 is budgeted, the remaining free balance is only $94,000 because $6,000 ($500 X 12 months) has already been committed for the repair service. At any point in time, the total budget, minus actual expenditures, minus remaining encumbrances, would result in the residual free budget balance for the period.

 

 
Did you learn?
Distinguish between monthly, quarterly, and annual budgets.
What is a continuous budget?
What is a flexible budget and what are the advantages of such budgets?
What is an encumbrance and what control purpose does it serve?