What is a budget? Put simply, it’s a financial plan for future operations of a company. A budget is also a formal plan of action expressed in monetary terms. The formal development of a budget helps to ensure a company’s success and survival. Budgeting compels planning, and it improves communication and coordination among organizational elements. Budgeting provides a guide to action and a basis for performance evaluation. This Skill discusses the concepts, relationships, and procedures used in budgeting. It also examines budget assembly and considers issues related to manager behavior and the budgeting process.

But how do budgets help a company? They allow a company to communicate business objectives, allocate resources, and generate pro-forma financial statements. For example, a company may want to assess the amount of money required to create a new product line. Therefore, it would need a budget to understand where it will get the resources to pay for the new product line.

Here are other reasons why the budgeting process is important to a company. First, budgets require people to think about the future. For example, how many units of product will be produced next month? What about the next 3 months? And what amount of raw materials is needed? Creating a budget moves a company from a reactive style to a proactive style of management. Therefore, rather than guessing the amount of raw materials on purchase, a budget projects the required amount needed ahead of time. Then, in a proactive way, the company determines where to generate cash to pay for those raw materials instead of waiting until it receives the bill from the material supplier. Thus budgeting can improve communication and coordination throughout the business.

What if a company’s production department needs a new factory built? How will it be paid for? Will the company need to issue bonds or take out long-term loans? Production will need to work with the finance department to determine how to pay for the factory. Therefore, the budgeting process gets the production department and the finance department to work together.

Budgeting also can provide a guide to action. Once a company knows, for instance, that it is going to have a new product line and can predict its projected sales, it can also estimate the number of salespeople as well as the sort of web presence or advertising needed.

Also, budgets provide a basis for performance evaluation. A company might have a budgeted income statement for each of its 50 product lines. When the year is over, the company may want to compare the budgeted profit for, say, product line A with its actual profit to see whether the product line exceeded its budgeted net income. And if it didn’t, why? Was it because product line A didn’t get as good a selling price as projected? Or is it because product line A cost more for raw materials than expected?

Companies carry out business activities for the purpose of making profits. Two key metrics frequently used to measure profits are net income and net profit margin. Net income is the final number presented on an income statement and is often referred to as the company’s bottom line. Net profit margin is a popularly used financial ratio that expresses a company’s profitability as a percentage of total sales revenue (net profit margin = net income/total sales revenue). The net profit margin ratio helps businesses determine the percent of net income or profit they have been able to earn for each sales dollar. For example, if a business has a 22% net profit margin ratio, this means that it had a net profit of $0.22 for each dollar of sales generated.

A limitation of income statements is that they are historical in nature because they are prepared for a given time period such as a year after that year has passed. Therefore, the two key financial metrics, net income and net profit margin, are only available to a company’s management after the fact or after that year has passed.

To be effective, management of a company needs more than just the historical data expressed in the company’s income statement. Management needs to be looking toward the future. The budgeting process can be used to generate an estimate of net income and net profit margin for the upcoming year, which helps management see whether the company will meet its targeted net income and net profit margin metrics.

To summarize, a budget is an estimation of revenues, expenses, and profit over a certain future period, usually monthly, quarterly, or yearly. It allows a business to plan expenses, reach business goals, and anticipate any changes needed to support the business. A budget helps a business understand its operating expenses, needed assets, and required amount of debt or equity. Budgets are an essential tool that managers of a company can use to ensure that cash is available to cover expenses.

With a proper budget in place, a business can anticipate expenses, plan for major increases in costs, and anticipate strategic changes needed for future success. Budgets can help a business set goals and communicate priorities, and they serve as an important source of information for a business’s potential investors and creditors.