What ruins budgets most is that they are prepared to be approved and then forgotten. A budget that is not compared with actual results every month is not a management tool — it is an archive document.
1 The operating budget chain
Sales
Always the starting point
Production
Sales + closing inventory − opening
Purchases and wages
What production requires
Expenses
Operating, selling and administrative
Cash budget
Receipts, payments and their timing
Pro forma statements
Expected income and financial position
A linked chain — an error in the sales estimate travels into everything after it
Do not forget the cash budget
An excellent profit budget does not mean sufficient liquidity. The cash budget reveals when cash comes in and goes out, and it may show a shortfall in one particular month even though the full year is profitable.
2 Static and flexible budgets
Comparing actual results with a budget built for a different volume is an unfair comparison. The answer is the flexible budget: recalculating the budget at the actual volume before comparing.
The budget was prepared for 4,000 units and actual output was 4,600 units. The standard variable cost is SAR 120 per unit and fixed costs are SAR 240,000.
| Item | Static budget (4,000) | Flexible budget (4,600) | Actual |
|---|---|---|---|
| Variable costs | 480,000 | 552,000 | 561,200 |
| Fixed costs | 240,000 | 240,000 | 246,000 |
| Total | 720,000 | 792,000 | 807,200 |
The wrong reading: “we overran the budget by SAR 87,200!” — unfair, because much of the increase is simply the cost of producing more.
The right reading: the true variance = 807,200 − 792,000 = SAR 15,200, of which 9,200 sits in variable costs and 6,000 in fixed costs — and that is what deserves investigation.
3 Reading performance variances
| Variance | The question it asks | Possible causes |
|---|---|---|
| Sales volume | Did we sell more or fewer units than planned? | Market · competition · a marketing campaign |
| Selling price | Did we sell at a different price than planned? | Discounts · customer mix · market conditions |
| Variable costs | Did we spend more per unit? | Supplier prices · waste · efficiency |
| Fixed costs | Did we overspend on fixed expenses? | New hires · emergency maintenance · rents |
A budget is a tool, not a weapon
When variances are used to reprimand managers, everyone learns to set lenient budgets that are easy to beat. The budget then becomes an annual performance instead of an honest plan.
4 Methods of preparing a budget
| Method | The idea | When does it fit? |
|---|---|---|
| Incremental | Last year’s budget plus a percentage increase | Stable activities · fast, but it carries slack forward |
| Zero-based | Every line is justified from zero | When costs need deep control |
| Rolling | A new period is added as each period ends | Fast-changing environments |
| Participative | Department managers take part in preparing it | Raises commitment but needs discipline |
Lesson summary
- The budget starts from sales and ends with pro forma statements, and it is incomplete without a cash budget.
- Compare actual results with a flexible budget at the actual volume, not with the original budget.
- A variance is a question about causes, not a means of blaming a manager.
- Each method has its merit: incremental is fast, zero-based is deeper, rolling is more flexible.
- Involving managers raises commitment to the budget and makes it more realistic.
5 Test yourself
Three quick questions
Choose the answer you think is correct — the result appears immediately.
1. Output was 4,600 units and the budget was built on 4,000. What should actual costs be compared with?
The flexible budget strips out the effect of the volume difference, so the real variance in efficiency and prices becomes visible.
2. A company’s budget shows a healthy annual profit, yet it failed to settle an obligation in March. What was neglected?
An annual profit does not guarantee liquidity in every month; the cash budget exposes timing gaps in advance.
3. What is the drawback of an incremental budget?
Building on last year’s figures assumes they were right — and they may not have been.