Cost vs. Budget

Budgets are used worldwide when an individual, organization, government or business needs to plan for income and expenses. Unfortunately -- or sometimes fortunately -- things don't always go according to plan. The actual cost of goods or services often varies significantly from the budget plan, and when this occurs, other budget items are affected. There are two basic budget types.

When a business uses a static budget, the original budget plan never changes. If the business has had steady income and costs in the past -- and expects the same in the future -- then the static budget approach is appropriate. When income or costs deviate from the budget, the manager performs a variance analysis. The variance analysis shows how much income or cost differed from the budget plan, and it's represented in dollar and percentage terms. If the difference is significant, then the business can develop a forecast using the actual data. The forecast combines actual and revised budget figures in one document.

Flexible budgets offer a more dynamic approach, because costs are often expressed as a percentage of revenue. This approach allows a manager to skip the forecast process altogether, because cost numbers automatically adjust up or down depending on income volume. Some costs are fixed and never change -- rent and annual taxes are two examples -- while other costs are variable. Direct costs, such as sales staff and materials costs, are highly variable in a manufacturing business.

One of the most popular analytical tools that a manager uses to assess a business's health is the gross profit margin. Gross profit margin tells the manager how efficiently the business operates. To calculate gross margin, subtract direct costs -- also called the cost of goods sold -- from sales revenue. What's left over must be enough to cover overhead costs and income taxes. If it is, then the business earned a net profit. Otherwise, it's breakeven, or a loss.

There are several financial statements that managers use to assess a business's health. Forecasts and budget analyses compare the budget plan with actual income and cost data. The income statement -- also called a profit and loss statement -- is where actual income and cost data are reported, and the actual gross margin is calculated based on its data. The balance sheet shows the business's total assets and liabilities as of a certain point in time. The cash flow statement shows how much in revenue is flowing in and out of a business during a particular period. Proper evaluation of a business requires using each of these reports.