Business Budgeting and Budget vs. Actual Analysis | Free Bookkeeping & Accounting Course

What you'll learn

How the pieces of a master budget fit together.
How to estimate sales realistically, with scenarios.
How to build a budgeted income statement and a month-by-month cash budget.
How to compare budget vs. actual and read variances, including with a flexible budget.
Budgeting habits that keep the plan useful all year.

So far you've looked backward: recording what happened and summarizing it in financial statements. A budget looks forward. It's how a business decides how much it can spend, when it will need financing and whether its goals are realistic. And every month it becomes the yardstick: are we doing better or worse than planned, and why?

The master budget, step by step

A complete budget is built as a chain, where each piece feeds the next:

Sales budget
Purchases and operating expenses
Budgeted income statement
Cash budget
Budgeted balance sheet

Sales budget: units and prices by product or line. It drives everything else and is the hardest to estimate.
Purchases or production budget: what you need to buy or make for those sales, considering the inventory you already hold.
Operating expense budget: rent, payroll, marketing, software, insurance.
Budgeted income statement: how much will we earn?
Cash budget: when will money come in and go out, including loan payments, equipment purchases, owner draws and taxes?
Budgeted balance sheet: where the business will stand at the end of the period.

How to estimate sales

History: sales for the same month last year, adjusted for growth and price changes.
Capacity: how many customers can you serve? A coffee bar with two espresso machines and three baristas can only make so many drinks during the morning rush.
Pipeline: for B2B sales, open opportunities × close rate × average deal size.
Seasonality: strong and weak months. Iced drinks in an Austin summer, holiday gift cards in December.
Scenarios: build at least three (pessimistic, base and optimistic) and make sure the business survives the pessimistic one.

Brightside's budgeted income statement

Maya's assumptions for next quarter: sales of $20,000, $22,000 and $24,000; COGS at 28% of sales; fixed costs of $11,200 a month (rent $3,500, wages $7,000, depreciation $200 and marketing $500); and $50 of loan interest each month.

Line	Month 1	Month 2	Month 3	Quarter
Sales	$20,000	$22,000	$24,000	$66,000
(−) COGS (28%)	($5,600)	($6,160)	($6,720)	($18,480)
Gross profit	$14,400	$15,840	$17,280	$47,520
(−) Fixed costs and marketing	($11,200)	($11,200)	($11,200)	($33,600)
Operating income	$3,200	$4,640	$6,080	$13,920
(−) Interest	($50)	($50)	($50)	($150)
Net income	$3,150	$4,590	$6,030	$13,770

Operating leverage from lesson 8 again: sales grow 20% from month 1 to month 3, but operating income grows 90%, because fixed costs don't move.

The cash budget: the piece that keeps you alive

The income statement tells you whether you'll earn money; the cash budget tells you whether you'll be able to pay the bills. Assumptions: Brightside starts the quarter with $12,000 in the bank after paying for a new patio. Customers pay at the register. Supplies are paid the month after they're bought, so month 1 pays the $6,000 bill from the opening month. The loan payment is $450 a month ($400 principal plus $50 interest). Maya takes a $3,000 draw each month, plus a $2,500 draw in month 2 to cover her quarterly estimated tax payment (lesson 13). Sales tax is collected and remitted separately, so it's left out. Depreciation isn't included: it isn't a cash payment.

Line	Month 1	Month 2	Month 3
Beginning cash	$12,000	$11,550	$11,000
(+) Collections from sales	$20,000	$22,000	$24,000
(−) Supplier payments (prior month)	($6,000)	($5,600)	($6,160)
(−) Rent	($3,500)	($3,500)	($3,500)
(−) Wages	($7,000)	($7,000)	($7,000)
(−) Marketing	($500)	($500)	($500)
(−) Loan payment	($450)	($450)	($450)
(−) Owner draws	($3,000)	($5,500)	($3,000)
Net cash flow	($450)	($550)	$3,390
Ending cash	$11,550	$11,000	$14,390

In month 1, net income is $3,150, yet cash falls by $450. Why? Brightside pays last month's $6,000 supplier bill, $400 of loan principal and Maya's $3,000 draw. None of those is an expense this month, but all of them are cash out the door. That's the gap between profit and cash from lesson 10, now visible in advance.

Set a minimum cash cushion

Pick a floor for your bank balance, for example one month of fixed costs and loan payments. Brightside's is about $11,450 ($11,200 of fixed costs less $200 of non-cash depreciation, plus the $450 loan payment), and month 2 dips just below it. Because Maya sees it now, she can delay the patio heaters, push a catering client to pay a deposit or ask her bank about a line of credit. Banks lend more easily to borrowers who aren't desperate.

1. Why does depreciation appear in the budgeted income statement but not in the cash budget?

Because it's an error
Because it's paid once a year
Because it's an expense that uses no cash; the cash left when the equipment was bought

Depreciation spreads the cost of an asset already paid for. It lowers profit, not the bank balance.

2. A business projects a profit every month, but its cash budget goes negative in month 4. What does that mean?

It will need financing or must change the timing of collections and payments that month, even though it's profitable
The budget must be wrong
The business should close

Profitability and liquidity are different things. Seeing the shortfall months ahead lets you fix it calmly.

Budget vs. actual: reading the variances

Each month, compare actual results with the budget. The difference is a variance. Higher revenue or lower costs than planned is favorable; the opposite is unfavorable.

Month 1	Budget	Actual	Variance	%	Type
Sales	$20,000	$18,800	−$1,200	−6.0%	Unfavorable
COGS	$5,600	$5,640	+$40	+0.7%	Unfavorable
Fixed costs and marketing	$11,200	$11,050	−$150	−1.3%	Favorable
Operating income	$3,200	$2,110	−$1,090	−34.1%	Unfavorable

Maya Torres, owner of Brightside CoffeeAustin, Texas · month 1 of the quarter, budget vs. actual

Sales came in 6% short, and operating income fell 34%. Each bar is shown as a share of the $20,000 sales budget.

Budget

Sales$20,000

COGS$5,600

Fixed costs$11,200

Operating income$3,200

Actual

Sales$18,800

COGS$5,640

Fixed costs$11,050

Operating income$2,110

A $1,200 sales shortfall became a $1,090 profit shortfall: with mostly fixed costs, lost sales fall almost straight to the bottom line.

The numbers only matter for the questions they raise:

Sales −6%: fewer customers, or a smaller average ticket? A new competitor, a week of rain, slow service at the morning rush?
COGS looks almost on budget, but it isn't. A flexible budget adjusts costs to the actual volume: at $18,800 of sales, COGS should have been 28% × $18,800 = $5,264. Actual COGS was $5,640, so it's really $376 unfavorable, and COGS rose to 30% of sales. Did bean prices go up, was there waste, were drinks given away?

Focus on what matters

Set a threshold, such as variances above 5% or above $500, and investigate only those. Chasing every penny burns hours without improving decisions.

3. You budgeted $800 for marketing and spent $950. How do you classify the variance?

Favorable by $150
Unfavorable by $150 (18.75% over budget)
Not relevant

Spending more than planned is unfavorable: $150 ÷ $800 = 18.75%. It may still be justified if it brought in more sales, so look at the whole picture.

4. A bakery budgets COGS at 28% of sales. Actual sales were $30,000 and actual COGS was $8,700. What is the flexible-budget COGS variance?

$8,700 unfavorable
$300 favorable
$300 unfavorable

At actual volume, COGS should have been 28% × $30,000 = $8,400. Actual was $8,700, so costs ran $300 over (29% of sales instead of 28%).

Budgeting habits that work

Build expense budgets from zero (zero-based budgeting) instead of copying last year plus 5%.
Update a rolling 12-month forecast every month with what you now know.
Give every budget line an owner who can explain its variances.
Include taxes, loan principal and owner draws in the cash budget, not just expenses.
Run budget vs. actual monthly, in a spreadsheet with SUMIFS or with your software's built-in report.

Practice exercise

A three-person marketing consultancy in Atlanta bills $45,000 a month on net-30 terms (this month's invoices are collected next month). Its expenses are $36,000 a month, paid in the same month. In January it collects December's $45,000. In February it hires a fourth consultant (an extra $9,000 a month in total cost) and expects to bill $52,500 a month from February on. Cash on January 1 is $10,000.

Project cash from January through April.
Which month is tightest, and what would you do?

See solution

               Jan        Feb        Mar        Apr
Beginning    10,000     19,000     19,000     26,500
Collections  45,000     45,000     52,500     52,500   (last month's billing)
Payments    (36,000)   (45,000)   (45,000)   (45,000)
Ending       19,000     19,000     26,500     34,000

February is the pinch point: the firm pays the new hire before collecting the extra billing that person helps generate, so cash stops growing. With a cushion of one month of expenses ($45,000), it's below target the whole time. Options: ask new clients for a deposit or retainer, move to net-15 terms or card payments, or open a line of credit before it's needed.

Summary

The master budget flows from sales to expenses, the budgeted income statement, the cash budget and the balance sheet.
The cash budget is what tells you whether you can pay: it includes loan principal, draws and taxes, and excludes depreciation.
Compare budget vs. actual monthly and investigate only the significant variances.
A flexible budget adjusts variable costs to actual volume and reveals problems a static budget hides.
Plan with scenarios and roll the forecast forward every month.

Budgeting your own household works the same way; see our guide on how to make a budget.

Next lesson: Financial Statement Analysis: Horizontal, Vertical, EBITDA and DuPont. You'll analyze two years of an online store the way lenders and investors do.