While many employees are held to a budget, many do not understand the method that creates this management tool. The process of budget creation, called budget modeling, consists of management estimation of future costs and revenues. This model is usually itemized and is a fluid document that is updated as more information is known about the budget period. Budgets are commonly used in organizations, and it is important to know where employees are likely to encounter them.
The most common way that budget modeling is used in organizations is to produce an annual forecast of revenue and expenses. Usually starting about halfway through the fiscal year, accounting and top management will start to make projections of the next year's revenue and expenses. These projections will be refined as the new year approaches and will help form departmental budgets and the company's performance metrics.
Special Project Analysis
Budget modeling is also used to evaluate special projects. If a company is considering the pricing of a special order, whether to make or buy a product, or even whether to expand operations, in many cases the management accounting function will prepare a budget forecast to determine if the proposed action is profitable.
Best Case / Worst Case
Newer budget modeling techniques involve the use of risk analysis in preparation of budget figures. Instead of just producing one static budget, accountants prepare an expected budget, a worst-case scenario budget and a best-case scenario budget and inform budget users what the probability of each scenario is. This gives management more insight into how likely the budget scenarios are to occur. It is important to note that the estimates of probability are subjective, and the strength of this, and any other budget technique, is only as great as the accountant's ability to estimate.
When a company is operating at a loss, budget modeling can be used to determine if the company should continue to operate, called a loss-operate condition, or should cease operations. If budget models show that the company has a positive gross margin, sales less variable costs, then the company is paying toward unavoidable fixed costs and should continue to operate. If it does not, it should cease operations.