In managerial accounting, differentiating between various types of costs is crucial. Usually, companies use several classifications to separate those costs.
For example, they can segregate any spending based on its nature, function, or behavior. Companies use these cost classifications to help in making well-informed decisions.
Usually, companies classify costs after they occur. At this point, they have critical information about it.
However, companies can also predict costs before they occur. This process requires indulging in the process of creating a budget.
Companies can prepare various types of budgets based on their needs. Usually, this process starts with income and then predicts expenses based on that.
Companies prepare cost budgets, which also include budgeted costs. These costs may apply to various areas within a business.
Cost budgeting is one of the most crucial types of the budget that companies prepare. It follows a similar process to creating other budgets.
However, it only covers future spending and expenses. One of the critical features of these budgets is that they include budgeted costs.
Before discussing them, it is crucial to understand what cost budgeting is.
What is Cost Budgeting?
Cost budgeting involves creating a plan for costs. It includes various cost estimations based on an activity level set by companies.
Usually, cost budgeting involves a similar process as other budgets. However, it focuses on expenses and spending only.
Cost budgeting helps companies estimate the sum of all expected costs for a defined period. With this process, companies can understand how much they need to spend in the future.
The cost budgeting process may differ from one company to another. Usually, it involves managers preparing a budget for their departments or functions.
Once those budgets are final, companies can combine them to reach an overall cost budget. However, it may require authorization and review first.
Companies can also prepare cost budgets for specific projects or areas within the business.
Cost budgets are essential in setting cost centers. These are a type of responsibility centers that some companies establish.
Consequently, companies can promote accountability for costs within each function or department. Cost budgets do not consider income or profits.
Therefore, they apply to cost centers better. However, that does not imply that these budgets are not crucial to other responsibility centers.
Cost budgeting is also a part of revenue and profit centers. One of the most critical purposes of a cost budget is to establish how companies spend their resources.
Companies may require additional finance if they do not have enough resources to fund their spending.
Therefore, cost budgeting can help establish whether companies must acquire finance to fund operations.
However, cost budgeting does not present that information on its own. Companies use cost budgets with other tools to prepare a plan for a defined period in the future.
These budgets may have several elements or components. For example, they consist of cost estimates, cost classification, and budgeted costs.
Each of these elements plays a crucial role in finalizing cost budgets.
What is a Budgeted Cost?
Companies prepare budgets and forecasts to predict their future needs. Usually, these needs depend on growth trends, customer demand, strategic plans, etc.
Companies then budget the costs for their activities in the future period through cost budgets. As mentioned above, these budgets allow companies to understand how much they must spend in that period.
These budgets also include budgeted costs.
A budgeted cost is an estimated spending plan that a company expects to incur in a defined period.
In other words, it includes the expenses that companies estimate will occur. A budget cost allows companies to understand the costs they will bear.
Consequently, they can plan on how to fund those costs. Budgeted costs are crucial in cost budgeting and the overall budgeting process.
Budgeted costs also help provide a base for other tools. For example, these costs are crucial in variance analysis when monitoring and controlling costs.
Budgeted costs may be for the company as a whole or a specific function. Based on the underlying cost budget, these costs may cover defined areas.
On top of that, companies can also estimate their budgeted expenditure for a project.
The budgeted costs will differ from one company to another. On top of that, these costs vary during different periods based on the underlying needs.
Companies follow a similar process when estimating budgeted costs. Usually, it involves increasing the prior period’s estimations based on an underlying assumption. Budgeted costs include both variable and fixed costs.
How to Prepare Budgeted Costs?
Companies prepare budgeted costs through a cost budget. Usually, it involves two stages. The first includes establishing an assumption for increasing or decreasing costs.
The other consists of determining the expenses associated with that assumption. An explanation of these stages is as follows.
Establish an Underlying Assumption
The first stage in setting a budgeted cost is determining the underlying assumption to use. Usually, companies prefer to estimate these costs based on revenues.
Therefore, they establish how much income they expect to earn. Based on that, they create the expenses they will incur.
However, this process only covers variable costs. Fixed costs usually stay constant with stepped increases.
Determine the Associated Expenses
Once companies estimate their income, they must determine the associated expenses. This process involves establishing the expenses they must incur to achieve the expected results.
Consequently, companies prepare a list of all the costs they will spend for that period. These costs are a part of the budgeted costs within that budget.
Similarly, they become the based for future changes in the underlying budget.
What is the Difference Between Budgeted, Actual, and Standard Costs?
Budgeted costs refer to future expenses created in a budget. These costs depend on various operations or transactions that companies expect to occur during a period.
Usually, companies establish budgeted costs based on a forecast and predefined goals. The most crucial part of budgeted costs is to estimate variable costs.
Fixed costs are also a part of these costs. However, they are more straightforward to predict.
Actual costs, on the other hand, do not constitute predictions. These costs come from the results obtained through a process.
Moreover, actual costs are the expenses companies incur after performing various tasks. These costs depend on the actual activity levels within that company.
Similarly, these costs are also a part of the financial reporting process performed by companies.
Lastly, standard costs come from a detailed analysis of forecast costs. Usually, these exist for each component of the step within operations.
Standard costs are similar to budgeted costs. However, they cover the ideal points companies expect for an optimal process.
The process of establishing standard costs differs from one company to another. On top of that, industry benchmarks may exist to determine these costs.
Overall, budgeted, actual and standard costs differ significantly. The difference between these costs is highly crucial in variance analysis and other managerial accounting processes.
Usually, budgeted costs come from how much companies expect expenses to be. Actual costs depend on the performance based on an activity level.
Lastly, standard costs come from a benchmark used to compare processes.
Limitation of Budgeted Cost
There are several potential limitations of budgeted costs:
- Inaccurate forecasts – Budgeted costs may be inaccurate due to insufficient data or knowledge of the future environment that could impact the cost.
- Unanticipated expenses – Emergencies or unexpected events can affect the budget’s cost estimates.
- Lack of flexibility – If a budget is not flexible enough, it could limit adaptation should change in the environment occurs that would be impossible to predict.
- Overly restrictive limits – Some budgets may be rigid and have strict restrictions, limiting the amount of resources available for new initiatives or opportunities.
- Lack of incentives – A budget with no incentives may leave employees feeling unmotivated, limiting their productivity and impact on overall cost management objectives.
Companies prepare cost budgets that estimate how many expenses they will incur during a period.
These budgets include various components, including budgeted costs. Usually, companies prepare these costs in two stages.
Budgeted costs include expenses that companies expect to occur during a specific period. These costs differ from actual and standard costs.