3.9 Budgets

(HL ONLY)

Introduction to Budgets

A budget is a financial plan for costs and/or revenues for a given future period of time.

Budget holders will be given responsibility for different areas of the business

Why set budgets?

  • To control/reduce expenditure or spending of funds

  • Allocating funds

  • Forecast for future use of funds

  • Set targets in terms of adding funds

  • To evaluate financial stability and performance

  • To promote forward thinking or future planning

  • To motivate managers

  • To assign financial responsibilities to budget handlers

Types of Budgets

Sales and Expenditure Budgets:

Sales

A forecast of the revenue received from product lines, departments, and branches.

Expenditure:

An expenditure budget is the plan for how much will be spent.

Due to the broad range that this type of budget covers, it has to be broken down into different categories.

Key Expenditure Types:

  • Staffing

  • Training

  • Marketing

  • Utilities & Rent

  • Maintenance

  • Equipment Purchase

  • Administration

  • Raw Materials

  • Contingency

Master Budget

The master budget factors both the sales and expenditure to create a overall plan.

  • Gives context to expenditure and revenue figures (it is hard to see anything from either figure individually

  • Allows for advanced planning for the year

  • As all costs and revenues are now planned for, budgeted profit/loss figures can be determined

How Are Budgets Set: Approaches to Budgeting

Top Down Budgeting

Budgets are prepared by top management and imposed on the lower layers of the organisation

Advantages:

  • Able to control the business's finance

  • Gives accountability to staff

  • Faster process

Disadvantages:

  • Inaccurate forecasting as departments would usually know what their budgets are in the beginning

  • Departments that feel as if they are underfunded may also underperform in retaliation

  • May decrease employee morale as they may feel their input is not valued

Bottom Up Budgeting

Supervisors and middle managers prepare the budgets and then forward them up the chain of command for review and approval

Advantages:

  • Increased motivation due to ownership of the budget

  • Should contain better information since employees most familiar with the department

  • Increases manager's understanding and commitment

  • Better communication between departments

  • Senior managers can concentrate on strategy

Disadvantages:

  • Senior managers may resent loss of control

  • Dysfunctional behaviour: budgets may not be in line with corporate objectives as managers lack a strategic perspective and will focus on divisional concerns

  • Bad decisions from inexperienced managers

  • Budget preparation is slow and disputes can arise

  • Budgetary stack: managers set targets that are too easy to achieve

  • Some departments may get more funding as they are more persuasive

Zero Budgeting

Zero-based budgets exist when budgets are automatically set at zero and budget holders have to justify their case to receive any funds

Advantages:

  • Zero-based budgeting represents a move towards allocation of resources by need and benefit

  • It creates a questioning attitude rather than one which assumes that current practice represents value for money

  • It focuses attention on outputs and in relation to value for money

  • It leads to increased staff involvement which may lead to improved motivation and greater interest in the job

Disadvantages:

  • Effective zero budgeting requires considerable management time spent in identifying and justifying the appropriate budget level

  • Bigger budgets may go to those more persuasive managers rather than those most in need of funds

Pre-budgeting Research

Setting budgets

Many firms will work on last years budget and other historical data and build in adjustments to take account of:

  • Expected changes in demand

  • Price changes

  • Cost rises

This is known as incremental budgeting

Pros:

  • Incremental budgeting is considered more reliable

Cons:

  • Forecast may be inaccurate deceasing efficiency

  • Doesn't account for unexpected events which haven't been budgeted for

How do new businesses set budgets?

Budget setting will be harder for a new business as they do not have historical data. Instead, they can find information about:

  • Competitor products

  • Market research

  • Entrepreneur expertise and experience

  • Instinct based on market knowledge

Qualitative considerations:

  • Available finance

  • Company objectives

  • Planned purchases

  • Negotiation process

Budgetary Control: Variance Analysis

Budgetary control involves corrective measures being taken to ensure that actual performance meets budgeting performance.

Variance Analysis put simply, it is measuring the difference between the forecasted figures and the actual figures. If the margin of difference is large enough "corrective action" - editing budget to account for under/over performance - can be taken

Budget variances

A variance is the amount by which the actual result differs from the budgeted figure

Variance = Actual Outcome - Budgeted Outcome

There are two different types of variances:

  • Favorable variance

Leads to higher than expected profits

  • Adverse variance

One that reduces profit

Evaluation of Budgeting:

  • It is a useful management tool because it helps to COORDINATE, CONTROL, and MOTIVATE

  • Budgeting forces businesses and perhaps yourself to plan ahead and think about the needs of the business or at least the needs of yourself

  • Good budgets should be flexible to change and be reviewed regularly

  • Though needs to be given to the budgeting process in order to avoid problems associated with budgeting

  • Budgeting can ensure that businesses do not overspend and potentially go into debt

  • Budgets must be audited frequently in order to ensure the integrity of the budgets themselves are not compromised

    • For example:

    • A manager can embezzle/steal funds easily by forging or creating false data on a budget and then pocketing the funds

    • An employee can fool a manager by creating false needs for budget usage and again, embezzle/pocket those funds

Potential Problems with Budgets

Whilst budgets are widely used to in business, you should appreciate that they have some important limitations.

In particular:

  • Budgets are only as good as the data being used to create them. Inaccurate or unreasonable assumptions can quickly make a budget unrealistic

  • Budgets can lead to inflexibility in decision-making

  • Budgets need to be changed as circumstances change

  • Budgeting is a time consuming process – in large businesses, whole departments are sometimes dedicated to budget setting and control

  • Budgets can result in short term decisions to keep within the budget rather than the right long term decision which exceeds the budget

  • Managers can become too preoccupied with setting and reviewing budgets and forgetting to focus on the real issues of winning customers

Budgets can also create some behavioural challenges in a business

  • Budgeting has behavioural implications for the motivation employees

  • Budgets are de-motivating if they are imposed rather than negotiated

  • Setting unrealistic targets adds to de-motivation

  • Budgets contribute to departmental rivalry - battles over budget allocation

  • Spending up to budget: it can result in a “use it or lose it” mentality - spend up to the budget to preserve it for next year

  • Budgetary slack occurs if targets are set too low

  • A “name, blame and shame” culture can develop - but managers should be answerable only for variations that were under their control