2.2.4 Budgets

Budgets

Key Definitions

Budget: A target for costs or revenue that a firm or department must aim to reach over a given period of time.

Income Budget: This involves setting a minimum figure for the revenue to be generated by a product or service, a department, or a manager. 

Expenditure Budget: This involves setting a maximum figure for what a department or manager can spend over a given period of time in order to control costs. 

Historical Budgeting: This involves setting a budget for the upcoming year based on previous figures on revenue and expenditure. 

Zero Budgeting: This involves setting all future budgets to 0 in order to force managers to justify their spending levels. 

Criteria: The 'yardsticks' that success, or a lack of success, is measured against. 

Variance: The difference between the budgeted figure and the actual figure, this can be favourable or adverse depending on the budgets. 

Favourable Variance: A difference between the budgeted figure and the actual figure that boosts a firm's profit and works in their favour. 

Adverse Variance: A difference between the budgeted figure and the actual figure that damages a firm's profit and does not work in their favour.

Delegation: The process of passing the authority for a task down to a worker in a lower position to give them more decision-making power.

The Purpose of Budgets

Budgeting is used: 

• To ensure that no department or individual spends more than what the company expects and preventing any unpleasant unexpected surprises.
  
• To provide a 'yardstick' against which the success or failure of a manager can be measured and rewarded.
  
• To enable spending power to be delegated to a local manager who is in a better position to know how to best use the firm's money - potentially improving and speeding up the decision-making process and motivating the local budget holders.
  
• To motivate staff in a department - budget figures can be used as a clear basis for assessing staff performance, enabling staff to know what exactly it is they need to do to be considered 'successful'. 

How to Construct a Budget

Budgeting is the process of setting targets, covering all aspects of costs and revenues. It is a method for turning a business's strategy into a reality. Nothing can be done in business without money, and budgets tell individual managers how much they can spend to achieve their objectives. A budgeting system shows how much can be spent per time period, and it gives managers a way to check whether they are on track. Most businesses use budgeting as a way of supervising their staff. The process is as follows:

1. Make a judgement of the likely sales revenues for the coming year. 

2. Set a maximum cost that allows for an acceptable level of profit. 

3. Break down the budget for the whole company's costs either by division, department, or cost centre. 

4. Break the budget down further into a budget for each manager to give them some spending power. 

In a  business start-up the budget should provide enough spending power to finance vital needs such as building work, decoration, recruiting and paying staff, and marketing. If a manager overspends in one area they know that it is essential to make cutbacks elsewhere. A good manger will get the best possible value from their budget. 

Types of Budget

Historical Budget

A historical budget involves using previous figures on revenue and expenditure to determine a budget for the upcoming financial year. Most firms treat last year's budget figures as the main things that determine this year's budget, but with minor adjustments made to cover for inflation and other foreseeable changes. 

Zero-Based Budget

A zero-based budget sets every department's budget to 0 for the upcoming year, and it demands that the budget holders justify what they set as their budget. It can be more time consuming for managers, making it sensible to use only every few years instead of every year. 

The best criteria for setting budgets are:

• To relate the budget directly to the business objectives - if a company want to increase their sales and market share the best method may be to increase the advertising budget and therefore boost demand.
  
• To involve as many people as possible in the budget-setting process - people will be more committed to reaching the targets if they have had a say in how the budget was set. 

Variance Analysis

The variance is the difference between the actual figure and the budgeted figure. It is usually measured every month by comparing the actual figure and budgeted figure. There are 2 types of variance: favourable (in which the difference leads to higher profits than expected) and adverse (in which the difference leads to lower profits than expected). 

The value of regular variance statements is the fact that they provide an early warning. If a product's sales are slipping below the budget the manager can respond by increasing marketing support or by cutting back on production rates and plans. 

Analysing Budgets and Variances

When significant variances occur management should first consider whether the fault was in the budget or in the actual achievement. When adverse variances occur senior managers are likely to want to hear an explanation from the responsible line manager. A clear explanation into what went wrong will be expected. 

The Difficulties of Budgeting

Budgeting is widely used in businesses both in the corporate and public sector. However the budgets are not always appropriate - for example, if the major factor determining sales is something that cannot be controlled easily, such as the weather. A business needs to decide whether designing and implementing a budgeting system will cost more in terms of time and money than it could potentially save - basically the opportunity costs. In the often chaotic world of business start-ups it is easy to see how time spent talking to customers and suppliers would be more valuable than working on a spreadsheet.