ANNOUNCEMENT: As of August 2024, Project Lethe is no longer updating this site. Feel free to continue to use it! Thank you, from the Lethe Admin Team!

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

Page updated

Google Sites

Report abuse