Wherever you work, whatever you do, you will always be affected by some kind of budget. Budgets can vary in both complexity and scale, ranging from individual and small business budgets, to probably the largest budget in the UK – the governmental budget. They are essential for good money management and resource planning, and may even help a failing business to survive and thrive once again. In accounting terms, a budget can often be your best friend.
A budget can be defined as a statement of estimated financial consequences of implementing a given business plan for a specified period of time. It is a plan to show how resources will be required and allocated to divisions, departments, strategic subunits, activities and investments over the period. The act of preparing the plan is known as ‘budgeting’, and the use of the plan to control activities is known as budgetary control.
The Many Uses of Budgets
Budgets are used for a variety of reasons, some of which have been listed below.
- Planning – deciding how much to produce or order, or estimating how much a future activity will cost.
- Controlling – actual results will be monitored against the budget to identify any differences.
- Co-ordinating – budgets will be prepared for different areas of the business so top-line managers can see the overall effect if all areas work together to achieve the businesses overall goals.
- Communicating – budgets are a good way of ensuring that people in the organisation know what is to be achieved.
- Motivating – if people know what is expected and see this as a realistic and challenging target, this may help to motivate them.
- Measuring performance – budgets can be used to compare with actual results to see if departments/the business has performed as well as expected. Some businesses may link promotion and pay rises to achievement of the budget.
As you can see from these listed uses, budgets are largely used for control purposes. I have addressed some of these control issues in last month’s post on ‘Behavioural Aspects of Control‘.
The Budgeting Process
Before creating a budget, there are a couple of preparatory steps that need to be taken into account. Firstly, a budget committee should be set up, which should be made up of various managers from all levels and operatives from different departments – this ensures all areas of the business are represented. And lastly, responsibility should be allocated by assigning jobs to people and budgets to be prepared.
- Identify objectives
- Identify relevant strategies which might contribute to achieving objectives
- Evaluate these strategies
- Choose the final course of action
- Implement the long-term plan
The budgeting process fits into the whole controlling process as follows;
Criticisms of Traditional Budgeting
Traditional budgets encourage rigid planning and incremental thinking i.e. “Now that we’ve got a plan, we won’t make any change. Let’s keep it the same and just increase the figures every year.”
Complacency can be a disease that infects businesses with too stringent a budgeting system, as it can stifle product and strategy innovation. This disease can grow and become an all encompassing factor that the business can no longer control as focus turns solely to sales targets rather than innovation or consumer satisfaction. In this sense, budgets can in fact lead to unethical behaviour by managers, for example building up slack. It is therefore extremely important to review not only the budget on a regular basis, but also the process in its entirety – looking at performance measures, targets and objectives.
There are a number of different budget functions that can be drawn up, including sales, production, materials, labour etc. However, cash is probably the most important function budget as the firm cannot afford to run out of cash. If the budget identifies a future cash shortage, arrangements must be made in advance to acquire the necessary funds. If the cash budget identifies a future cash surplus, it makes sense to decide how to invest it or return it to the shareholders. Cash is not the same as profit, as the latter is calculated using the matching concept and thus includes non-cash items such as credit purchases and sales, and depreciation of fixed assets. These must be deducted from the equation and the cash budget prepared strictly on a receipts and payments basis.
Cash Budget Example (Sole Ltd.)
Sole Ltd. manufacture and sell shoes. They have the following predicted figures for the next 5 months;
Half of the sales are cash and the remainder on credit. Of the credit sales, three quarters are expected to pay the month following the sale and the remainder two months after the sale. Variable costs are paid in the month they occur and fixed costs are £4,000 per month. In February, interest of £600 is due and in March there is planned capital expenditure of £46,000. At the start of January, the bank balance is £4,000.
Question || Produce a cash budget for January, February and March showing clearly the balance at the end of each month.
Alternative Budgeting Systems
Fixed and Flexed Budgets
Fixed budgets are those which are set at the beginning of the budgeting period and do not change. There are a number of styles of fixed budgets, and methods of arriving at the final budget, for example ‘Top-down’ and ‘Bottom-up’.
Flexed budgets recognise that there are different cost behaviour patterns and thus allow for changes as production volume changes. Contingency budgets can be prepared if plans are likely to change and the budget can be controlled by flexing it when the actual output is known – this makes figures and costs more reliable and certain. For flexed budgets in particular, it is important that cost behaviour is understood in relation to output (regression, learning curve, forecasting etc.), as this may significantly affect costs and other financial decisions.
Incremental budgeting is simply increasing prices and costs on a budget from one period to the next, with no significant changes to the budget. These marginal increments in prices and costs are most likely reflections of inflation. The basic process is;
- Use last years budget as a starting point
- Allow for any changes in the budget
- Add a percentage increase or decrease to reflect changes in prices and costs
The problem with this method of budgeting is that it builds budgetary slack (providing a cushion in the budget in order to avoid an unfavourable variance at the end of the budgeting year). This may be achieved by spending up to the budget to get the same amount the following year, by spending money on discretionary and unnecessary items etc. Although budgetary slack makes the budget easier to attain and allows managers to plan for uncertainty, it creates bad habits.
Rolling (Continuous) Budgets
Managers may need to re-budget due to changes such as; organisational structure change, competition, technology, environment, activity level, inflation etc. Rolling budgets can deal with these changes by constantly being updated. The budget is reviewed periodically (this ‘period’ varies in length depending on how frequently the budget is reviewed) and changes are made to reflect the current conditions. This means that this method of budgeting provides more up-to-date and realistic information, thus any feedback during the reporting and analysis process is much more meaningful.
This is essentially the same as ‘bottom-up’ budgeting – the department/business starts with a budget of £0 and works its way up to a spending limit. There is a three-step technique adopted in carrying out this budgeting method;
- Define the decision packages (in blue)
- Rank the decision packages using cost/benefit analysis (starting with 1 as most important)
- Allocate resources accordingly
This type of budget allows us to see, if the spending limit was to be cut, which decision package should be dropped, or which decision package to take on if the spending limit is increased. It is usually only practical to review the activities every 3 or 4 years, or if new activities are introduced. There are many advantages to using this type of budgeting system, for example; it creates an environment where change is accepted, helps to focus on the company’s objectives and goals, identifies inefficient and obsolete operations, shows where money could be spent if they have additional funds, and others. However, defining decision packages and ranking them takes more time than other methods e.g. incremental, and therefore it may be considered a more disruptive method (although it may only be disruptive every few years).
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