Chapter 5.

32 – Budgets

32.1 The meaning and purpose of budgets

Financial planning for the future is important for all businesses. If no plans are made, a business will:
• be without a direction or purpose
• be unable to allocate the scarce resources of the business effectively
• have demotivated employees with no plans or targets to work towards
• be unable to measure its progress by measuring the plans against actual performance.
Planning for the future must take into account the financial needs and likely consequences of these plans. This is the
budgeting process: setting and agreeing financial targets for each section of a business. Budgets should be set for sales,
revenue and costs. It is usual for each cost centre and profit centre to have budgets set for the next 12 months, broken
down on a month-by-month basis.

The measurement of performance

All business managers should consider how they might measure the performance of their business. Knowing how the
different departments and divisions of a business are performing helps managers assess the strengths and weaknesses
of the organisation. Management action can then be taken to build upon strengths and correct the weaknesses.
Assessing actual performance against pre-set targets is the best way of measuring the performance, over time, of each
section of a business.
Non-financial targets can be established as well as financial ones. Non-financial targets might include those for customer
loyalty, customer service levels and labour productivity. In order to review the financial performance of a business,
financial targets will need to be set (for example revenue, costs and profit). These targets are called the budgets of the
business and they should be established for all divisions and sections of a business. Measuring financial performance is
one of the benefits of budgeting.

Benefits of using budgets

• Planning: The budgetary process makes managers consider future plans carefully so that realistic targets can be set.
• Allocating resources: Budgets can be an effective way of making sure that the business does not spend more
resources than it has access to.
• Setting targets: Most people work better if they have a realistic target to aim for.
• Coordination: Discussion about the allocation of resources to different departments and divisions requires
coordination between these departments.
• Controlling and monitoring a business: Plans cannot be ignored once they have been set and agreed with the budget
holder. Checks must be undertaken regularly to control and monitor the performance of the budget holder and their
department.
• Measuring and assessing performance: Once the budgeted period ends, variance analysis is used to compare actual
performance with the original budgets. This is an important way of assessing managers’ performance. It would not be
possible to assess how well individual departments had performed without a clear series of targets to compare actual
performance with.

Potential drawbacks of using budgets

• Lack of flexibility: If budgets are set with no flexibility built into them, then sudden and unexpected changes in the
external environment can make them very unrealistic. Unrealistic budgets will demotivate the budget holder and other
employees.
• Focus on the short term: Budgets tend to be set for the relatively short term, for example, the next 12 months.
Managers may take a short-term decision to stay within budget that may not be in the best long-term interests of the
business.
• Unnecessary spending: If managers have underspent their budgets just before the end of the budgeting period, they
might make decisions to spend unnecessarily so that the same level of budget can be justified next year.
• Training on budgets: Setting and keeping to budgets is not easy and all managers with delegated responsibility for
budgets will need extensive training in this role.
• Budgets for new projects: Setting budgets for big new projects is very difficult and often inaccurate. This is
particularly true if similar projects – like a super-fast train line – have not been undertaken before.

Key features of effective budgeting

• A budget is not a forecast but a plan that businesses aim to fulfil. A forecast is a prediction of what could occur in
the future given certain conditions.
• Budgets may be established for any part of an organisation as long as the outcome of its operation is measurable.
This means most cost centres and profit centres will have budgets set, including budgets for sales, capital expenditure,
labour costs and profit.
• Coordination between departments when establishing budgets is essential. This should avoid departments making
conflicting plans.
• Budget setting should involve participation. Decisions regarding budgets should be made with the managers who
will be responsible for meeting the targets. Those who are responsible for fulfilling a budget should be involved in
setting it. This sense of ‘ownership’ not only helps to motivate the department concerned to achieve the targets but also
leads to the establishment of more realistic targets. This approach to budgeting is called delegated budgets.
• Budgets are used to review the performance of each manager controlling a cost or profit centre. The managers will
be appraised on their effectiveness in reaching targets. Successful and unsuccessful managers can therefore be identified.

Setting and using budgets

1. Incremental budgeting
This method takes last year’s budget and makes changes for this year based on last year’s budget. The revised budget
might be raised or lowered, depending on market conditions. Cost budgets will be adjusted for forecasted inflation and
expected changes in output. Incremental budgeting does not allow for unforeseen events. Using last year’s figure as a
basis means that each department does not have to justify its whole budget for the coming year – only the change or
increment. There is no fundamental appraisal of each department’s targets or need for resources.
2. Zero budgeting
The zero budgeting approach requires all departments and budget holders to justify their whole budget each year. This
is time-consuming, as a fundamental review of the work and importance of each budget- holding section is needed each
year. However, it does provide added incentive for managers to defend the work of their own section. Also, changing
situations, such as the external environment, can be reflected in very different budget levels each year.
3. Flexible budgeting
Most budgets are fixed for the time period under review. This means that they are based on the assumption that the level
of output remains at the predicted or budgeted level. If actual output falls or rises above this level, then this could lead
to obvious variances from the fixed budgets. However, these variances do not necessarily indicate real efficiency
problems.

This shows a favourable variance of $2 000 because direct materials are lower than budgeted. Lower costs should
increase profit. However, this ignores the fact that output is 20% below budget. This lower output should lead to lower
material use anyway. A more realistic direct materials budget would adjust for the lower output figure. This is called
flexible budgeting, which sets new budgets depending on the actual output level achieved.

Table 32.2 shows a new flexible budget for direct materials based on the lower output level. The actual level of direct
materials now gives an adverse variance of $2 000. This shows that materials seem to be used less efficiently or are
costing more per unit than originally budgeted

32.2 Variance analysis

A variance is the difference between a budget and the actual figures achieved at the end of the budget period. It is
important to calculate and analyse the reasons for these variances because:
• Variances measure differences from the planned performance of each department over a given period. Measuring
performance is a key benefit of budgets.
• Finding out the reasons for variances can help set more realistic budgets in the future.
• Finding out the reasons for variances can help the business take better decisions.
• The performance of each individual cost centre and profit centre may be appraised in an accurate and objective
way.
If the variance has had the effect of increasing profit above budget, then it is called a favourable variance. If the
variance has had the effect of reducing profit below budget, then it is called an unfavourable or adverse variance.

Managers may need to respond quickly to both adverse and favourable variances. Trying to find cheaper material
supplies or increasing labour productivity will help to reduce adverse variances in future. Favourable variances need
analysing too. They may reflect a poor and inaccurate budgeting process where cost budgets were set too high. A
favourable direct cost variance caused by output being much less than planned for is not a sign of success – why were
sales and output lower than planned for?

Variance analysis: example

The benefits to be gained from regular variance analysis include:

• Identifying potential problems early so that remedial action can be taken. Perhaps, in this case, a new competing
computer retailer has opened up and WIC will have to quickly introduce strategies to combat this competition.
• Allowing managers to concentrate their time and efforts on the major problem areas. This is known as
management by exception. In this case, it seems that managers should quickly investigate the likely causes of the
lower-than-expected sales figures.