Budgets and Budgeting

What is a budget?

  • A financial plan for the future concerning the revenues, costs and profits of a business

Budgeting is a process:

  • The process by which financial control is exercised in a business

  • Budgets for revenues, costs and profit are prepared in advance and then compared with actual performance to establish any variances

  • Managers are responsible for controllable costs within their budgets

  • Managers take action if adverse variances are regarded as excessive

Many uses of budgets in business:

  • Establish priorities and set targets

  • Turn objectives into practical reality

  • Provide direction and coordination

  • Assign responsibilities

  • Allocate resources

  • Communicate targets

  • Delegate without loss of control

  • Motivate staff

  • Forecast outcomes

  • Monitor performance

  • Control income and expenditure

Three main types of budget:

  • Revenue (or income) budget:

    • Expected revenues

    • Broken down into more detail (products, locations)

  • Cost (or expenditure) budget:

    • Expected variable costs based on sales budget

    • Expected fixed costs

  • Profit budget:

    • Based on the combined sales and cost budgets

    • May form the basis for performance bonuses

How a profit budget is constructed:

  1. Analyse market:

    • Market size and growth

    • Market share

    • Market prospects

  2. Draw up revenue budget:

    • Sales forecast

    • New products

    • Pricing changes

  3. Draw up a cost budget:

    • Based on the sales budget

    • Allow for known changes in supplier prices

    • Include contingensies

Potential drawbacks of budgets and budgeting:

  • Sales forecasting:

    • Harder when the market experiences rapid changes (e.g. new technology)

    • Startup firms find it hard to estimate likely sales and revenues

    • Competitor actions are difficult to predict

  • Costs:

    • Always likely to be expected costs

    • Will vary depending on the sales budget

    • Changes in the external environment will impact costs (e.g. taxes, exchange rates)

Problems and limitations of budgets:

  • Are only as good as the data being used

  • This can lead to inflexibility in decision-making

  • Need to be changed as circumstances change

  • Take time to complete and manage

  • This can result in short-term decisions to keep within the budget