3.9 Budgeting

Introduction

• Budget: detailed financial plan for the future.

Benefits of setting budgets

• Planning - the budgetary process makes managers consider future plans carefully, so

  that realistic targets can be set.

• Effective allocation of 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 to be achieved - most people work better if they have a realizable target at which to aim. This motivation will be greater if the budget holder or the cost-centre manager and profit-centre manager has been given some delegated accountability for setting and reaching budget levels.

• Coordination - discussion about the allocation of resources Co different departments

  and divisions requires coordination between these departments. Once budgets have been agreed, people will have to work effectively together if targets set are to be achieved.

• Monitoring and controlling - plans cannot be ignored once in place. There is a need to check regularly that the objective is still within reach. All kinds of conditions may change and businesses cannot afford to assume that everything is fine.

• Modifying - if there is evidence to suggest that the objective cannot be reached and

  that the budget is unrealistic, then either the plan or the way of working towards it must be changed.

• Assessing performance - once the budgeted period has ended, variance analysis will

  be used to compare actual performance with the original budgets.

Key features of budgeting

• Delegated budgets: control over budgets is given to less senior management.

Preparation of budgets

• Stages in setting budgets

  1. The most important organizational objectives for the coming year are established
  2. The key or limiting factor that is most likely to influence the growth or success of the organization must be identified
  3. The sales budget is prepared after discussion with sales managers in all branches and divisions of the business.
  4. Subsidiary budgets are prepared, which will now be based on the plans contained in the sales budget.
  5. These budgets are coordinated to ensure consistency. This may be undertaken by budgetary committee with special responsibility for ensuring that budgets do not conflict with each other and that the spending level planned does not exceed the resources of the business.
  6. A master budget is prepared that contains the main details of all other budgets and concludes with a budgeted profit and loss account and balance sheet.
  7. The master budget is then presented to the board of directors for its approval.

• Setting budget levels

  • Incremental budgeting: uses last year’s budget as a basis and an adjustment is made for the coming year.
  • Zero budgeting: setting budgets to zero each year and budget holders have to argue their case to receive any finance.

Potential limitations of budgets

• Lack of flexibility

• Too focused on the short term

• Lead to unnecessary spending

• Training needs must be met

• Revised budgets may need to be set for new projects

• Cost centre: section of a business, such as a department, to which costs can be allocated or charged.

• Profit centre: section of a business to which both costs and revenues can be allocated.

Budgetary control - variance analysis

• Variance analysis: process of investigating any differences between budgeted figures and actual figures.
  • Favorable variance exists when the difference between the budgeted and actual figures leads to a higher than expected profit.
  • Adverse variance exists when the difference between the budgeted and actual figures leads to a lower than expected profit.