Budgeting (A level BS)
From WikiTextbook
Businesses use budgets to plan their short-term expenditures and revenues. A budget is a plan and not a forecast; a forecast tries to predict what might happen in the future, whilst a budget is a plan of what the business hopes to achieve in the future. Budgets will contain the expenditure targets drawn up by separate departments/functional areas and by the business as a whole. The budget will usually cover a one year time period, but it could cover a month or several years. The preparation and use of a budget can help a business to plan its expenditure and check on its performance.
The most famous budget is probably the national Budget that the Chancellor of the Exchequer gives every year. This Budget sets out the spending plans of the Government and how it plans to finance that spending through the use of taxes.
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Setting the budget
First the business will predict how much revenue it will receive in the following year. Then it will decide how much of that revenue it is willing to spend, this is the cost budget for the whole business. Next the overall budget is broken down so that each functional area has its own budget for the following year. It is possible to break the budget for each functional area down even further, for example, within marketing and sales function the budget would be divided so that the marketing manager of each product would have his or her own budget.
Methods of setting budgets
There are a number of different ways that a business can decide upon the size of a budget:
Incremental budgeting
Most businesses will base next year’s budgets on last year’s. They may increase them to allow for increases in price (inflation) or other expected events. Setting the budget in this way is fairly quick as managers simply look at last year’s budget and then make minor changes. A problem of this method of budgeting is that managers may feel that they have to spend their entire budget otherwise they will be given a smaller budget in future years. This will have the effect of increasing the total costs of the business.
Zero budgeting
This method assumes that each budget is zero unless the managers can justify the money they are asking for. Zero budgeting has been introduced by many businesses in the hope of preventing managers just asking for a bit more than last year, even if they don’t need it. This can lower the costs of the business which may lead to higher profits or free up money for expansion. Despite this benefit managers can find themselves spending a significant amount of time producing the budget, when they could be doing something more productive.
Sales related budgeting
A department will be given a budget that is in proportion to its sales, i.e. the higher the sales, the larger the budget will be.
What is the purpose of the budget?
The main purpose of a budget is to ensure that the business or an individual functional area doesn’t spend more money than it can afford. Managers who overspend their budget can expect to have to explain their actions to their boss!
The budget is a good method of controlling spending by workers, as individuals would need to ask permission from the budget holder before spending the business’s money. This should help to prevent excessive spending on unnecessary items and fraudulent purchases by unauthorised personnel.
Many managers will be motivated if they feel they are being given the responsibility to control their own budget. They will try and impress their superiors by using the budget wisely.
A simple budget
An example of a simple budget for Steve’s Record Shop is shown below:
Revenue Cost Sales £120,000 Records £60,000 Wages £24,000 Rent £20,000 Advertising £1,000 Utilities £2,000 Other costs £3,000 TOTAL REVENUE £120,000 TOTAL COSTS £110,000
This shows that Steve’s Record Shop plans to receive £120,000 in revenue, spend £110,000 in costs and therefore make £10,000 profit next year. The profit is the difference between the revenues and the costs.
Variance analysis
A variance is the difference between the budgeted figure and the actual figure. Variances can either be favourable or adverse. A favourable variance is one that leads to higher profits, for example, lower costs or higher revenues. An adverse variance is one that leads to lower profits, for example, higher costs or lower revenues. Variances can provide a warning of slipping revenues or rising costs. This should then allow management to implement a new strategy to offset the variance.
The table below shows the budgeted figures and actual figures for Steve’s Record Shop:
Budget Actual Variance Sales £120,000 £130,000 £10,000 Favourable Records £60,000 £65,000 £5,000 Adverse Wages £24,000 £24,000 £0 Rent £20,000 £22,000 £2,000 Adverse Advertising £1,000 £3,000 £2,000 Adverse Utilities £2,000 £1,500 £500 Favourable Other costs £3,000 £1,500 £1,500 Favourable
These figures show that the actual profit of £13,000 is above the budget profit figure of £10,000.
Overview
The way that budgets are used can tell you a lot about the firm’s culture. Firms with a strict autocratic culture will tend to use a tightly controlled budgetary system. Organisations with a more open culture will use budgeting as an aid to discussion and empowerment. Whatever the culture, the manager has the responsibility to meet the budgetary requirements.
There are a number of advantages of budgeting:
- Help to control income and expenditure, helping to draw attention to waste, losses and inefficiency.
- They can emphasise and clarify responsibilities.
- Enable delegation though the organisational structure, as subordinates have clear budget targets.
However there are some disadvantages:
- If the budget is too rigid then the business may suffer as it won’t be able to react to internal and external changes.
- If the actual business results are very different to the budgeted ones then the budget can lose its importance.
