32. Budgeting

Question 1

Budgeting
* Benefits

Answer 1

1. Planning: The budgetary process makes managers consider future plans carefully so that realistic targets can be set. With a clear sales budget, for example, departments in the business will know how much to produce or how much to spend on sales promotion.

2. Allocating resources: Budgets can be an effective way of making sure that the business does not spend more resources than it has access to. Without a detailed and coordinated set of plans for allocating the business’s money and resources, who would decide ‘who gets what’?

3. Setting targets: Most people work better if they have a realistic target to aim for. This motivation will be greater if the budget holder or profit centre manager has been delegated some accountability for setting and reaching budget levels.

4. Coordination: Discussion about the allocation of resources to different departments and divisions requires coordination between these departments. Once budgets have been set, people will have to work effectively together if targets are to be achieved.

5. 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. Many factors might have changed since the budget was set. Managers cannot assume that the budget target will be achieved without careful control and monitoring.

6. 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.

Question 2

Budgeting
* Limitations

Answer 2

1. 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.

2. 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. For example, cutting the size of the workforce to stay within the labour budget may restrict the ability of the business to increase output if sales rise quickly in the future.

3. 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. If a large surplus exists at the end of the budget period, how could managers justify the same level of resources next year?

4. 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.

5. 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.

Question 3

Key features of effective budgeting

Answer 3

1. 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.
2. 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.
3. Coordination between departments when establishing budgets is essential. This should avoid departments making conflicting plans.
4. 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 thedepartment concerned to achieve the targets but also leads to the establishment of more realistic targets. This approach to budgeting is called delegated budgets.
5. 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.

Question 4

Incremental budgeting

Answer 4

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.

Question 5

Zero budgeting

Answer 5

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 budgetholding 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.

Question 6

Flexible budgeting

Answer 6

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.

Flexible budgets are more motivating for budget-holding managers as they will not be criticised for adverse variances, which might occur just because output was lower than budgeted. The flexible targets are more realistic. Also, flexible budgets make it easier to produce valid and accurate variance analyses as they indicate changes in efficiency, not changes in output.

Question 7

Variance analysis uses

Answer 7

1. Variances measure differences from the planned performance of each department over a given
   period. Measuring performance is a key benefit of budgets.
2. Finding out the reasons for variances can help set more realistic budgets in the future.
3. Finding out the reasons for variances can help the business take better decisions. For example, if the
   revenue variance for a business was negative because of lower sales caused by an economic
   recession, then reducing prices might be the right decision to make.
4. The performance of each individual cost centre and profit centre may be appraised in an accurate and
   objective way.

Question 8

Possible causes of adverse variances

Answer 8

• Revenue is below budget because either fewer units were sold or the selling price had to be lowered due to competition.
• Actual raw material costs are higher than planned because either output was higher than budgeted or the cost per unit of materials increased.
• Labour costs are above budget because either wage rates were raised due to shortages of workers or the labour time taken to complete the work was longer than expected.
• Overhead costs are higher than budgeted, perhaps because the annual rent rise was above the forecast.