Types and purposes of budgets
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How are budgets set?
Budgets need to be realistic, agreed, co-ordinated, challenging and flexible. These may have to be negotiated as there is a natural tendency to inflate budgets, so as to make it easier to be met.
Budgets are set by reference to:
- Historical data - what has happened in the past, previous experience and knowledge of previous trends.
- Organisational aims and objectives - the budgets will need to complement the aims of the business. If expansion is planned, budgets will need to reflect this. The aims and objectives need to be expressed in terms of sales revenue, market share and ultimately profits.
- Available finance - budgets must be realistic as firms cannot spend more than the funds available.
- Benchmarking - a firm may set budgets that reflect industry best practice and in line with similar sized organisations. Procter and Gamble and Unilever are among the world's largest advertisers and major competitors. No doubt an increase in the marketing budget by one of these two will be quickly matched by the other.
- Negotiation and discussion - budgets should be set though concensus not by imposition. A manager will only feel responsible if there is agreement when it is set.
Benefits and Limitations of budgeting
Budgets have features which enhance performance and efficiency and help improve financial control. Budgets:
- Control and monitor costs and link costs to revenues
- Make individuals responsible for their performance
- Provide data for rewarding individuals
- Motivate individuals by setting challenging, but achievable targets
- Improve communication within, and between, departments
- Force managers to consider the direction of the business and the role of departments in the process of reaching organisational aims and objectives.
However, budgeting does not always produce positive results:
- Budgeting is not an exact tool since they are built on forecasts of revenues and costs. If an inaccurate budget is set, it may be very demoralising for the budget holder who may be held responsible.
- Powerful departments and individuals may be able to set higher budgets than necessary as a way of demonstrating their status.
- Budgets may encourage short-termism to meet unrealistic targets and promote a focus on financial targets at the expense of less tangible, but important factors such as brand building, teambuilding, effective leadership and customer satisfaction.
- Unless budgets are allowed to roll over to the next financial year, managers may be encouraged to spend unnecessarily near the end of the financial year, before the money is taken away.
- Budgets may be set by adding on an increment to the previous year's budget rather in relation to actual need. This is called historical budgeting.
- The process of setting budgets and updating them takes considerable time and can be expensive. It is unlikely that smaller firms or sole traders will be willing to spend money on extensive market research - making predictions less accurate.
- Senior managers will often try to control the level of spending by different departments by insisting on 'efficiency gains'. This means that departmental managers have the amount allocated to them reduced by a small percentage each year to encourage productivity increases. This may be resented by staff, who see this as unfair.
- The budgeting process may limit co-operation between departments as they fight to increase their own budgets to protect self interest, even if this is at the expense of other departments and the overall success of the business.
- The procedure of setting an annual budget may not be suitable when markets and external environments are changing rapidly.
Although planning for the future is highly desirable, critics of budgeting argue that it can be an inflexible and inappropriate tool. As a result alternative forms have developed. Two of these are:
- Flexible budgeting
- Zero-based budgeting
Flexible or flexed budgeting allows budgeted targets for revenues and costs to alter as circumstances change. For example the external environment can change rapidly and this should be reflected in the budget process. Recessions may cause sales revenue to fall below target and this should be reflected in lower expenditure as less output is required. When budgets are prepared they may include targeted expenditure at different levels of sales, e.g. 95%, 90%, 85% of forecasted sales levels.
Although this allows the business to respond to changing conditions, the changes may loosen the link between budgets and company objectives.
The financial information used in most budgets is based on historical data. A department holder is likely to look at last year's planned and actual expenditure as a starting point in preparing the current year's budget. Additional sums may be included to cover increased costs and inflation. However, some expenditure may be difficult to quantify, especially if there are no previous examples. Here Zero-based Budgeting (ZBB) is employed.
The budget holder starts with nothing and is required to justify every $1 of expenditure. Nothing is included in a budget unless the person responsible for it can demonstrate why funds are required, what benefits the expenditure will bring and how it will help the organisation achieve its objectives. This prevents spending just because it has always been spent. It can be a long and costly process to set up budgets this way.
- Nothing is taken for granted. Every cost has to be justified.
- Previous budgets do not influence the present one
- Efficiency should be improved as a result of the questioning procedure and resource allocation should be improved
- Staff motivation should be improved, if the process is part of a suitable corporate culture.
- Managers are forced to evaluate expenditure on a regular basis
- It encourages the examination of possibly cheaper alternatives
- May be very time consuming to collect all the relevant data
- Managers may be demotivated by constantly fighting for funds
- Managers may not be prepared to support each and every item
- Managers may not spend in areas that would, in fact, benefit the business
- Decisions may be more political and influenced by subjective opinions.