A Budget is a plan expressed in financial terms.
C.I.M.A. defines a budget as ‘A plan quantified in monetary terms, prepared prior to a defined period of time... to attain a given objective’, A budget is normally for a relatively short period, e.g. 1 year.
Purposes of Budgeting
A number of purposes of budgeting have been identified. They include:
This is a system which uses budgets as a means of controlling the activities of the organisation. It has three main aspects:-
Budgetary planning is the
process of preparing detailed, short-term plans for all the functions,
departments and activities of the organisation. It is important that the
short-term plans and objectives that make up the budget are related to the
long-term plan and objectives of the organisation. The budget may be drawn up
by preparing an overall budget for the organisation which is then broken down
into more detailed budgets for the different parts of the organisation [the top-down
approach] or by devising budgets for the various parts of the
organisation and then bringing them together to build up the overall budget
[the bottom up approach].
Extrapolations, Forecasts and Plans
In discussing budgetary planning it is important to distinguish between extrapolations, forecasts and plans.
An extrapolation is the continued projection of an existing trend.
A forecast will be based on an extrapolation, but is adjusted to take account of any known factors which will affect the trend.
A plan involves some intervention by the organisation in order to modify events in such a way as to make it more likely that the organisation’s objectives will be achieved.
It is vital that the plans of each department are related to each other and are integrated together to make a coherent whole e.g. it is no use planning for sales of 150,000 units if productive capacity is restricted to 120,000 units. Note the significance in this context of limiting factors and the principal budget factor.
The principal budget factor is the factor which acts as an over-riding limitation on the activities of the organisation. It might be sales, productive capacity, finance, shortages of materials, labour or energy. The principal budget factor can change over time. Identifying limiting factors is a key element in the co-ordination aspect of budgetary control.
The Master Budget
This is the overall plan for the business’s financial activities, to which, therefore, its
sectional plans must be related. For commercial organisations it will be normally in the form of a planned Income Statement, Balance Sheet and Cash Flow Statement.
The master budget is the key element in budget co-ordination as it summarises all the other plans and reveals any inconsistencies amongst them.
As far as possible, actual Activity should be in line with the original plan and steps should be taken to restore Activity to the plan when there are deviations from it [although on occasions it will be necessary to adjust the plan to meet changing circumstances].
Control is exercised in organisations by the continual feedback of information to facilitate such corrective action.
Variations from plan are revealed by measuring actual performances and comparing it to planned performance. These variations [known as variances] are analysed in more detail and reported to managers for action. NB taking action on variances is the key part of the control mechanism. It is important therefore, that information [in the form of budgetary reports] is timely, relevant and comprehensible.
We shall discuss the control aspects of budgeting in more detail in the next session.
We can sum up the purposes of budgeting as follows:
It has been claimed that the operation of a budgetary control system within an organisation can be valuable in a number of different respects. These include:-
The budget is a useful way of setting out in detail the planned activities of the organisation for the coming period and relating them to the objectives of the organisation.
The budget can be an instrument by which a fair and efficient allocation of resources may be achieved. Without a coherent budget; resources may be allocated indiscriminately with consequent detrimental effects on the organisation as a whole.
A carefully prepared budget should help to co-ordinate the organisation’s activities and resources. For example, production must be co-ordinated with sales; purchases of materials and labour with production; and stocks of materials with production requirements, storage facilities and the cash available.
The budget is vital in comparing actual performance to planned performance and enabling corrective action to be taken when deviations occur.
Budgets have an important part to play in the communication of objectives, targets and responsibilities throughout the organisation. Carried out properly, this can have considerable benefits in promoting co-operation at all levels.
By setting challenging but realistic targets well designed budgets can play a significant part in motivating managers. The targets must be clear and achievable, and the manager should participate in setting his or her own budget.
The budget gives senior management a means of judging the performance of their teams. It must be remembered, however, that adherence to the budget alone cannot measure all aspects of a manager’s performance.
In order to carry out budgetary
control, it is necessary to formulate a fully co-ordinated detailed plan
in both financial and quantitative terms for a forthcoming period. The duration
of the period is usually one year. The plan needs to be in line with the long
term development strategy of the organisation, although in the shorter term of
a budget year, conditions may prevail which could dilute this aim. For example
a depressed economy could lead to a temporary departure from the long term
plans. Therefore, before formulating the budgets, the policy to be pursued
during the forthcoming trading period needs to be established.
Once budgets are operating
throughout an organisation, it is important that feedback is made available to
the managers responsible for its operation. This is often done by means of
monthly budget reports. These reports contain comparisons between the budget
and the actual position and throw up differences which are known technically as
There are two major aspects to
budgetary control; planning and control. [We will focus on Control
in the next session].
Planning - The budget is a
corporate plan that sets out in detail the financial and/or quantitative
objectives of every department and Activity within the organisation, and
reconciles them in an overall plan. The plan needs to be internally consistent.
In drawing up the plan one of the
first actions needed is to identify the Limiting Factor. As the
name implies this is the factor which will limit the size and scope of the
company’s operations. In order to produce an internally consistent plan, the
budget will need to be built around and reconciled to the limiting factor.
Before proceeding further into the
area of planning, a distinction needs to be drawn between a budget and a
forecast. One of the prime reasons for formulating budgets is to try to
attain future objectives by means of a co-ordinated detailed plan. In other
words budgets are drawn up with a view to influencing the course of future
events. On the other hand, a forecast is simply a prediction of future events
assuming that present trends will continue, or that they will be modified by
There are several benefits that can
accrue from careful detailed planning.
The Budget Period - This is
the period of time for which a Budget is employed. The period varies depending
on the type of Budget.
Examples: (a) Trading Budget [say] 1 year.
It should be borne in mind, that if
a Budget is for more than one year, that the chances of it being modified are
Although the overall Budget may be for a year or more, it is always broken down into shorter periods. Budget periods in excess of one year would be broken down into annual amounts, and the annual amounts would be further sub-divided into monthly accounting periods. Budgets which are compiled for the duration of one year, would similarly be broken down into accounting periods.
Having arrived at the amounts for each period, the actual expenditure incurred during a period can be compared with the appropriate Budget and Variances extracted.
Types of Budget -
There are two basic types of Budget:
Examples: (a) Sales Budget
a. Manpower Budgets
a. Revenue Expenditure Budgets
d. Short Term Cash Budgets
These budgets are inter-related. (See Chart on PXX)
Designing and Operating a
Budgetary Control System
The procedures will vary from one
organisation to another, but a general pattern can be established as follows:-
NB It will take a number of attempts before the budget is finalised. Thus budgeting is a reiterative process.
Costs are best controlled at the
point at which they occur. Suitable areas of control must be selected and they
should not be too large. Examples might be workshops in a factory and wards in
a hospital. The areas selected should comply with the responsibilities
of supervisors and managers. These areas are known as budget centres
[or cost centres] and the budgets are attached to them as departmental
budgets. It will also be necessary to have budgets prepared to summarise
the performance and costs for each function. The departmental budgets are then
integral parts of the functional budgets.
The Master Budget is the overall plan which summarises and is derived from the functional budgets. It integrates the supporting budgets and is the corner-stone of the co-ordinating process.
The budgetary control process places great emphasis on the location of responsibilities within the organisation. The recognition that performances can be traced to managers, supervisors and workers is an integral part of budgetary control therefore, to distinguish clearly between controllable and uncontrollable costs. Controllable costs are those which can be traced to a particular person or group of persons. It would be unfair to hold a manager responsible for costs which are outside his or her control.
Responsibility accounting enables management by exception to be practised, i.e. managers are given information only on matters not going to plan.
Fixed and Flexible
A fixed budget is ‘a budget which is designed to remain unchanged irrespective of the volume of output or turnover attained’. CIMA Terminology. It is of limited value, therefore, for control purposes. A flexible budget is one which is designed to adjust the budgeted cost levels to match the level of Activity actually achieved. It thus recognises the difference between fixed and variable costs in relation to output and is designed to change appropriately.
Budgets need to be formulated along
the lines of executive responsibility. The organisation requires to be
sub-divided into its major constituent parts as represented by the senior
management functions, or example - Production - Marketing - Distribution -
Personnel - Finance and Administration. These major areas need to be further
sub-divided into their constituent parts, again along the lines of management
responsibility, and this sub-dividing will continue through each descending
tier of management. Care needs to be taken to ensure that the fulfilment of
every part of the budget is the direct responsibility of a designated manager,
and that dual or overlapping responsibility for an operation is avoided.
Then control is applied in two
The use of variances enables a
manager to adopt the technique of management by exception, concentrating
his efforts on the parts of the plan that are going wrong and thus using
valuable time efficiently.
The basis of control is the circulation of management
information. The problem is, accountants can produce the information but they
cannot make managers use it. Therefore, a very relevant question is, what
factors can encourage managers to use the information supplied?
There are several factors, besides
the relevance of the information that determines whether or not management
information is used by managers.
The information needs to be
presented with clarity. It needs to be readily understandable, it needs to
point to the need for action, and it should highlight significant changes. It
should be in sufficient detail to enable managers to make use of it, but
excessive detail needs to be avoided.
Managers are more likely to use
management information if it is presented with timeliness. Information, to be
of value, needs to be presented as soon after the event as practicable. This
has the double effect of relating to events which are still fresh in the
manager’s mind, and giving an opportunity to take corrective action on adverse
trends as soon as possible.
Levels of Attainment
The levels of expected performance
which are set influence the motivation of managers responsible
for target achievement.
If levels are set too high, then
there is a strong disincentive to management involvement in the budgetary process,
and a low level of motivation.
It levels are set too low, then
managers can achieve targets easily despite inefficiencies. This is known as budgetary
Setting appropriate levels of
attainment in budgets is a complex and difficult Activity with an important
Conflicting Purposes of
As we saw in the last session,
budgeting may serve a number of different purposes. There is a danger,
therefore, that using the same budget for the various purposes may be
For example, a budget may be used
for planning [as a forecast], for motivating [as a target]
and for evaluating performance [as a yardstick].
A forecast needs to be realistic
but a target needs to be demanding. A target should be challenging
but a yardstick must be fair. A forecast, while it should be plausible,
will be prepared in advance of the period, but a yardstick should be based on
the most up to date information as to what is achievable.
Thus it has been suggested there
should be two budgets:
The question then arises which
budget would be used for performance evaluation? Budget holders would argue
understandable for the first, but then would the second retain its power to
Benefits and Limitations of
Budgeting is a form of planning and
control system found in most organisations of any size, in both the public and
the private sectors. There are benefits to be gained from the process, but they
do not come automatically. It is important, therefore, to be aware of the
problems which may be encountered and to re-appraise the system constantly.
Benefits of Budgeting
Limitations of Budgeting
.1. The budget system may cause
antagonism and poor motivation [due to undue pressure, poor human relations
Conditions for Successful