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The Purpose of Business Budgets: An Overview

Person holding smartphone with the calculator app open

This is an exclusive extract from Accounting for Non-Accountants.

The system used to set budgets for an organization will depend on a number of factors, not least the size of the organization.

For a small business, the time taken in setting either an individual budget or a set of budgets may not be long, whereas for a large organization, perhaps located in many different areas, budget setting can be a very time-consuming and therefore very costly process. In order to justify the time spent on the construction of the budgets for an organization, the benefits gained must justify the costs incurred. These benefits would include the following.

Forecasting

For a business planning its level of production, we would expect that it will have needed to forecast how many units it expects to sell. This will require a sales forecast. Obviously, no forecast can be expected to be entirely accurate. However, the accuracy of the forecast will be crucial in ensuring that the correct level of budgeted activity is planned. Sales forecasts themselves will depend on a number of different factors – with many of these outside the control of the business.

The pricing policy of the firm will affect the sales forecast, as the level of sales usually varies inversely with the selling price. A firm can attempt to forecast the effect of a price change on the sales (in economics, this is referred to as a product’s ‘price elasticity of demand’). However, the effect of a change in price will also depend on action taken by competitors.

Factors outside the firm’s control will include the state of the economy; for example, if economic growth is expected to fall, then the level of sales will normally be expected to be adversely affected, though this is more complicated than it might seem. The demand for most goods varies positively with the rate of economic growth, with faster growth leading to greater levels of spending in an economy and a greater demand for goods and services. However, the demand for some goods shows very little variation with changes in economic growth, and some goods actually show a negative correlation – in other words, the demand for those goods (which are known in economics as ‘inferior’ goods – not a comment on their quality but just their relationship with changes in economic growth) will increase in periods of slow or negative economic growth.

Forecasts of the economic environment will therefore be important for predicting the level of sales for future periods. Obviously, the further away into the future, the less reliable the forecast. However, even over the short term economic forecasts can be unreliable, making a sales forecast vulnerable to being less valid.

Forecasting sales also involves second-guessing how consumers will respond to a particular good. Market research can shed some light on consumer motives. However, there is a danger that any attempt to forecast sales will be futile if consumer behaviour changes unexpectedly.

Seasonal factors will also impact on any forecast. The demand for most goods and services will vary over the course of a year. For retailers, there are peak sales periods depending on the type of goods produced. For the construction industry, the winter months are likely to lead to a significant decline in output. Bad weather conditions, which are almost impossible to forecast to any degree of accuracy other than seasonal variations, are also likely to affect the level of output.

In this section, we have looked at the difficulties of forecasting events. However, this should not detract from the central point that forecasting will be important in the setting of budgets. It should not matter that events and their implications cannot be forecast with 100% accuracy. The better the forecast, the better the budget. Firms with the necessary resources can make use of professional forecasts and reports. Smaller businesses will have to rely on forecasts gleaned from the media, and on extrapolation of existing trends.

Planning

Once a forecast has been made, the planning can begin. For example, a forecast may provide details on the level of expected sales. With this information, the managers of the business can begin to plan for this expected level of sales. The good or service being provided by the firm may have a long lead time in terms of production. The forecast will enable the firm to organize the purchase of materials in advance of production. Even if the firm provides a service rather than a physical product, the forecast will enable the firm to plan for the correct level of staffing in order to meet this level of expected sales.

Planning will mean that the business can look ahead to ensure it has the necessary resources for the expected level of future activity, thus giving managers the chance to anticipate problems in providing for the budgeted level of activity.

For example, if a firm has forecast a certain level of sales, financing may need to be arranged. If a business offers generous credit terms to its customers, it may be some time before the money generated by the sales is returned to the business. In the meantime, overdraft facilities or some other form of short-term finance may need to be arranged. Staff may need to be hired, which, depending on the level of specialist skills the staff need, could be time-consuming.

New facilities or new equipment may also be needed. All of these things require adequate timing. Obviously, the degree of confidence in the forecast will affect how far the managers of the business want to go in terms of planning for a level of activity.

For example, a forecast that predicts a high level of sales may necessitate a significant expansion of productive facilities. If confidence in the forecast is not particularly high, management may decide against providing for the expected sales level. Businesses may also plan for a range of different outcomes based on the expectations associated with a particular forecast.

Coordination

Without a system of budgeting, a manager may act in a manner that conflicts with the other areas of the business.

For example, the work of the sales department may generate a level of sales which lies beyond the current capacity of the production department. A coordinated budgetary system should help to ensure that actions taken by the different departments or functions within a business can take place with a more coherent, coordinated set of decisions.

The initial budget will usually be set by the higher management of the organization and they can make the decisions as to where the priorities lie. Often the sales level is decided as the key factor from which other budgets will flow. However, this is not necessarily the case; the capacity of an organization or the limit on the finance available may act as the limiting factor before other budgets can be determined.

Control

A comparison between the budgeted data and the actual data can be made by the managers of an organization. Variance analysis (this was covered in Chapter 10) can be used to compare unusual or unexpected variances – for example, where a department or area of the business may be consistently overspending.

The method used by a business in setting the budgets in the first place can provide a basis for controlling resources and costs within the business. For example, in some organizations, budgets are often set by comparison with previous budgets. This system of incremental budgeting is covered later, but can be seen as a way of controlling expenditure if the firm uses gradual reductions in budgeted total for expenditure over time.

Motivation

Budgets act as a target to be met by the department or area of the business to which the budget is assigned. For example, workers and managers might be motivated to work harder in order to achieve the set target of expenditure. If the level of expenditure allocated by the budget is seen as unduly tight (ie the cut in expenditure would be too difficult to achieve), the budget may actually act as a demotivator on those who are constrained in their activities by the budget. Likewise, if the budgeted total for expenditure is unduly lenient, it may not provide much of a challenge for those affected and this would not particularly motivate the workers within the organization to increase their efforts.

As a result, the budgeted totals need to provide a challenge for those responsible in that they need to set a level that can be achieved but which will provide a spur for workers to try harder than before in achieving the budgeted targets.