2.2.4 Budgets

Budget

Encourages businesses to spend up to the budget so it is maintained next year, decreases efficiency, increases costs, reduces profitability

🔑 Surplus = Income is larger than expenditure

🔑 Income budget = Plan of income over a period of time

🔑 Expenditure budget = Plan of expenditure over a period of time

$$Profit budget = Income budget – expenditure budget$$

Types of budgets

• Historical

• Zero-based 🔗 Historical budget: Budget based on previous figures

• Realistic as based on actual past performance

• Uses extrapolation, doesn't consider changes in business conditions or external influences e.g., demand spikes or an economic downturn, decreases accuracy, adjustments may need to be made Extrapolation: Assuming past trends will continue in the future

🔗 Zero-based budget: No money is allocated to cover costs; managers have to bid for and justify spending in their department

• Forces the business to examine all costs, money is more likely to be spent efficiently and not wasted
• Easier to adapt when circumstances change
• Gives more flexibility in response to changes in the market
• Lacks flexibility when business may require finance immediately e.g., due to a demand spike, which bidding process may take too long for
• Funds may not be distributed evenly, demotivates staff in specific departments, disrupts operations

Variance analysis

Variance: Difference between actual and budgeted figures

Favourable variance: Actual budget is better than planned (lower costs or higher sales)

Adverse variance: Actual budget is worse than planned (higher costs or lower sales)

Benefits and Drawbacks of Budgeting

• Establish priorities and set targets, motivate staff, more commitment increased productivity, higher output
• Forces the business to monitor the allocation of resources, highlight waste, improve efficiency, help cut costs, improve profitability
• Opportunity cost, is time-consuming to make, if too inflexible the business may miss out on opportunities when markets change
• Does not make allowances for circumstances changing, e.g., may lose customers or costs may change, decreases accuracy
• Encourages businesses to spend up to the budget so it is maintained next year, decreases efficiency, increases costs, reduces profitability
• Sales goals may be set too low, a higher target could have acted as a motivational target for workers