Definition and types of budgets

A budget acts as a financial blueprint for a business, projecting expected income and spending over a set period, usually over a 12-month period.

Main types of budgets

• Income budgets - These forecast the amount of money that will come into the business as revenue.
• Expenditure budgets - These predict the business's total costs for the year, including fixed and variable costs.
• Profit budgets - These use the income budget minus the expenditure budget to calculate expected profit or loss.

Purpose and structure of budgets

Budgets serve multiple roles in a business, acting as tools for communication and coordination across different areas. They outline what must be accomplished in terms of revenue and costs to meet profit goals, influencing operations throughout the organisation.

Key purposes of budgets

• Budgets communicate financial targets to stakeholders, including employees and investors.
• They show what needs to be achieved in terms of sales and expenditure to reach profit targets.
• Budgets affect all areas of the business.

Structure of budgets

Budgets are often divided to make them more manageable and accountable:

• Departmental breakdown - The overall expenditure budget is split into smaller budgets for individual departments.
• Budget holders - These are individuals responsible for spending the money for each budget.
• Activity-specific budgets - Departmental budgets are further broken down into budgets for specific activities.

Methods of setting and developing budgets

Creating budgets involves careful research and consideration of various factors to ensure they are realistic and aligned with business goals. The process requires negotiation and aims to challenge the business without being unattainable.

Process of setting budgets

• Income budget setting - This requires research and predictions about sales revenue.
• Expenditure budget setting - This involves research on labour costs, raw materials costs, taxes, and inflation.
• Influence of business objectives - Budgets are influenced by a business's objectives.
• Negotiation and achievability:
  • Annual budgets are usually agreed by negotiation.
  • They are designed to stretch the abilities of the business but must be achievable.
  • Unrealistically high income budgets or low expenditure budgets will demotivate staff.
• Monitoring performance - Budget holders check performance against the budget using variance analysis.

Approaches to developing budgets

Businesses can use different methods to create budgets, each with its own benefits and drawbacks.

Fixed and flexible budgeting

Budgets can be rigid or adaptable, depending on the business's needs and market conditions. The choice affects how well a company can respond to changes.

Fixed budgeting

• Fixed budgets require budget holders to stick to plans throughout the year.
• Fixed budgeting can prevent a firm reacting to new opportunities or threats.
• Fixed budgets provide discipline and certainty, important for businesses with liquidity problems.

Flexible budgeting

• Flexible budgets allow budgets to be altered in response to significant market changes.
• Zero-based budgeting gives a business more flexibility than historical budgeting.

Advantages and disadvantages of budgeting

Budgeting offers several benefits for planning and control, but it also comes with potential drawbacks that businesses must manage.

Advantages of budgeting

• Motivation - Provides clear targets that can be motivating by giving employees targets.
• Control - Helps control income and expenditure.
• Decision-making - Helps managers review activities and make decisions.
• Priorities - Helps focus on priorities.
• Communication - Can be used as a communication tool.
• Coordination - Lets departments coordinate spending.
• Investor attraction - Helps persuade investors that the business will be successful.

Disadvantages of budgeting

• Internal conflicts - Can cause resentment and rivalry if departments compete for money.
• Inflexibility - Can be restrictive, preventing response to changing market conditions.
• Time demands - Is time-consuming and can distract from focusing on winning business.
• Prediction challenges - Inflation is hard to predict accurately.
• Challenges for new businesses - Start-up businesses may have inaccurate budgets due to lack of comparative data.