A budget is a financial plan for the future regarding the revenues and costs of a business.

Budgetary control is the process through which financial control can be exercised throughout a business. Budgets are created for income and expenditure in advance. They can then be compared to the actual performance in order to establish any variances.

Variance analysis

Budgets must be reviewed and revised by businesses. Variances are discrepancies between the actual results and those budgeted.

It’s important that a business investigates any variances in order to find out why they occurred. This is called budgetary control.

A variance can be positive as well as negative

A positive variance is where the money coming into the company is more than budgeted or where the money leaving the company is less than budgeted. This could be due to a number of reasons, for example there’s more demand for a product than predicted or there’s less competition to contend with.

A negative or adverse variance is where the money coming into the business is less than budgeted or where the money leaving the business is more than budgeted. This could also be due to a number of reasons including economic recession or an increase in the cost of labour.

When carrying out budgetary control, management tends to look only at large variances which have been the result of large underspending or overspending and ignore the smaller ones. This is called management by exception.

Benefits of budgets

Budgets can be created for a number of reasons:

– Establish targets and priorities

– Turn the objectives into a reality

– Give direction

– Assign responsibilities

– Allocate resources

– Set targets

– Motivate employees

– Improve efficiency

– Forecast outcomes

– Monitor performance

– Control income and expenditure

It’s important that good budgetary control is implemented in order for it to be successful.

This includes:

• Responsibilities being clearly defined
• The budgets being adhered to
• Performance being monitored against the budget
• Corrective action being taken if the actual results are very different from the budget
• Variances being investigated into
• Any departures from the budget having to be approved first of all

There are two main approaches to budgeting.

Historical budgeting

This is where the previous year’s figures are used to create the current year’s budget. It’s a realistic approach as it’s based on actual results.

However, it doesn’t encourage efficiency and if circumstances have changed, for example the introduction of new products or a credit crunch, then the data may not even be valid.

Zero budgeting

Zero budgeting is where a budget is set down to zero for a particular period of time. The manager of that department is then forced to justify any expenditures that they want to make.

This is a common tactic during a downturn or economic recession when finances are tight and a business wants to make major cutbacks on its expenditure. It helps a business see where essential capital and minimal expenditure is required within the company.

However, this type of budgeting requires more time to organise than those traditionally set up.

Limitations to budgets

The problems surrounding budgets include:

• They’re only as good as the data used.
  • Decision-making can be less flexible.
  • As circumstances change so the budget must change.
  • They take time to complete and manage properly.
  • They can result in short-term decisions being made to keep within the budget as opposed to long-term decisions for fear that the budget is exceeded.
  • They can be demotivating if seen to be imposed as opposed to discussed.
  • Unrealistic targets can be demotivating.
  • Budget allocation can lead to departmental rivalry.
  • Departments may try and spend up to the budget so they can get the same the following year (‘use it or lose it’ attitude).