Session D
What is a budget?

1 Introduction

How would you feel if you were never sure if you would be paid on pay-day or not?

To ensure that you do get paid on the right day, your organization needs to plan and to control the ways in which it spends and receives money so that enough cash is available to pay wages and salaries when due. The organization draws up a plan indicating how it expects money to flow in and out. This plan is better known as a budget.

You probably do the same at home, planning how to use your income. You budget, your employer prepares a budget and, of course, the country as a whole budgets.

Each year, the Chancellor of the Exchequer presents a Budget to Parliament. Its aim is to achieve things which are part of the government's policy on how best to run the country.

Activity 42

Write down three things the Chancellor might try to achieve through the annual Budget.

Typical examples might be to:

     improve public services;

     reduce inflation;

     combat unemployment;

     help small businesses;

     win the next election!

Whatever plans and policies the government has, they all have to be financed. The Budget is all about getting hold of and using money.

To achieve this, the Chancellor might introduce policies to:

     cut or tighten control over major items of expenditure;

     switch expenditure and resources from one item to another;

     use a variety of financial incentives and penalties.

The national Budget requires a lot of analysis, planning negotiations and juggling with resources. It covers both national income and national expenditure. All budgets work in similar ways; just the amounts involved differ.

 

 

2 The purpose of budgets

Think about your own workplace for a moment. Your work team may be earning income through the sales it achieves or the services it supplies.

Or it might be contributing to profit (the surplus of income over costs) in one or two other ways.

Whatever it does, your work team is certain to incur expenditure (costs), in doing its job. Almost certainly, the organization you belong to will have prepared a budget for its expenditure. If it generates income directly, then there will be a budget for that as well.

A budget can be described as:

a quantitative plan of action prepared in advance of a defined period of time.

Let's look at this definition more closely.

     A budget is quantitative.

That means it must be stated in figures; in practice this usually means in sums of money. A general statement of what you intend to do may be useful, but it's not a budget.

     A budget is prepared in advance.

A budget must be drawn up before the period to which it refers. Figures produced during or after the period may be important, but they are not part of a budget.

     A budget relates to a particular period.

Budgets are drawn up for a certain specific period (often, though not always, one year). An open-ended financial plan for the future isn't a budget.

     A budget is a plan of action.

This is perhaps the most important point of all. A budget can't be a definite statement of fact, because it relates to something which hasn't happened yet. It is what the organization is planning will happen.

Conditions may change during the budget period, which means the budget will be inaccurate. Like all plans, budgets seldom turn out to be totally correct predictions of the future. Even so, they can still be useful in guiding the actions of those using them. This guidance role is very important.

Of course, you must know what you are trying to achieve before planning. Everything else depends on that.

‘Knowing what to achieve’ is referred to in business as an objective.

The objectives of your workplace will depend to some extent on what kind of organization it is and may be short, medium or long term. Manufacturing industries, for example, have to make a profit. Local government services have to provide a certain level of service. A nationalized industry may be required to achieve a planned return on capital invested.

Some other examples of objectives are:

     to make a profit of 30% on a certain product;

     to increase the share of the market by 5% for a certain product;

     to improve service to the public in certain areas;

     to survive commercially for a financial year (this is particularly relevant to new, small businesses).

To achieve any of these objectives needs planning and will probably involve the production of budgets.

Activity 43

Write down two different kinds of budget that are used in your organization to meet its objectives. One example would be a sales budget.

The budgets listed below are all common types. Perhaps your suggestions are among them, though you could well have thought of others too.

     Sales budget.

     Production budget.

     Research and development budget.

     Training budget.

     Departmental costs budget.

     Cash budget.

All budgets are important, although it is arguable that the cash budget is most important because without cash a business cannot survive.

Let's look briefly at sales budgets and cash budgets, to make sure we understand what they mean.

In a sales budget, a forecast is made of the sales the business will make during the relevant period. This may be broken down by section or department. Knowing how much you plan to sell is essential, in order to decide how much raw materials you will buy, how many employees you will need, and so on.

In a cash budget the business will forecast:

     what cash will be received and paid out during the budget period;

     the timing of receipts and payments;

     the bank balance or overdraft for each month.

The cash budget is especially important for small, newly established businesses.

Activity 44

Who do you think would need to see the cash budget of a newly established business? Write down one suggestion.

EXTENSION 4 Assignment 14 in The Business Plan Workbook, by C. Barrow, P. Barrow and R. Brown, gives illustrations of the situations faced by businesses that have and have not prepared a cash budget.

You may have thought of a number of possibilities. The one I had in mind was the bank manager who will want to examine the cash forecasts of a new business, and will almost certainly insist on a cash budget before authorizing a loan for a new business.

However, I don't want to give the impression that it is only new, small businesses which find cash budgets important. Organizations, large and small, use them, and so do charities and social clubs. Everyone needs cash.

3 Beginning a budget

Here, we are going to think about the beginning of the budget process. We'll start with manufacturing industry – in a business which makes and sells something.

We need first to identify the critical factor which influences all the budgets in a certain workplace. The factor influences all other budgets, and is called the key or limiting budget factor.

In practice:

     the sales budget is the commonest limiting budget factor in established commercial businesses;

     the cash budget is the commonest limiting budget factor in newly established small businesses.

Sometimes the production budget is the limiting budget factor, although this is less common.

In a non-profit organization, the limiting budget factor is likely to be the availability of funds.

Activity 45

In each of the following situations, the key budget – the one on which other budgets will depend – will have to be produced first. To remind you, in a manufacturing company, this may be a cash, sales or production budget. Look at each situation and decide which is the key budget for each.

	Key Budget
Firm A exists in a highly competitive market and currently sells 500 units per month. It plans to increase this to 600 units per month in the coming year and, in fact, has the capacity to produce 750 units per month.	Cash Sales Production
Firm B is the sole supplier of a specialist component. It can sell all it produces and more.	Cash Sales Production
Firm C is a small business with a large overdraft. It is currently owed a great deal of money, and its bank insists that the overdraft cannot be extended.	Cash Sales Production
Firm D is a haulage contractor with a fleet of ten lorries on the road that has been offered a contract to transport 12 lorry-loads of goods to Southern Europe on a weekly basis. The firm cannot afford to purchase additional lorries.	Cash Sales Production

Here is what I would say is the key budget, on which all other budgets would depend, for each of these firms.

     For Firm A, it's a sales budget. The firm must sell more. Everything else, including production, will follow from that.

     For Firm B, it's a production budget. The firm has to produce more. If it achieves this then extra sales will follow.

     For Firm C, it's a cash budget. The most important thing is for the firm to earn cash at the moment. This might even mean that the firm would have to refuse a potentially profitable contract if it didn't bring in cash quickly enough.

     For Firm D, the key is the cash budget because the firm does not have enough cash to buy more lorries to provide the transport service offered.

4 Why do we need budgets?

Some people think of a budget as something that restricts what we want or need to do. It certainly can be very frustrating when the constraints of a budget, drawn up by accountants who (you may feel) have no understanding of your problems, prevent you from taking certain actions in your job.

See if you recognize any of the following situations or something similar.

The training budget of a hospital has been spent. A nursing sister is refused permission to go on a course to learn how to use a new piece of equipment for monitoring heart disease. She is concerned because she feels that patient care may suffer.

The entertainments budget of a growing electronics firm is exhausted. The sales manager is unable to offer the kind of hospitality he would like to a visiting trade delegation from Saudi Arabia. No orders are won.

The overtime budget of a shipbuilding company is already overspent. No new overtime is authorized and the ship ends up three months late to the customer. Massive penalties result.

The departmental budget in the chemistry department of a university is underspent with one month of the financial year to go. The professor authorizes a spending spree to ensure his budget is not cut next year. Unneeded equipment which is rarely if ever used is purchased.

Having a plan, which is all the budget is, can only be a good thing. In these examples, the budgets themselves were not to blame for the unfortunate results. So what went wrong?

Activity 46

Write down any ideas you have about who or what was responsible for the problems arising in any of the situations described above.

A budget is only a plan and provides guidance. Budgets should not be rigidly kept to as an excuse for not managing. Sometimes an adaptation of a plan is more sensible.

You may have noted a number of possibilities but perhaps we can narrow them down to the following.

     An over-rigid view of how the budgets should be enforced has been taken – this seems likely to be the case in the first and second examples.

     The budgets have been badly produced, managed and controlled, particularly the third and fourth examples.

If necessary, senior management usually have authority to over-ride a budget if they consider it would be economically worthwhile to do so. For example, it is probably appropriate to intervene to prevent the company having to pay contract penalties for late delivery, because its overtime budget is overspent. They might achieve this by transferring savings made in one budget to another, a process known as virement.

After all, budgets are intended to be beneficial.

It is when they are badly produced, managed and/or controlled, that they can have undesirable consequences.

But what do we mean by this? The easiest way to see how bad production, management and control of budgets have poor effects is to trace through the problems in one of the situations above.

Let's take a look at the hospital training budget example.

     The training budget was drawn up at the beginning of the financial year without reference to the equipment budget, which showed that new equipment was being purchased to monitor heart disease.

     BAD PRODUCTION – more access to information would have shown the need to budget for this training.

     Two key staff left and were not replaced. Instead a series of temporary staff, each of whom had to be trained in certain procedures, were taken on, so using up the training budget.

     BAD MANAGEMENT – more effort should have gone into recruiting permanent staff.

     A discretionary training course became available which had not been planned at the beginning of the year. All staff were ordered by the human resources department to go on the course, without evaluation of whether it was needed by the departments holding the training budget.

     BAD CONTROL – the usefulness of the training course in comparison with the heart disease monitor course should have been evaluated by the managers responsible for the heart disease ward.

Having seen the downside of poor practice, let us look at the benefits of good budget practice.

5 The advantages of budgets

Organizations benefit in a number of areas through budgeting.

     Co-ordination and team work

The process of budgeting means that management at all levels and in different departments are given the opportunity to meet, discuss and relate their targets to each other. Organizations are most successful if everyone works together to meet common goals rather than each manager acting selfishly to build their own empires.

The co-ordination process helps managers get an understanding of how each activity relates to the whole, which is very important for them and for the business. It would be pointless, for example, for the sales manager to plan a 10% increase if the production manager is aiming for a 5% cutback.

     Communication

In order to work to a budget, people have to know what is possible or impossible in their own workplace.

Budgeting encourages management at all levels to talk to one another about the company's policies and the targets they are aiming for. Again this builds team work; people working for each other and for their organizations.

     Planning

As we've seen, planning is at the heart of a budgeting system. Using a budgeting system means that managers and supervisors have to use formal procedures to think about the future, instead of muddling along from one day to the next. It also means that thought is given to the level of performance expected in every part of the organization.

     Control and performance evaluation

The whole point of a budget is to influence the direction the organization is taking. For a budget to be of value,

the actual outcome must be regularly compared with the planned outcome.

If the two don't match up, then controls can be used to take appropriate action. Without a plan there is no yardstick to measure what's happening; any controls, therefore, are fairly random.

The idea of a system of budgets is to get a clearer picture of planned activities and to make departments and individuals responsible for spending and cost control in their own areas. In this way, the strengths of sections and departments can be capitalized on, and ways found to overcome any weaknesses.

     Motivation

The more people are involved at every level in setting up a budget, and in the planning and control that goes with it, the more they understand and support what the organization is trying to achieve. Involvement is an important motivating factor at any level.

All these points are valid, but the two most important purposes of budgets are planning and control. The planning process enables control to be exercised.

Let's explore the idea of budgetary control a little further.

6 Using budgetary control

Budgetary control involves drawing up budgets which relate what has to be done to the managers who have to do it, and then comparing actual results against the plan.

It is a very useful management tool. It should enable a manager or supervisor to do his or her job more effectively, without detracting from individual skill or flexibility.

Control must be an active process.

Activity 47

Here is an important question for a manager, which budgets should help to provide the answer to. ‘Is my work team (or section, or department) keeping its spending within agreed limits?’

Can you think of at least one other question to which a manager might want to know the answer, and which budgets should help provide?

You may have thought of several possible questions. Perhaps you included the following.

     ‘Are we reaching agreed targets?’

     ‘If we are not reaching agreed spending limits or agreed targets, where are we falling down, and for what reasons?’

     ‘What can I do to try to improve the performance of my team?’

     ‘Do events suggest that the budget needs to be modified?’

By monitoring actual results against budgets, control is improved. You should be able to identify problems and take action quickly, and there is less incentive just to let matters slide.

No budget is perfect. Unforeseen circumstances do arise. For example, a competitor may suddenly bring out a new product, the bottom may drop out of a market or we may have a strike on our hands. Any number of events can make budgeted figures less accurate, some within the control of managers, some not.

Activity 48

This Activity may provide the basis of appropriate evidence for your S/NVQ portfolio. If you are intending to take this course of action, it might be better to write your answers on separate sheets of paper.

Think about your own job.

Write down two factors that might make your work team deviate from its budget, and which are largely within your control.

Now write down two factors that might make your work team deviate from its budget, which are largely outside your control.

Your response will be related to your own job.

     As factors within your control you might have put down answers such as faulty work, bad timekeeping by employees, inefficient organization of the department, new staff not inducted properly, and so on.

     Factors likely to be outside a line manager's control are the hold-up of supplies, teething problems with new products or systems, shortages of staff and so forth.

Because there are many ways in which a budget can become out of line with the plan, an organization must try to obtain the best possible information at the time of preparing the budget. It should look to see, for instance, what it has achieved in the past, and what its costs actually are.

Self-assessment 4

Answers to these questions can be found on pages 122–3.

 

 

7 Summary

     A budget is a plan, usually described in financial terms, prepared in advance of a defined period of time.

     The starting point in producing a budget is to determine the key or limiting factor which influences all other budgets. This will often be the sales budget.

     Control is central to the budgeting process. The system of using budgets and comparing actual and budgeted results to control progress towards stated objectives is budgetary control.

     Budgeting should never be so inflexible as to prevent sensible decisions being taken.

     Budgets can also help to improve:

     co-ordination and team work;

     communication;

     motivation.

     Good budgeting should help an organization meet its goals and ensure that everyone works together towards those goals.