the benefits and drawbacks from the use of budgets

5.5 Budgets – Meaning, Purpose and Use

Learning Objective

Students will be able to evaluate the benefits and drawbacks of using budgets, describe the main types of budgets, explain how budgets are used for performance measurement and control, and apply variance analysis in a business context.

1. What is a Budget?

A budget is a detailed financial plan that quantifies the resources required to achieve specific objectives over a set period (normally one year). It sets targets for revenue, costs, cash flow and profit, and provides a benchmark against which actual performance can be measured.

2. Purpose of Budgets

• Planning: forecast sales, production, staffing and cash requirements.
• Coordination: align the activities of different departments with the overall business strategy.
• Motivation: set clear performance targets for individuals and teams.
• Control: monitor actual results against the budget and take corrective action.
• Communication: convey organisational priorities to staff, shareholders and other external stakeholders.

3. Budgets and Performance Measurement

Budgets provide the benchmark against which performance is measured. The difference between actual and budgeted figures is expressed as variances. Variances are classified as favourable (when results are better than expected) or unfavourable (when results are worse than expected). By analysing these variances managers can assess efficiency, effectiveness and profitability, and decide what corrective action is required.

4. Benefits of Using Budgets

1. Improved Planning and Forecasting – Preparing a budget forces managers to consider future market conditions, capacity constraints and financial requirements, producing more realistic plans.
2. Enhanced Coordination – Departmental budgets must be linked, preventing conflicting activities such as over‑production or under‑staffing.
3. Objective Performance Measurement – Budgets give a clear standard for variance analysis, making appraisal of managers and teams transparent.
4. Cost Control and Efficiency – When costs are budgeted, managers are aware of spending limits and are motivated to seek efficiencies.
5. Motivation and Goal‑Setting – Achievable targets, especially when tied to incentive schemes, can raise employee effort and morale.

5. Drawbacks of Using Budgets

1. Rigidity – Budgets are often fixed for a year, making it difficult to respond quickly to unexpected market changes.
2. Time‑Consuming Preparation – Developing detailed budgets requires considerable managerial time and resources.
3. Potential for Distortion – Managers may manipulate assumptions to make targets easier to achieve, leading to inaccurate planning.
4. Short‑Term Focus – Pressure to meet budgetary figures can encourage decisions that boost short‑term results at the expense of long‑term strategy.
5. Demotivation – Unrealistic or overly aggressive targets can disengage staff and reduce productivity.

6. Main Types of Budgets

7. The Budgeting Cycle (Budgetary Control Process)

1. Forecasting: Analyse market trends, past performance and internal capacity to estimate future activity.
2. Setting Targets: Translate forecasts into specific revenue, cost and profit targets for each department.
3. Budget Preparation: Prepare functional budgets (sales, production, labour, cash, etc.) and combine them into the master budget.
4. Approval: Senior management reviews, adjusts and formally authorises the budget.
5. Implementation: Departments operate according to the approved budget; resources are allocated accordingly.
6. Monitoring & Variance Analysis: Compare actual results with budgeted figures, calculate variances and investigate causes.
7. Review & Revision: Adjust the budget (or prepare a new one) in response to significant changes in the business environment.

8. Variance Analysis – Measuring Performance

Variance analysis quantifies the difference between budgeted and actual results. It helps managers understand why performance deviated and what corrective action is required.

9. Linking Budgets to Functional Areas

• Marketing: The sales budget provides the revenue base; marketing spend is allocated to achieve the forecasted sales.
• Production/Operations: The production budget translates sales forecasts into required output, raw‑material and labour needs.
• Human Resources: Staffing budgets are derived from the production plan and any planned expansion.
• Finance: Cash‑flow and capital‑expenditure budgets ensure the firm can fund its operations and investment projects.

10. Budgets in Decision‑Making

• Pricing Decisions: Contribution‑margin analysis from the budget helps set prices that cover variable costs and contribute to fixed costs.
• Product‑Mix Decisions: Compare the profitability of alternative products using budgeted contribution per unit.
• Make‑or‑Buy Decisions: Use the relevant‑costs section of the budget to decide whether to produce in‑house or purchase from a supplier.
• Investment Appraisal: Capital‑budgeting forecasts (e.g., cash‑flow budgets) feed into pay‑back period, NPV or IRR calculations.

11. Real‑World Example – Retailer “StyleCo”

StyleCo, a mid‑size clothing retailer, prepares a flexible budget for its three main stores. The budget separates fixed costs (rent, salaries) from variable costs (stock purchases, utilities). At the end of Q2 the actual sales volume is 10 % lower than forecast. Using the flexible budget, StyleCo calculates:

• Revenue variance: –£120,000 (unfavourable)
• Variable‑cost variance: –£30,000 (favourable – less stock was bought)
• Fixed‑cost variance: £0 (fixed costs unchanged)

Management investigates the shortfall, discovers a competitor’s promotional campaign, and decides to launch a targeted discount in the under‑performing store – a decision directly driven by the variance analysis.

12. Sample Budget Calculation (Simple Profit Budget)

Assume a company expects to sell 10,000 units at £25 each. Variable cost per unit is £12 and fixed costs total £80,000.

Budgeted Revenue          = 10,000 × £25 = £250,000
Budgeted Variable Cost    = 10,000 × £12 = £120,000
Budgeted Contribution     = £250,000 – £120,000 = £130,000
Budgeted Profit           = £130,000 – £80,000 = £50,000

13. Flexible‑Budget Variance (Practice Calculation)

Using the profit budget above, actual sales were 9,000 units at £26 each, variable cost remained £12 per unit and fixed costs were unchanged.

Actual Revenue          = 9,000 × £26 = £234,000
Actual Variable Cost    = 9,000 × £12 = £108,000
Actual Contribution     = £234,000 – £108,000 = £126,000
Actual Profit           = £126,000 – £80,000 = £46,000

Flexible‑budget for 9,000 units:
   Revenue = 9,000 × £25 = £225,000
   Variable Cost = 9,000 × £12 = £108,000
   Contribution = £117,000
   Profit = £117,000 – £80,000 = £37,000

Flexible‑budget variance = Actual Profit – Flexible‑budget Profit
                         = £46,000 – £37,000 = £9,000 (favourable)

14. Key Points to Remember

• Budgets are both a planning and a control tool.
• Effective budgeting requires realistic assumptions, regular monitoring and the flexibility to revise figures when circumstances change.
• Know the three main budget types – incremental, flexible and zero‑based – and when each is most appropriate.
• Variance analysis is the cornerstone of performance measurement; distinguish between revenue, cost, profit, activity and price variances.
• Budgets link all functional areas and support strategic decisions such as pricing, product mix and capital investment.

15. Suggested Diagram

16. Application Questions (Exam Practice)

1. Explain how a variance analysis could be used to improve performance after the first quarter of a financial year. Include at least two different types of variance in your answer.
2. Discuss two situations in which the rigidity of a budget might be a disadvantage for a business. Suggest how the budgeting process could be adapted to overcome each problem.
3. Compare and contrast incremental budgeting with zero‑based budgeting. In which type of business environment would each be most suitable? Provide reasons.
4. Using the profit budget example above, calculate the **flexible‑budget variance** if actual sales were 9,000 units at a price of £26 each, with variable costs remaining at £12 per unit and fixed costs unchanged.