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Budgets Part 2

You may have come up with something similar to this:

Enables planning

Enables delegation of spending to managers/departments

Facilitates monitoring of actual expenditure

Allows targets to be set

Motivates performance to achieve targets

Means of control

Shows areas and periods of potential surplus or deficit

Sometimes the different uses of budgets are seen to conflict. For example the more budgets are used as a means of control, the more likely they are to be manipulated and the less useful they are as a means of planning. (This is discussed more fully later on).

Reading

This is will be covered in more depth in your chosen text book.

TYPES OF BUDGET

There are different types of budget and different ways of setting them. Large organisations are likely to draw up a variety of budgets for example a University will know that income does not arrive evenly throughout the year as fees are generally paid at the beginning of each year or term. On the other hand, staff salaries are paid each month. It is therefore important that a university prepares a cash flow budget to ensure that there will not be problem caused by this mismatch.

Most departments will have an expenditure budget for the period of the whole financial year. This is likely to be divided into different budgetary headings which will be similar to the list of costs you thought about earlier. However, sometimes a Rolling Budget is used. This is ‘a budget continuously updated by adding a further period and deducting the earliest period’. So in August 2009, the budget would be for August 2009 to July 2010. At the start of September 2009, the August 2009 figures are discarded and a new budget for September 2009 to August 2010 is used.

SETTING A BUDGET

Setting of budgets is often an iterative process, as various constraints such as reductions in expected income or rises in staff costs mean that the budgets of individual departments or cost centres have to be adjusted.

You may be asked to set a budget for a project or to contribute to discussions about the budget for your department. There are a number of ways to determine budgetary amounts of which these are the two most common.

Incremental Budgets

This is a traditional approach. The actual expenditure for a particular budget heading for the current year is taken as the starting point and then adjusted to take account of such things as inflation or other forecast changes. For example when determining the staff costs element of a budget, any agreed future pay increases can be taken into account. However at the point when the budget is set, pay negotiations may not have been finalised and an estimated percentage may have to be added to the known actual expenditure for the current year.

Zero Based Budgets

The CIMA defines this as ‘A method of budgeting whereby all activities are re-evaluated each time a budget is set. Discrete levels of each activity are valued and a combination chosen to match funds available’.

One implication of this is that just because an item incurred actual expenditure this year, there is no reason to automatically include it in next year’s budget. Each item has to be justified anew.

This is often the means used to budget for projects or new items. Managers may specify ‘packages’ of work which they would like to carry out. These are then submitted to senior managers who rank them and allocate resources to the successful items.

Reading

Your chosen text book may include examples of other types of budget and methods of budget setting.

VARIANCE

It is not usually very helpful to set a budget and then ignore it. Once the budget is in place – ideally agreed but at least understood - then it is likely that each budget-holder will be held accountable by senior managers for actual expenditure under the various budget headings. Regular monitoring of how actual income and expenditure compares to budget is required. Furthermore, knowing that expenditure is out of line with the budget is not usually enough. Reasons for the difference will be required and if necessary action taken.

The difference between the budget amount and the actual amount is referred to as a variance. These can be favourable– that is expenditure was less than budget (or income was greater) or adverse(income was less than budget or expenditure was greater).

In general, it is not a good use of time to investigate every small variance. Small variances usually balance out over a period of months. However if there is a trend – such that one item is above or below budget by a small amount every month it should be investigated as these small amounts may add up over the course of the year to a significant variance. It is up to each budget-holder or organisation to determine what level of variance requires investigation.

You need to be wary of just looking at the ‘bottom line’ – the total of your actual compared to your budget. Consider the following example which compares actual with budgeted expenditure:


Month 1


Month 2


Month 3



Budget

Actual

Budget

Actual

Budget

Actual

Visits

100

150

100

150

100

150

IT

500

0

0

450

0

0

Stationery

200

200

200

100

200

200

Total

800

350

300

700

300

350

In month one there is a large favourable variance on the total. Investigation will show that most of this was caused by the IT budget. The variance on IT is corrected in month 2 – it looks as if the payment for this was delayed for some reason leading to a large adverse variance in this month. By month three the bottom line variance is nil.

However these bottom line variances mask the fact that there is a potential problem with the item headed ‘Visits’. This is consistently above budget. There are a number of possible reasons. It may have been incorrectly budgeted for – perhaps the visits are further away than expected so the travel costs are higher. There may have been an unexpected rise in travel costs overall or there may be more visits taking place.

FLEXING THE BUDGET

What if the figures for Visits looked like this?


Month 1


Month 2


Month 3



Budget

Actual

Budget

Actual

Budget

Actual

Visits

150

100

150

100

150

100

This looks like a good situation as costs are consistently below budget. However it is discovered that the Visit budget was drawn up on the basis of 15 visits per month at an average cost of £10 per visit, whereas in fact, the number of visit made was 10 in month 1, 11 in month 2 but only 6 in month 3. The rate of visits has dropped. At an average cost of £10 per visit you would expect the figures to look like this:


Month 1


Month 2


Month 3



Budget

Actual

Budget

Actual

Budget

Actual

Visits

100

100

110

100

60

100

This budget has been ‘Flexed’ to take account of the actual volume of visiting carried out. From this you can see that further investigation is probably required to determine why the month three cost was so high and whether this trend is set to continue. Suppose there is a backlog of visits, but an increase in travel costs (perhaps fares or petrol prices rose sharply in month three) which is set to continue. In this case it is likely that by the end of the year there will be an adverse variance against the ‘ Visits’ heading.

OUTTURN

Another way of showing the effect of variances is to produce an Outturn. This is often carried out halfway through the budgetary period. Thus, if you know that there has been an significant change in the expected expenditure (or income) , either because of a change in costs or in activity you can indicate the effect of this while also preserving the original budget.

You might see something like this at the six month outturn.


Budget to Date

Actual to Date

Budget for Year

Outturn

Visits

500

700

1000

1200

IT

500

500

700

700

Stationery

600

400

1200

1200

Based on the actual costs of visits for the first half of the year, it might be expected that the total for the year would be £1400. However this outturn shows that expenditure is not expected to continue at the increased rate in the second half of the year.

The reverse is true of Stationery.

BUDGETARY CONTROL

It may not be possible to do anything about this predicted variance. However at least if you investigate the cause you can consider your options and you have an answer when a senior manager asks you what happened. It may be that if ‘Visits’ are optional activities you can cut down on the number of visits in order to keep costs down. If the visits have to take place and there is no obvious way to cut the cost per visit then you may have to ‘ subsidise’ the visit budget by reducing costs elsewhere. At a higher level, moving budget from one heading to another is sometimes known as ‘virement’.

Within your organisation there will be budgetary control systems designed to make sure that variances which require action are noticed and acted upon promptly. Typically this means that each budget-holder will receive monthly reports relevant to her/his area of responsibility and will be asked to comment on variances which are outside agreed tolerances. Budget holders will also be expected to be pro-active about notifying any areas of concern.

Performance against budget is usually included as at least part of the performance monitoring of employees who have financial responsibility. If the budget is regarded as in some way unfair or unrealistic, or employees are held responsible for variances caused by events outside their control, then the employee is unlikely to be positively motivated to try to achieve the budgetary targets. On the other hand, being given a realistic – albeit not extravagant – budget to complete a project or task and then being given the opportunity to achieve or better it can be a very motivating experience.

There is debate about the extent to which managers should be allowed to set their own targets. We have become painfully aware of the effects of financial systems where senior executives set their own performance targets and are then given huge rewards for exceeding them. Of course they will introduce as much slack as possible into the budgets. This is not an argument against involving managers in setting their own targets, but these targets must be set within the strategic framework of the organisation, over a realistic timescale and no-one should be assessed on the achievement of financial targets alone.

You may be more familiar with the approach which always tries to spend up to budget – leading to the spending spree at the financial year end. This can be particularly true where next year’s budget is set on the basis of this year’s actual expenditure. In this case there is a real sense of ‘use it or lose it’ especially if there is no facility to carry forward unspent money into the following period.

There are clear links here with the sections later in this module on Employee Performance and Motivation.

Reading

These topics will be explored in more depth in your chosen textbook.