Budgeting

by John Kind

What is a budget?

A budget is a short-term plan, typically for a 12-month period. If the budget is for a business or organisation, it can be broken down into budgets for each organisational unit, such as a department, function, section, project or team. The financial aspects of a budget tend to receive particular attention, but the ‘non-financial’ aspects are also important. These non-financial aspects include customer satisfaction levels, market share objectives, staff retention rates and health, safety and environmental targets.

A budget is, therefore, a formal, short-term commitment to achieve an agreed set of financial and non-financial results. In the case of a 12-month budget, it may be divided into shorter intervals, such as calendar months or four-week periods, to allow, for example, for seasonal fluctuations.

Definition

A budget is a short-term plan. It is a formal commitment to achieve a set of financial and non-financial results for a given period, typically 12 months.

According to the practice in an organisation, the budget may remain the budget even if circumstances change during the budget period: as a result of higher than expected inflation or a major incident, for example. In this sense, the budget is ‘fixed’. In other organisations, the budget may be altered as new information becomes available that invalidates some of the assumptions under which the original budget were prepared. This approach is sometimes called ‘flexible’ budgeting.

Budgeting philosophy

A budget should not be regarded as a massive ‘number crunch’ dominated by the accountants. Instead, the budget preparation process should be seen as a genuine opportunity to review and improve performance, albeit under a tight schedule. Of course, politics and personalities will be involved. ‘Games’ will be played. But simply carrying on with the same processes and routines is most unlikely to lead to better results. Don’t forget the comment of the author, Somerset Maugham – ‘only the mediocre are always at their best!’

Links between the short and longer terms

There should be clear links between the budget (short term) and longer-term plans, since the achievement of targets during the next budget period will help an organisation, department and team to achieve its longer-term ambitions.

Master budget

The budget for a complete business or organisation is sometimes referred to as the ‘master’ budget. It will include the items listed below.

  • Revenues or sales – the value of the goods and services expected to be provided to external customers during the budget period.
  • Costs – the expenditure expected to be incurred during the budget period, including
  • Salaries and related costs, such as pension contributions and health care premiums
  • Purchases of raw materials
  • Depreciation (reducing the value of tangible longer-term assets, such as buildings, vehicles and machinery)
  • Amortisation (reducing the value of intangible longer-term assets, such as intellectual property)
  • Information technology, such as systems development
  • Utility charges, such as energy and telephone
  • Accommodation costs, such as office rent and business rates
  • Hotel, travel and corporate entertainment
  • Insurance premiums
  • Research and development
  • Advertising and public relations
  • Audit, accountancy and consultancy fees
  • Distribution and transport
  • Recruitment and staff training
  • Maintenance and repairs
  • The difference between budgeted revenue and budgeted costs, to produce the budgeted profit-and-loss account or income statement for the budget period. The budgeted income statement can be broken down into a number of different elements, including the gross profit (the difference between revenue and the cost of sales or direct costs such as raw materials and labour) and the operating profit (the difference between the gross profit and operating or indirect costs, such as management salaries, and the costs of support activities like HR, Finance and IT).
  • Cash inflows and outflows:
  • Receipts from customers and other sources, such as new loans, additional capital from shareholders and the cash proceeds from asset and business disposals
  • Payments to pay employees, external suppliers and contractors
  • Payments for capital expenditure on longer-term assets or resources (for example, on additional property, plant, equipment and vehicles and on acquisitions and joint ventures)
  • Payments to repay loans, to meet interest charges and to pay dividends
  • Changes in short-term assets or resources, such as
  • Inventory or stock levels
  • Amounts due from customers referred to as receivables or trade debtors
  • Cash balances
  • Changes in both short- and longer-term obligations or liabilities, such as
  • Short-term borrowings (for example, a bank overdraft repayable within 12 months)
  • Amounts due to external suppliers – referred to as payables or trade creditors
  • Amounts due for unpaid expenses, such as unpaid utility charges and unpaid consultancy fees – referred to as accrued charges
  • VAT (Value Added Tax)
  • Longer-term borrowings (due for repayment after one year from the end of the budget period)
  • Longer-term obligations, such as borrowings and pension liabilities
  • The financing provided by shareholders.
  • Important financial performance measures, such as the gross profit margin (revenue less the cost of sales expressed as a percentage of revenue), which highlights the profitability of goods and services and how long, on average, customers take to pay their bills (referred to as days’ sales outstanding or DSO).