Budgets turn objectives into numbers (Topic 1.4.2). A sales objective becomes a sales (revenue) budget; the resources needed to meet it become expenditure (cost) budgets for each department; together they produce a profit budget for the whole business.
Budgets provide the benchmark against which actual performance is measured. At the end of each month, actual figures are compared with the budget; the differences (variances, 5.5.2) show which departments are on target and which need attention. This lets managers act quickly — before a small overspend becomes a large one — and judge the performance of each budget holder fairly.
| Use | How budgets help |
|---|---|
| Measuring performance | Actual results are compared with budgeted targets; good and poor performance can be identified |
| Allocating resources | Budgets decide how much money each department, project or branch receives, directing resources to priorities |
| Controlling | Budget holders must keep spending within limits; overspending needs explanation and approval |
| Monitoring | Regular variance analysis tracks progress through the year, so problems are spotted early |
| Planning and coordination | Departments must plan ahead and coordinate — production budgets must match sales budgets |
| Motivation | Achievable budgets, especially when set with the budget holder, give targets to work towards |
| Benefits | Drawbacks |
|---|---|
| Force managers to plan ahead and think about priorities | Budgets are based on forecasts, which may be inaccurate |
| Give clear targets, which can motivate when realistic | Unrealistic budgets demotivate; imposed budgets may be resented |
| Benefits | Drawbacks |
| Control spending and reduce the risk of overspending | Can be inflexible — managers may miss opportunities because 'it isn't in the budget' |
| Help coordinate departments towards common objectives | Encourage 'use it or lose it' spending at year end to protect next year's budget |
| Provide a basis for measuring performance and accountability | Setting and monitoring budgets takes considerable management time |
Budgets work best when budget holders are involved in setting them (participation, linking to Topic 2.2), when targets are realistic, and when they are reviewed and adjusted as conditions change.
| Method | Advantages | Disadvantages |
|---|---|---|
| Incremental | Quick and simple; stable — departments know roughly what they will receive | Past inefficiencies are carried forward; no review of whether spending is still needed; encourages 'use it or lose it' |
| Flexible | Fairer comparisons — managers are judged on costs for the output actually produced; useful when output varies | More complex to prepare; requires costs to be accurately split into fixed and variable |
| Zero | Every activity is reviewed, eliminating waste; resources go to current priorities; managers must justify spending | Very time-consuming; managers need training; may cause conflict between departments competing for funds |