Purpose and Value of Budgeting (AQA A Level Business): Revision Note

Purpose and value of budgeting

• A budget is a financial plan that sets out expected income, spending or profit over a future period - typically a month, a quarter or a financial year

  • It gives managers a clear target to aim for and a benchmark against which actual performance can be measured

• Budgets are prepared in advance and are based on the best available information about future trading conditions

Why budgeting is important

Planning

• Preparing a budget forces managers to think carefully about the future

  • Forecasting sales, anticipating costs and identifying potential financial pressures before they arise

• This helps the business to prepare for challenges rather than simply react to them

Control

• Once a budget is set, actual performance can be compared against it at regular intervals

• The difference between a budgeted figure and the actual figure is called a variance

  • Identifying variances early allows managers to investigate problems and take corrective action before they escalate

Coordination

• Budgets help ensure that different departments within a business are working towards the same financial goals

  • For example, if the sales team plans to increase revenue by 20%, the production and logistics departments need to know this so they can plan their own spending accordingly

Motivation

• Giving individual managers responsibility for their own budget can increase their sense of ownership and accountability

• Having a clear target to work towards can be motivating

  • Particularly if managers are involved in setting the budget rather than simply having figures imposed on them

Communication

• The budgeting process communicates financial priorities and expectations of senior management throughout the organisation

• It ensures that everyone understands what the business is trying to achieve financially and what resources are available to them

Supporting decision-making

• Budgets provide a financial framework for evaluating decisions

  • For example, if a manager wants to invest in new equipment or hire additional staff, the budget helps assess whether the business can afford it and what impact it will have on profit

Types of budget

• Businesses typically use several different budgets, each focusing on a different aspect of financial performance

• In practice, these budgets are linked

  • A change in expected revenue will affect the profit budget

  • A rise in costs in one department will need to be reflected in the overall expenditure budget

Approaches to setting budgets

Incremental budgeting

• Incremental budgeting uses the previous year's budget as a starting point and adjusts it by a set amount or percentage to reflect expected changes, such as inflation, anticipated growth, or planned cost increases

• It is the most widely used approach in large organisations

Example

A marketing department had a budget of £80,000 last year.

Using incremental budgeting with a 5% increase for inflation, next year's budget would be set at £84,000 without necessarily reviewing whether every element of last year's spending was necessary

Zero-based budgeting

• Zero-based budgeting starts from scratch every budget period

  • Rather than adjusting last year's figures, every department must justify all of its planned spending from zero, as if the budget were being set for the first time

• No spending is automatically approved simply because it happened in a previous year

Example

A customer service department using zero-based budgeting cannot simply ask for last year's budget plus inflation

Instead, it must justify every cost, such as staffing levels, software subscriptions and training, by explaining what value each delivers to the business