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2.2.4 Budgets

A) Purpose of budgets

Budget – An agreed spending limit within the business

By having a budget it allows the business to plan. This is because they can anticipate any areas in which there may be overspending and are able to fix the problem before it arises. In addition to this, it may be motivating to managers due to the fact that they are in control of their budget which gives managers responsibility as well as allowing them flexibility on where money is spent as long as it is in budget. This is a benefit as the managers/people within the business making financial decisions are in the best position to make them due to the fact that they’re in charge of the department. Budgets can also be used as a comparison tool in order to measure how well the business is doing in comparison to its aims and objectives.


B) Types of budget

Historical budget – This is when the budget is based on previous year’s budgets. For example, if the budget was underspent in the last year then it will be cut for the present year.

Zero based budget – This is when the budget is not based on potential performance rather than previous budgets. Therefore managers must negotiate their budgets and justify why they need a certain amount of money.


C) Variance analysis

Favourable variance – This is when the manager underspends their budget. For example, if the manager’s budget was £2,000 and they only spent £1,500 then there would be a favourable variance of £500

Adverse variance – This is when the manager overspends their budget. For example, if the budget was £2,000 and the manager spent £3,000 then there would be an adverse variance of £1,000.


D) Difficult ties of budgeting:

Inflexible – The budget is a set amount of money that managers are able to spend and therefore can often be inflexible. This is unlikely to work for businesses that work in dynamic markets

Managers may spend up to the limit – If the business uses a historical budget then managers may spend up to the limit unnecessarily to make sure that there next year’s budget does not fall.

Time consuming – It can be very time consuming to make the budget as well as monitoring them and keeping them up to date.

Inter-department rivalry – There may be disputes between departments if they have been set different budgets.

Short-termism – By setting departments a budget it may make them focus on the short term to meet the budget rather than what is best for the long term future of the business.

Difficult to plan ahead – Businesses may be faced with many uncertainties making it difficult to plan ahead. For example, in industries such as farming unpredictable weather such as floods can have a massive impact on the business and therefore the budget also.

Demotivation – If the budget set is unrealistic it can make managers feel unmotivated as they will not be able to achieve it despite working hard.

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