‘We didn’t actually overspend our budget. The allocation simply fell short of our expenditure.’
Keith Davis, former American football player
In a nutshell
A budget is a financial and operational business plan. It is used to implement an organisation’s objectives by setting financial targets.
A forecast is an estimation of an organisation’s financial performance for specific periods in the future, for example the final quarter of the year.
Budgets are usually set annually in advance of a financial year, whereas forecasts are typically prepared more frequently and updated a number of times during a financial year.
Management accounts (see Chapter 31 Management accounts) will usually include a report of actual performance compared to budget and a forecast of the predicted activity level and results. The budget is used to benchmark past performance, whereas the forecast is used to predict future performance.
Need to know 
The format of the budget
The main budget (known as the master budget) follows the format of the primary financial statements. For example:
| Profit and loss account | Balance sheet | Cash flow |
|---|---|---|
Supported by:
| Supported by:
| Comprising:
|
Why is this important? 
Budgets and forecasts are important for the following reasons:
Planning
Even though actual results are often different from budgets and forecasts, the process of planning is an important business discipline. Successful businesses set themselves clear objectives during strategic planning. Setting and managing budgets and forecasts is helpful in trying to meet those objectives.
Identification and utilisation of scarce resources
The process of budgeting helps to identify scarce resources and other constraints that need to be carefully managed. For example, companies do not have unlimited cash reserves. The budget process will help allocate cash to those departments which can generate the most value.
Communication and coordination
All the areas of an organisation must fit and work together to drive the business in the right direction.
A budget gives a sense of the big picture. It is an effective way to communicate objectives to every area of a business and to make sure that everyone works towards the same goal.
Organisational control
Budgets provide a basis for authorising expenditure and delegating financial responsibility to ‘budget holders’. Budget holders can be classified by their responsibility, for example:
| Cost centres | Revenue centres | Profit centres | Investment centres |
|---|---|---|---|
| Responsible for managing and controlling costs. Most budget holders in practice will be cost centres. | Responsible for managing sales revenue, for example, a sales team. | Responsible for both sales and managing costs, for example, a retail outlet. | Responsible for managing profits as well as some balance sheet items, such as capital expenditure, credit customers and suppliers. For example, regional offices of multinationals. |
Budget holders can be motivated by being set realistic yet challenging targets. However, if the budget is too challenging this can sometimes have the reverse effect.
Performance measurement and evaluation
Budgets are a useful benchmark against which to measure and evaluate performance. Monitoring actual performance against budget is also an effective method of organisational control. It helps to ensure that income, expenditure and cash flows are managed and is good corporate governance (see Chapter 22 Corporate governance and whistleblowing).
Management can take corrective action against underperformance against budget (‘negative variances’) to steer the organisation back on track. Alternatively, performance improvements (‘positive variances’) can be encouraged, where desirable.
In practice most businesses will use the principle of ‘management by exception’, concentrating on variances above a certain percentage or amount.
Advance warning
Regular forecasting can help spot problems before they happen. Budgets rarely match reality and forecasts are needed to navigate unpredictable environments and steer the business back on course before it is too late. Cash flow forecasting, in particular, is critical as businesses may need to take short-term action to manage their cash position.
Budgeting and forecasting challenges
Time and money
The budget-setting process can take several months in some organisations and involves many finance and non-finance personnel. The budget-setting and monitoring process often results in a large cost for a business.
In 2021, APQC collected data on budgeting from more than 3,900 organisations and found that the bottom quartile of organisations took twice as long to complete their annual budget as the top quartile.1
Out of date
Ironically, despite budgets taking a long time to create, they are often out of date a few months into the new financial year as events unfold. Budgeting is usually an annual event and budget cycles do not always coincide with cycles in the business environment.
A constraint
In some organisations the budget can act as a constraint, in that once it is set, management does not allow any movement away from the budget. Some argue that this restricts creativity and means that businesses miss out on opportunities which were not foreseen when the budget was set. In addition, it is argued that an undue emphasis on the budget results in an overly internal focus.
Budgetary slack and padding
Budgets are a great measure of performance. However, if they are used by management as a target then (what is known as) Goodhart’s law can become an issue. ‘When a measure becomes a target, it ceases to be a good measure’.
Budget holders may be motivated to underestimate revenue and overestimate costs when setting budgets, to ensure they exceed their budget and receive a positive evaluation. This motivation may be enhanced when rewards such as bonuses are received for meeting or exceeding budgets.
If a significant percentage of budget holders attempt to pad their budgets, it will lead to inaccurate planning and potentially wasted resources.
As a further issue, it is likely that budget holders with built in contingency will spend close to their full allocation, due to the old adage ‘if you don’t use it, you lose it’. This is often evidenced by a surge of spending close to the accounting year end.
When is this important? 
In most organisations the budget-setting process takes place annually, several months before the year end. The process is usually a combination of ‘top-down’ guidance from senior management with ‘bottom-up’ input involving budget holders from every area of the business and centrally coordinated by the finance department.
During the financial year budget holders will receive regular reports, usually monthly, of their progress against their budget.
Forecasting on the other hand is more of a ‘top-down’ process undertaken by the finance department with input from selected budget holders. Forecasts usually take place either monthly or quarterly. This is illustrated in the diagram below.
In practice 
- ■Businesses should be aware of the drawbacks of budgeting and make efforts to avoid them where possible. For example, using additional measures of performance, such as efficiency and productivity or benchmarking against external relative targets versus fixed internal targets.
- ■Budgets should clearly identify those elements which are under the control of the budget holder and those which are not, for example centrally allocated overheads.
- ■Businesses should consider the time and resources required to build and monitor budgets as well as the level of detail required and ensure that the benefits of budgeting exceed its cost.
Nice to know 
Alternative methods of budgeting
Incremental
An incremental approach is where budgets are based on the previous year’s budget plus or minus a set percentage.
The advantage of this approach is that it is quick and involves less effort. It is the most common form of budgeting in organisations. The drawback is that any inefficiencies, padding or slack are carried forward.
Zero-based
The opposite of incremental budgeting is zero-based budgeting. This approach calculates the budget from a ‘zero base’, i.e. starting from scratch.
The advantage is that any inherited efficiencies can be eliminated and the budget is more accurate. The drawback is the time, resources and hence cost required to set the budget in this way.
In practice, an effective compromise is to zero base the budget every few years or alternatively to zero base different parts of the budget on a rotational basis each year, with the drawback that this can lead to inconsistency across the organisation.
Rolling
An alternative to a ‘fixed’ (or ‘periodic’) budget is a rolling (or ‘continuous’) budget, which re-budgets on a regular basis, usually monthly or quarterly. Each period the budget is updated, i.e. ‘rolled forward’. For example, see the illustration below.
The advantage is that new information is incorporated as events unfold and the budget is more up to date. Additionally, as budget holders are aware that the budget will be updated, they may be less likely to build in ‘contingencies for unplanned events’. The drawback is the time required each period to update the budget. However, supporters of rolling budgets argue that as budgeting takes place more regularly the time is simply spread over the year and doesn’t require as much ‘up front’ time.
Cisco Systems, Electrolux and General Electric are examples of companies who use rolling budgets in practice.
Rolling budgets are most effective when the budget period is continually extended for at least 12 months ahead as this reduces the ‘shrinking visibility’ problem of most fixed annual budgets (when budgets and forecasts do not extend beyond the financial year end). For fixed budgets, as the year end approaches the future time horizon ‘shrinks’ and organisations have less visibility of what lies ahead.
Some organisations opt for a compromise and use annual budgets together with rolling re-forecasts, continually extended at least 12 months ahead.
Optional detail 
The use of spreadsheets for budgeting
Many accounting systems have budgeting capability – however, in practice spreadsheets remain a well-used and popular budgeting tool.
Microsoft has previously reported that 40% of SMEs use Excel to prepare their accounts, forecasting and budgeting.
While spreadsheets are invaluable and flexible tools, it is important to be aware of their risks when budgeting and forecasting.
Professor Ray Panko of the University of Hawaii is one of the world’s leading experts on spreadsheet errors. In association with EuSpRIG (European Spreadsheet Risks Interest Group) Professor Panko notes that his research has found ‘ample evidence demonstrating that spreadsheet errors are common and nontrivial.’2
For example, in 2020, nearly 16,000 coronavirus cases went unreported in England due to a spreadsheet error by Public Health England.3
Also, in 2020 a report published by Grant Thornton revealed that a copy-and-paste error in a spreadsheet started a chain of events which ultimately delayed the opening of the new £150 million hospital in Edinburgh.4
In practice, most spreadsheet errors are caused by simple mistakes such as including too many or too few figures in totals or adding figures that ought to be subtracted. The importance of error checking cannot be underestimated.
Beyond budgeting
Operating since 1998, the Beyond Budgeting Round Table (BBRT), an independent research collaborative, has proposed that budgeting, as it is currently practised by most organisations (a traditional command and control management model), should be abandoned.
Beyond Budgeting principles of ‘empowerment’ and ‘being adaptive’ have attracted organisations from all over the world, including American Express, Google, Handelsbanken, John Lewis Partnership, Southwest Airlines and Toyota.
BBRT assert that their principles help organisations to ‘break free from the shackles of budgeting and its culture of gaming and misinformation’. They suggest that planning is undertaken on a continuous, participative basis and only high-level forecasts are needed.
BBRT suggest that performance evaluation should be based on relative performance indicators which take account of the conditions, including long-term external benchmarks, under which the business is operating.5
Reflect and embed your understanding 
- 1What is the biggest challenge of successful budgeting?
- 2The challenges of budgeting are widely debated and understood. What can organisations do to overcome these issues?
- 3Reflect on why spreadsheets remain such a popular tool for budgeting and forecasting, despite the well-documented risks.
For the authors’ reflections on these questions please go to financebook.co.uk
Where to spot in company accounts 
Budgets do not feature in company accounts.
Public company announcements may include forecasts of their year-end results and sometimes future outlook.
Consolidate and apply
To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36 (p. 432).
Watch out for in practice 
- →Does the budget setting process coincide with the strategic planning process? An ideal budget should follow an organisation’s objectives and be linked to its strategy.
- →Is the budget setting process ‘top-down’, ‘bottom-up’ or a combination of both? There are disadvantages of both extremes. Realistic budgets will involve a degree of iteration between the top and bottom of an organisation.
- →Budget holders incorporating ‘padding’ or ‘slack’ during the budget setting process.
- →An escalation of expenditure by budget holders towards the year end. This could be evidence of a ‘use it or lose it’ mentality, where budget holders spend their full cost budget each year to avoid it being cut in future years. This can result in carried forward inefficiencies in incremental budgets.
- →Does management take corrective action upon finding variances from budget? If variances are not followed up there is a risk that they are deemed ‘acceptable’.
1apqc.org/resource-library/resource/cycle-time-days-complete-annual-budget
3bbc.co.uk/news/technology-54423988