Notes · AccountingUK · A-Levels

Budgeting and budgetary control

This chapter opens the management-accounting half of the course. It explains why businesses budget, how to prepare a cash budget and other functional budgets, how budgetary control compares actual results with a flexed budget to produce meaningful variances, and the behavioural benefits and limitations of budgeting - always pairing the numbers with their interpretation.

4 sections~17 min reading time3 competenciesLevel Standard 2 · Advanced 2

T·121212 / 18

Exam profile

AO1 · Understand the purpose, benefits and methods of budgetingAO2 · Prepare a cash budget and other functional budgets and flex a budget to actual activityAO3 · Analyse and evaluate the benefits, limitations and behavioural effects of budgeting

Operators:preparecalculateexplainanalyseevaluaterecommend

basic level

AS-Level expects the purpose of budgeting and the preparation of a cash budget.

higher level

The full A-Level expects flexed budgets, budgetary control and evaluation of the behavioural aspects and limitations of budgeting.

Depth

Text

Contents · 4 sections

Budgeting and budgetary control

The purpose and benefits of budgeting#

StandardAQA 7127 3.9

The budgetary control cycle

Fig. 1Budgeting is a cycle: objectives are turned into budgets, actual results are compared against them, variances are analysed and acted on, and the objectives are refined.

A budget is a financial plan for a future period, setting out the expected revenues, costs, cash flows or output of the business or a part of it. Budgeting turns the organisation's objectives into quantified, time-bound targets, and it does so before the period begins so that action can be planned rather than merely reacted to. The functional budgets - sales, production, purchases, labour, overheads and, crucially, the cash budget - are drawn together into a master budget, a projected income statement and statement of financial position for the coming period. Budgeting is thus the practical link between a firm's strategy and its day-to-day operations.

Budgets serve several distinct purposes, and a good answer distinguishes them rather than treating 'budgeting' as one thing. They plan the use of resources in advance; they coordinate the different functions so that, for example, production is geared to expected sales and finance is arranged to fund it; they communicate targets and expectations down the organisation; they motivate managers by giving them targets to aim at and responsibility for a part of the plan; they authorise spending up to agreed limits; and - the purpose that dominates budgetary control - they provide the benchmark against which actual performance is later measured. The same budget can serve all these purposes, which is part of its value and part of its difficulty.

The benefits that flow from budgeting are considerable. It forces managers to look ahead and anticipate problems (a projected cash shortfall, a capacity constraint) while there is still time to act; it improves the coordination and communication between departments; it clarifies responsibility and can motivate through the achievement of targets; it provides a basis for control and for holding managers accountable; and it supports requests for finance by showing lenders a costed plan. A well-run budgeting process imposes a discipline of forethought and coordination that a business managed purely reactively would lack.

There are different approaches to setting budgets, and the choice affects both the effort involved and the control achieved. Incremental budgeting takes last period's figures and adjusts them for expected changes; it is quick and simple but risks perpetuating past inefficiencies and 'budget padding'. Zero-based budgeting starts each budget from zero and requires every item of expenditure to be justified afresh; it controls costs far more tightly and questions whether each activity is worthwhile, but it is time-consuming and can be demoralising if overused. The right approach depends on the stability of the business and the importance of tight cost control, and evaluating that choice is a typical higher-mark task.

Worked example

Choosing a budgeting approach

A firm under pressure to cut costs is deciding between incremental and zero-based budgeting for its overheads. Recommend an approach, with reasons.

Weigh incremental budgeting
Incremental budgeting is quick and cheap but simply carries forward last year's overheads with an adjustment, so it risks perpetuating the very inefficiencies the firm wants to cut.
Weigh zero-based budgeting
Zero-based budgeting requires each overhead to be justified from zero, forcing managers to question whether each activity is worthwhile - directly serving the cost-cutting objective, though it takes considerable time and effort.
Recommend and evaluate
Because the priority is tight cost control, recommend zero-based budgeting for the overheads, at least as a periodic exercise; the extra time is justified by the savings and the discipline it imposes, but the firm should guard against it demoralising managers if applied to everything every year.

Result: Zero-based budgeting is recommended for the overheads because it forces every cost to be justified and so serves the cost-cutting aim - accepting that its cost in management time means it may be best used periodically rather than for every budget every year.

Typical mistakes

Listing 'planning' as the only purpose of budgeting and omitting coordination, motivation and control.
Describing zero-based budgeting as simply 'starting from zero' without explaining the justification of each item and its cost in time.

Active revision

Explain three benefits a growing manufacturer would gain from introducing a formal budgeting system.

Active recall

Recall the key points — then reveal.

Sources: AQA A-level Accounting 7127 specification (AQA)

Preparing the cash budget#

StandardAQA 7127 3.9

A three-month cash budget

Fig. 2The cash budget reveals a deficit in January and February (negative closing balances) before recovery in March - a shortfall the firm can now plan to bridge.

The cash budget is the most important functional budget for survival, because it forecasts the actual movement of cash into and out of the business month by month and reveals in advance when the firm might run short of cash. It is built, for each period, from the opening cash balance, the total cash receipts, the total cash payments, the net cash flow (receipts less payments) and the closing balance (opening balance plus net cash flow), where each period's closing balance becomes the next period's opening balance. Because it deals in cash, not profit, it recognises the timing of receipts and payments - customers paying after a delay, suppliers paid on credit - which is exactly what determines whether a business can pay its way.

Preparing a cash budget accurately depends on getting the timing right. Receipts are entered in the month the cash is actually received, not the month of sale - so a credit sale made in January but paid for in March appears as a March receipt. Payments are entered when cash actually leaves - so goods bought on two months' credit in February are paid for in April. Non-cash items such as depreciation never appear in a cash budget, because no cash moves. Capital items (buying a machine, receiving a loan, injecting capital, paying dividends) do appear, because they involve cash. Distinguishing cash flows from the profit-based figures of the income statement is the central skill and the commonest source of error.

A worked example shows the mechanism and its value. Suppose a business begins January with £4,000 of cash and forecasts receipts of £20,000, £25,000 and £34,000 and payments of £26,000, £24,000 and £30,000 for January, February and March. January's net cash flow is £20,000 - £26,000 = -£6,000, taking the closing balance to £4,000 - £6,000 = -£2,000. February's opening balance is that -£2,000; its net flow is £25,000 - £24,000 = +£1,000, giving a closing balance of -£1,000. March's opening balance is -£1,000; its net flow is £34,000 - £30,000 = +£4,000, giving a closing balance of +£3,000. The budget reveals a cash deficit in January and February before recovery in March.

The point of preparing the budget in advance is that the forecast deficit can be managed before it becomes a crisis. Seeing the negative closing balances for January and February, the firm can arrange an overdraft facility to cover them, chase customers to pay earlier, negotiate longer credit from suppliers, delay non-essential spending, or reschedule a capital payment - all actions that are only possible because the shortfall was anticipated. This is the whole purpose of the cash budget: to turn an invisible future risk into a visible, manageable one, so that a fundamentally sound business is not sunk by a temporary, foreseeable cash gap.

\text{Net cash flow} = \text{Cash receipts} - \text{Cash payments}

Net cash flow

Only actual cash movements - never depreciation. Capital receipts and payments are included.

\text{Closing balance} = \text{Opening balance} + \text{Net cash flow}

Closing balance

Becomes the next period's opening balance. A negative closing balance flags a cash shortfall to plan for.

Worked example

Preparing a cash budget

A firm begins January with £4,000 cash. Forecast receipts: January £20,000, February £25,000, March £34,000. Forecast payments: January £26,000, February £24,000, March £30,000. Prepare the cash budget and advise.

January
Net cash flow = £20,000 - £26,000 = -£6,000. Closing balance = £4,000 - £6,000 = -£2,000 (an overdraft).
February and March
February: opening -£2,000; net = £25,000 - £24,000 = +£1,000; closing -£1,000. March: opening -£1,000; net = £34,000 - £30,000 = +£4,000; closing +£3,000.
Advise
The budget shows the firm needs cash of up to £2,000 in January and remains in deficit through February before recovering in March. It should arrange an overdraft of at least £2,000, or bring receipts forward or defer a payment, to cover the shortfall it now knows is coming.

Result: Closing balances are -£2,000, -£1,000 and +£3,000: the firm faces a temporary cash deficit in the first two months and should arrange an overdraft of about £2,000 in advance - the value of budgeting the cash flow ahead of time.

Typical mistakes

Including depreciation or entering a sale in the month of sale rather than the month of receipt.
Carrying the wrong figure forward - each month's closing balance is the next month's opening balance.

Active revision

A business opens January with £4,000. Forecast receipts are £20,000 (Jan), £25,000 (Feb), £34,000 (Mar); payments are £26,000, £24,000, £30,000. Prepare the cash budget and advise on the cash position.

Active recall

Recall the key points — then reveal.

Sources: AQA A-level Accounting 7127 specification (AQA)

Budgetary control: fixed and flexed budgets#

AdvancedAQA 7127 3.9

Flexing a budget

Fig. 3Flex before you compare: against the flexed budget for 12,000 units (profit £46,000), the actual profit of £38,000 is £8,000 adverse - not the £8,000 favourable a naive comparison with the original budget would suggest.

Budgetary control is the process of comparing actual results with the budget, calculating the differences (variances), and acting on them. But a naive comparison of the actual results with the original budget can be seriously misleading if the actual level of activity differed from the level assumed in the budget. If a firm budgeted for 10,000 units but actually made and sold 12,000, its actual costs will of course be higher than budgeted simply because it did more - and comparing the two would wrongly suggest cost overruns. The solution is to flex the budget before comparing.

A fixed budget is the original budget, set for one planned level of activity, and it is not changed. A flexed (flexible) budget recasts the budget for the actual level of activity, applying the budgeted revenue and variable cost per unit to the actual output while keeping fixed costs unchanged. This makes a like-for-like comparison possible: the flexed budget shows what the revenues and costs should have been for the activity actually achieved, so that the variance from the actual results reflects genuine differences in performance (efficiency, prices, spending) rather than the mere difference in volume.

A worked flexed budget shows why this matters. Suppose the original budget for 10,000 units was sales £200,000 (£20 each), variable costs £120,000 (£12 each) and fixed costs £50,000, giving a budgeted profit of £30,000. Actual output was 12,000 units. Flexing the budget to 12,000 units gives expected sales of £240,000, expected variable costs of £144,000 and unchanged fixed costs of £50,000, so the flexed budget profit is £46,000. If the actual results at 12,000 units were sales £240,000, variable costs £150,000 and fixed costs £52,000, actual profit is £38,000. The meaningful comparison is the flexed budget (£46,000) against the actual (£38,000) - an adverse profit variance of £8,000, made up of £6,000 of extra variable costs and £2,000 of extra fixed costs.

The lesson is that you must flex before you compare, or the variances are meaningless. Comparing the original budgeted profit (£30,000) with the actual (£38,000) would misleadingly suggest the firm did £8,000 better than planned, when in truth, once the higher volume is accounted for, it did £8,000 worse than it should have. Flexing separates the effect of doing more or less (a volume difference, planned by the sales function) from the effect of controlling costs and prices (an efficiency and spending difference, the responsibility of operational managers). This separation is what makes budgetary control a fair basis for holding managers accountable, and it leads directly into the detailed variance analysis of the next chapter.

\text{Flexed budget cost} = (\text{Variable cost per unit} \times \text{Actual units}) + \text{Fixed costs}

Flexing a budget

Apply the budgeted variable cost per unit to the actual output; keep fixed costs unchanged. Then compare with actual results.

Worked example

Flexing a budget and finding the variance

A firm budgeted for 10,000 units (sales £200,000, variable costs £120,000, fixed costs £50,000) but made 12,000 units, with actual sales £240,000, variable costs £150,000 and fixed costs £52,000. Flex the budget and calculate the profit variance.

Find the per-unit rates
Budgeted selling price = £200,000 / 10,000 = £20; budgeted variable cost = £120,000 / 10,000 = £12 per unit. Fixed costs £50,000 do not vary.
Flex to 12,000 units
Flexed sales = 12,000 x £20 = £240,000; flexed variable costs = 12,000 x £12 = £144,000; fixed costs £50,000. Flexed profit = £240,000 - £144,000 - £50,000 = £46,000.
Compare with actual
Actual profit = £240,000 - £150,000 - £52,000 = £38,000. Variance = flexed £46,000 - actual £38,000 = £8,000 adverse (variable costs £6,000 over, fixed costs £2,000 over).

Result: The flexed budget profit for 12,000 units is £46,000; actual profit is £38,000, an £8,000 adverse variance - revealing genuine cost overruns that a naive comparison with the original £30,000 budget would have hidden.

Typical mistakes

Comparing the original budget with actual results without flexing for the difference in volume.
Flexing the fixed costs as though they varied with output - only variable costs and revenue are flexed.

Active revision

Original budget (10,000 units): sales £200,000, variable costs £120,000, fixed costs £50,000. Actual (12,000 units): sales £240,000, variable costs £150,000, fixed costs £52,000. Flex the budget and calculate the profit variance.

Active recall

Recall the key points — then reveal.

Sources: AQA A-level Accounting 7127 specification (AQA)

Behavioural aspects and the limitations of budgeting#

AdvancedAQA 7127 3.9

Budgets are prepared and used by people, so they have powerful behavioural effects that can help or hinder the business. Used well, a budget motivates: a challenging but achievable target that a manager has helped to set gives a clear goal and a sense of ownership, and meeting it is satisfying. Used badly, a budget demotivates and distorts behaviour. Targets imposed from above without consultation breed resentment; targets set too high seem unattainable and are abandoned; targets set too low fail to stretch. The way a budget is set - participative versus imposed - therefore matters as much as the numbers in it, and this is a favourite area for evaluation.

Budgets can also encourage dysfunctional behaviour that undermines the firm's real interests. Managers may build 'slack' into their budgets - overstating costs or understating revenues - so that the target is easy to beat and they look good, which wastes resources and corrupts the plan. They may 'spend up' to their budget near the year end on unnecessary items so that next year's allocation is not cut, whatever the true need. They may pursue their own department's budget target at the expense of the business as a whole, or manipulate the timing of transactions to hit a target. These behaviours are rational responses to how budgets are used, and controlling them is part of designing a good budgeting system.

There are further limitations that support a balanced evaluation. A budget is only as good as the forecasts and assumptions behind it; an unrealistic budget produces meaningless variances and misleads rather than informs. Budgets take time and money to prepare and monitor, and in a fast-changing environment a fixed annual budget can become obsolete and constrain a firm from responding to opportunities or threats - a rigidity that has led some organisations to adopt rolling budgets or to move 'beyond budgeting' altogether. And an over-emphasis on hitting short-term budget targets can crowd out longer-term investment in things like training, research and maintenance that do not pay off within the budget period.

The balanced conclusion is that budgeting is valuable but must be handled with care, and the best practice addresses each weakness. Budgets should be realistic and, where possible, participative, to motivate rather than alienate; attention should focus on the significant variances (management by exception) and on investigating their causes rather than apportioning blame; budgets should be revised when circumstances change materially, so they remain a live tool rather than a straitjacket; and they should be set in the context of the firm's longer-term objectives so that short-term targets do not sabotage long-term health. Handled this way, budgeting's benefits of planning, coordination, motivation and control outweigh its costs - but the handling is decisive, which is exactly the kind of judgement the top bands reward.

Worked example

Evaluating budget slack

A divisional manager builds slack into his budget by overstating expected costs, then comfortably beats the budget each year. Analyse the effect on the business and recommend how to reduce this behaviour.

Explain the behaviour
Budget slack is deliberately setting an undemanding target - here by overstating costs - so that actual results easily beat the budget and the manager appears to perform well.
Analyse the effect
Slack wastes resources (money is allocated that is not needed and may be spent up), distorts the master budget and its coordination, and produces meaningless favourable variances that hide the division's true potential.
Recommend a response
The firm could scrutinise and challenge budget submissions (or use zero-based budgeting to justify each cost), compare with external benchmarks and prior trends, and reward realistic forecasting rather than simply beating the budget - so that accuracy, not slack, is incentivised.

Result: The slack wastes resources and produces hollow favourable variances; the remedy is to challenge budget submissions, benchmark them, and reward accurate forecasting rather than merely beating an undemanding target.

Typical mistakes

Treating budgets as purely technical and ignoring their behavioural effects on managers.
Presenting budgeting as either wholly good or wholly bad rather than a valuable tool whose success depends on how it is used.

Active revision

A manager consistently overstates the costs in his budget so he can beat it easily. Explain the behaviour, its effect on the business, and how the budgeting process could discourage it.

Active recall

Recall the key points — then reveal.

Sources: AQA A-level Accounting 7127 specification (AQA) · Ofqual - GCE AS and A level qualifications (Ofqual)

References & sources

Sources

AQA

AQA A-level Accounting 7127 specification

Ofqual

Ofqual - GCE AS and A level qualifications

Budgeting and budgetary control

4 sections~17 min reading time3 competenciesLevel Standard 2 · Advanced 2

Budgeting and budgetary control

Key points

Choosing a budgeting approach

Key points

Preparing a cash budget

Key points

Flexing a budget and finding the variance

Key points

Evaluating budget slack

Sources

Budgeting and budgetary control

Key points

Choosing a budgeting approach

Key points

Preparing a cash budget

Key points

Flexing a budget and finding the variance

Key points

Evaluating budget slack

Sources