Nature and purpose of budgeting: formula sheet

Key formulas

Definition of a budget

Budget = quantified plan for a future period, approved in advance

Use this to open any short answer. It is a plan, not a forecast. A forecast predicts what may happen; a budget sets what management intends to happen.

Six purposes (memory aid)

Plan, Coordinate, Communicate, Control, Motivate, Authorise

Check scenario wording against each word. Also remember evaluation of performance if the question lists it.

Control loop

Variance = difference between actual and budget, labelled favourable or adverse by its effect on profit

The sign depends on the item. For income and profit, actual above budget is favourable. For costs, actual above budget is adverse. Budgetary control means comparing, investigating and acting.

Principal budget factor

Principal budget factor = the factor that limits activity in the budget period

Also called the limiting factor or key budget factor. It is budgeted first. It can change from one period to the next.

Order of the budget process

Objectives → guidelines → identify principal budget factor → prepare that budget → prepare other budgets → coordinate and review → master budget → approve → monitor

Learn the order. Objective tests often ask which step comes first or next.

Master budget

Master budget = budgeted income statement + budgeted statement of financial position + cash budget

It summarises all the functional budgets.

Budget committee role

Budget committee = coordinates, reviews and approves budgets, and resolves conflicts between departments

It usually includes senior managers from each major function, often chaired by the managing director.

Budget manual role

Budget manual = written instructions on how and when budgets are prepared

It sets out responsibilities, timetable, forms, and the approval and revision procedures.

Top-down budget

Set by senior management → passed down to budget holders

Pros: fast, strategic fit. Cons: low commitment, ignores local knowledge.

Participative budget

Budget holders propose figures → negotiated with senior management

Pros: motivation, better information. Cons: slow, slack, possible bias.

Incremental budget

New budget = last period's figure × (1 + expected change) ± known adjustments

Assumes the existing cost base is justified.

Zero-based budget

Each activity justified from zero → decision packages ranked → resources allocated by rank

Used when waste must be challenged, e.g. discretionary costs.

Budgetary slack

Slack = budgeted cost − cost actually needed (or needed revenue − budgeted revenue)

Created deliberately by budget holders, often under participation.

Variance

Variance = Actual − Budget (or Budget − Actual, depending on convention)

Label each variance as favourable (F) or adverse (A). A cost below budget is favourable. Revenue above budget is favourable.

Feedback control

Actual results vs budget, after the event, then corrective action

Backward-looking. Based on variances.

Feedforward control

Forecast results vs budget, before the event, then preventive action

Forward-looking. Based on forecasts.

Responsibility centre scope

Cost centre: costs. Revenue centre: revenue. Profit centre: costs and revenue. Investment centre: profit and capital invested

Match the manager's authority to what they are judged on.

Controllable cost test

Controllable if the manager can influence it in the period; otherwise uncontrollable

Controllability depends on the manager and the time frame. A cost can be controllable for one manager and not for another.

Quick revision

• A budget is a quantified plan for a future period; a forecast is a prediction of what is likely to happen.
• Main purposes: planning, coordination, communication, motivation, control, and authorisation of spending.
• The principal budget factor is the factor that limits activity; it is often sales demand, but can be labour, materials or cash.
• The budget for the principal budget factor is prepared first, and the other budgets are built around it.
• Incremental budgeting starts from last period's figures and adjusts them; it is simple but can carry forward waste.
• Zero-based budgeting starts from zero, and every activity must be justified; it takes more time.
• Rolling budgets are updated regularly, adding a new period as one ends.
• Participative budgeting raises motivation and commitment but can lead to budgetary slack.
• Imposed budgets are set by senior management; they are quick but may reduce commitment.
• Control works by comparing actual results with budget, finding variances and taking action.
• A manager should be held accountable only for items they can control (controllability principle).
• Responsibility centres: cost centre (costs), revenue centre (revenue), profit centre (costs and revenue), investment centre (profit and assets).

Common mistakes

• Treating a budget as a forecast. Fix: Remember a forecast is a prediction. A budget is a plan management commits to and tries to achieve.
• Confusing coordination with communication. Fix: Coordination means aligning activities so plans fit together. Communication means passing targets and expectations to managers.
• Assuming sales demand is always the principal budget factor. Fix: Always compare demand with resource availability. Sales is the limit only if resources are enough to meet demand.
• Preparing the production budget first by default. Fix: Budget the limiting factor first. Production can only be planned once you know the limit on sales or resources.
• Treating top-down and incremental as the same thing. Fix: Top-down is about who sets the budget. Incremental is about the starting point of the figures. A budget can be both.
• Saying participative budgets always remove slack. Fix: Participation raises commitment but gives budget holders the chance to pad. Review and challenge are needed.
• Calling any budget comparison feedforward. Fix: Check the timing. Actual against budget after the event is feedback. Only forecast against budget before the event is feedforward.
• Treating a profit centre as an investment centre. Fix: An investment centre manager also controls capital investment and is judged on profit relative to capital employed.

Exam tips

• Match the scenario's action word to a purpose before looking at the options.
• In multiple response questions, read the required number of answers first and select exactly that number.
• Keep short written answers to three parts: name the purpose, explain it, tie it to the scenario.
• Expect questions on conflicts between purposes, especially control versus motivation.
• Do not confuse budgets with forecasts or standards; examiners use these as distractors.
• Read the data and test every resource against demand before naming the limiting factor. Do not guess sales.
• For multiple response questions, select exactly the number asked. Wrong extra choices cost the whole mark.
• Remember that questions on committee versus manual usually test who does what. Committee means people and approval. Manual means written rules.