Budgets are important. They allow an organisation to understand where its financial resources are coming from and to prioritise where they will be spent. They also act as an early warning system if things aren’t going according to plan. So overspending against your budget can be a problem. But it isn’t necessarily your fault. And here’s why.
1. You can’t control demand
If you’re creating a product, the costs that you incur will depend on how much of that product you create. And if you provide a service, the costs will depend on the number of people using your service.
Sometimes, greater demand equals greater costs – but also means more income, too. So as long as income and costs are rising roughly in proportion to each other, then you’ll probably not be too upset. It’s when costs are rising but income isn’t that the problems tend to start.
In such cases, if you can simply stop providing the product or service once you’ve maxed out against your budget, then fine. But if you can’t control demand and can’t just stop doing things – as is usually the case in the public services – then you have to keep spending money to meet that demand.
Take social care, for example. I can estimate at the beginning of the year how many people I think will need care and how much I think that care will cost. But I have little or no control over how many people actually end up needing care. And I can’t tell in advance how much that care will really cost me.
So unless I want to simply stop providing social care – which isn’t an option if I work, for example, for a local authority that is obliged to provide this care – then I just have to take the budget hit and hope that it doesn’t get too out of hand. This, I hardly need to say, will result in a budget overspend – and there’s nothing at all I can do about it.
2. Your ‘fixed’ costs weren’t as fixed as you thought
When preparing a budget for a given level of activity, we can regard some costs as essentially fixed for that general level of activity. Other costs will vary depending on the actual level of activity. Costs that are usually regarded as fixed are things like premises costs, insurance and management salaries. Variable costs might include raw materials, consumables and electricity usage.
Some fixed costs, though, are only fixed within a certain range of activity levels. If we go above some upper limit of activity, our costs could increase. These are called (rather unimaginatively, I’ll admit) ‘semi-fixed’ costs or ‘stepped’ costs.
Take the example of a university science course. I’ve estimtated that we’ll get fifteen students on the course and have budgeted on that basis. However, it turns out that twenty two students have signed up for the course. But the laboratory I was going to use can only take twenty students. So I’m going to need to use a bigger (and more expensive) laboratory or run each laboratory session twice.
If I’d recognised the stepped cost here, I could have limited the course to twenty students. And in this case I should have known, so it’s my fault. But there are other stepped costs that may not be apparent in advance. Or you might not be able to limit activity so that it remains on a given ‘step’. In such cases, you may not be able to prevent an overspend against budget due to the resulting increase in fixed costs.
3. You can’t control the costs
One of the tenets of good budgeting is that the person responsible for a particular budget should be able to control the costs included within that budget. However, not all accountants appear to have got that memo.
It is quite common, unfortunately, for budget holders to be held accountable for costs over which they have no control. This quite frequently includes things like internal recharges, where the cost of back-office functions like human resources and finance are recharged to front-line services.
Recharges are frequently made on the basis of cost drivers like headcount, so the bigger your department the greater the recharge imposed on it. The problem here is that the actual amount recharged can depend on how much the human resources or finance department (or whatever) actually costs to run. And that’s not something over which you have any control.
Some organisations, of course, come up with sensible ways of managing recharges so that budget holders know how much they’re going to pay. But many don’t. And some only reveal the level of recharges at (or after) the end of the financial year. This is very poor financial practice. And it drives me nuts.
4. You know how much, but not when
While budgets are frequently prepared for a whole year, it is sensible to monitor performance against them on a more frequent basis. This may be monthly, it may be weekly and it may – in some particularly fast-paced sectors – happen daily.
So when we budget for a particular cost, we need to know not only how much that cost will be, but also how it will be incurred and paid.
It’s quite common for costs to be spread across the year when budgets are compiled. This is called ‘profiling’. And absent any information to the contrary, it’s usual for the annual amount to be profiled evenly over the twelve months of the year.
If your costs aren’t spread evenly across the year, though, then it’s very easy to go over budget in one month, and then come in under budget the next. This is fine if you look at things in aggregate across the year. But if someone (your boss, for example) looks at just one month in isolation, it can present a less-than-flattering picture of your ability to manage your budget.
I always advise my clients to think carefully when profiling income and expenditure across the year. Otherwise, it leads to loss of confidence in budget monitoring. And it makes the budget-monitoring-as-an-early-warning-system practically worthless.
5. It’s the budget that’s wrong
It’s a sad fact of life that some budgets aren’t very good. They’re prepared by people who don’t understand the organisation, don’t understand how it works and don’t understand its income and expenditure streams.
This makes it highly unlikely that the budget represents an effective predictor of how incoming and outgoing financial resources will be generated and allocated. And so any attempt to monitor actual financial performance against the budget is going to lead to consternation.
It’s vitally important, therefore, that budget holders engage fully in the budget-setting process. Because if you don’t, you could end up with a budget that just cannot be achieved in the real world. And that’s not good for anyone.
While the above scenarios outline some ways in which an over- or underspend against budget may not necessarily be your fault, sometimes it will be your fault. In such cases, I’d suggest that you accept that these things happen, learn from it and move on. And hope that your accountant does the same.
* This is called the ‘accruals’ method of accounting. As opposed to the ‘receipts and payments’ method, where income is recorded when the cash is actually received and costs are recorded when the money is actually paid out.