Functional budget

Functional budget shows revenues and expenses for each separate functional area. In a business, the major functional areas are marketing, finance, and production. In a nonprofit, these might be development, finance, and services. The services subunit can then be further broken down into program subunits, if desired. The main advantage is that each area can be held responsible for costs, revenues versus costs, or net revenue versus investment.

The functional budget delivers a better understanding of what funds are to be spent. It combines information about inputs and responsibility centres or programs that are being funded. It also permits a certain amount of cross-program comparison within the overall budget of the organization.

Components of functional budget

The following are the components of a functional budget:

• Objectives: A functional budget outlines the organization's objectives and goals. This includes both short-term and long-term objectives, and the budget should be tailored to help the organization meet these goals.
• Cost Analysis: A cost analysis is used to determine the cost of goods and services necessary to meet the objectives. This includes the cost of materials, labor, and equipment.
• Revenue Forecast: A revenue forecast is used to determine how much money the organization can expect to make from sales and other revenue sources. This helps to determine how much money should be allocated to each functional area.
• Budgeting Process: The budgeting process involves estimating the costs and revenues associated with each functional area. This helps to determine how much money should be allocated.

Overall, a functional budget is an important tool used to allocate resources to different areas of an organization according to their activities and goals. It is used to determine the cost of goods and services, forecast revenues, and create a budgeting process. This helps to ensure that the organization is spending money in the most effective and efficient manner.

Example of Functional budget

The following is an example of a functional budget for a small business:

• Objectives: Increase revenues by 10% over the next 3 months and reduce expenses by 5%.
• Cost Analysis: Research the cost of materials, labor, and equipment needed to meet the objectives.
• Revenue Forecast: Estimate the expected amount of revenue from sales and other sources.
• Budgeting Process: Allocate a certain percentage of the budget to each functional area and consider any changes that need to be made to meet the objectives.

This example of a functional budget outlines the objectives, cost analysis, revenue forecast, and budgeting process of a small business. It is used to ensure that the organization is making the most efficient use of its resources and to help it meet its goals.

Formula of Functional budget

The formula for a functional budget is as follows:

Functional Budget = Objectives + Cost Analysis + Revenue Forecast + Budgeting Process

When to use Functional budget

Functional budgets should be used when an organization wants to allocate resources to different areas of the business. This is useful for organizations that need to allocate resources to different departments or functional areas in order to meet their goals. It provides a way to track and manage spending, and helps to ensure that resources are being used efficiently and effectively. Functional budgets can also be used to forecast future performance and to plan for future investments.

Types of the functional budgets

Functional budgets are prepared for each function and they are subsidiary to the master budget of the business. Types of the functional budgets to be prepared will vary according to the size and nature of the business. The commonly used functional budgets are:

• Sales budget
• Production budget
• Plant utilisation budget
• Direct materialusage budget
• Direct material purchase budget
• Direct labour budget
• Factory overhead budget
• Production cost budget
• Ending-inventory budget
• Cost of goods sold budget
• Selling and distribution cost budget
• Administration expenses budget
• Research and development cost budget
• Cash budget

Steps of Functional budget

The steps of a functional budget include:

• Establishing the Budget: This involves determining the organization's objectives and identifying the resources that need to be allocated in order to meet these objectives.
• Forecasting Revenue: Forecasting revenue is used to determine how much money the organization can expect to make from sales and other revenue sources. This helps to determine how much money should be allocated to each functional area.
• Estimating Costs: Estimating costs helps to determine the cost of goods and services necessary to meet the objectives. This includes the cost of materials, labor, and equipment.
• Budget Formulation: Budget formulation involves creating a plan that outlines how the budget should be allocated to each functional area. This is used to ensure that the organization is spending money in the most effective and efficient manner.

Overall, the steps of a functional budget involve establishing the budget, forecasting revenue, estimating costs, and budget formulation. This helps to ensure that resources are allocated in the most effective and efficient manner, according to the organization's objectives.

Advantages of Functional budget

Functional budgeting has several advantages for an organization. These include:

• Improved Performance: By tracking costs and revenues for each functional area, an organization can identify areas where it can improve its performance. This can lead to increased efficiency and higher profit margins.
• Cost Control: Functional budgeting allows an organization to better control costs by identifying areas where costs can be reduced or avoided. This can help to reduce overhead costs and increase profits.
• Financial Planning: Functional budgeting helps to ensure that the organization is properly allocating funds according to its objectives. This can help to ensure that the organization is making wise financial decisions and is better positioned for future growth.

Limitations of financial budget

There are several significant limitations to the functional budgets. Structure limits management's ability to discern the spending flow in terms of the total operation. Knowing 'what spending is for' is equally as important to management as knowing ' how money is being spent' ( i.e. function, salaries, travel and other). For example, since that is a multi-product firm, the knowledge of planned expenditure for individual products, especially when considered in relation to forecasted sales, would be as valuable to management planning, controlling and decision-making as the knowledge of the function and object for which spending occurs.

The example of the advertising division illustrates the inability of the functional budget to provide product information. Although the total advertising costs for a product line are identified, the structure does not provide any indication of the planned spending for individual products. Even though advertisements do cover an entire product line, a large number of individual product advertisements are included with the total product line costs: consequently, they cannot be easily separated.Thus, the identification of the total marketing spending for a specific product is virtually impossible under the functional budgets structure.

Other limitations include:

• Dependence on Estimates: Functional budgets are based on estimates and forecasts, which can be inaccurate or imprecise. This can lead to over - or under-budgeting, which can affect the organization's ability to meet its objectives.
• Unforeseen Events: Unforeseen events can have a significant impact on the budget, as they may require additional funds to be allocated. This can make it difficult to predict the exact amount of money that will be needed.
• Inflexibility: Functional budgets are not flexible and cannot be quickly adjusted if needed. This can lead to inefficient use of resources, as the budget might not be able to accommodate changes in the organization's needs.

Other approaches related to Functional budget

• Activity-Based Budgeting: Activity-based budgeting is a process that uses a budget to allocate resources to different activities, depending on the goals and objectives of the organization. This approach takes into account both the direct and indirect costs associated with each activity, which helps to ensure that resources are allocated in the most effective manner.
• Zero-Based Budgeting: Zero-based budgeting is a process that starts with a "zero" base and requires justification for each expenditure. This approach is used to create an effective budget that meets the organization's objectives while minimizing unnecessary spending.
• Flexible Budgeting: Flexible budgeting is an approach that allows a budget to be adjusted as needed in response to changes in the external environment. This helps to ensure that the budget is adapted to meet the changing needs of the organization.

Overall, there are several approaches related to functional budgeting that can be used to create an effective budget for an organization. Activity-based budgeting, zero-based budgeting, and flexible budgeting are three of the most commonly used approaches. Each approach has its own advantages and disadvantages, so it is important to choose the one that best fits the organization's needs.

Footnotes

Functional budget — recommended articles

Master budget — Committed cost — Cash Budget — Cost element — Cost behavior — Differential costing — Costing system — Fixed budget — Allocated cost

References

• Graham A., (2014). Canadian Public-Sector Financial Management, McGill-Queen's University Press, Ottawa.
• Hankin J.A., Seidner A., Zietlow J., (1998). Financial Management for Nonprofit Organizations, John Wiley & Sons, Toronto.
• Tulsian P.C., Tulsian S.D., (2002). Commercial Studies & Application, Ratna Sagar, Delhi.
• Wilson R.M., (2016). Financial Dimensions of Marketing, Macmillan International Higher Education, Sheffield.

Author: Dawid Barcik