Benefits of budgeting

Budgets are a financial representation of an organisation’s strategy. The process of budgeting requires managers to plan ahead, for example, to identify the resources required to meet targets. This is particularly important in the insurance industry due to the complex nature of the products offered. Insurance generally addresses medium- and long-term needs of customers. Decisions taken now are likely to have financial implications for many years to come.

For example, in the UK, Zurich offers a protection product which provides a payment in the event of the death of the policyholder to pay off an outstanding mortgage. Typically, this product offers protection for 15 to 25 years. Zurich guarantees a price to the policyholder for the whole term. If the outcome is different to that which was assumed when the price was set (e.g. fewer or more deaths occur or fewer or more policies are cancelled than expected), Zurich will either make a profit or a loss on that product. Due to the long-term nature of these products any profit will emerge over many years.

Analysing variances

The budgeting process can be used for monitoring and control of financial performance. Results can be reviewed as frequently as necessary against budgets to identify good and poor performance areas. Managers need to investigate the difference or variance between budgeted and actual results.

Where actual figures are worse than budgeted, these are called adverse variances. Adverse variances may suggest problems. Where budgets are not being met, action can be taken. Budget targets can be highly motivational and staff who meet or exceed budgeted targets may be rewarded with bonuses.

Challenges of effective budgeting

Suppose sales volume, prices and costs were all projected to rise annually by 10% (incremental budgeting). This would make budgeting easy, but it is highly unlikely. To increase sales may require price reductions and discounts. Successive rises in sales volume might bring economies of scale, but might need investment to expand production in order to meet that demand.

Effective budgeting is full of challenges. Whilst financial accounts relate to the past, budgets are about the future. All data is therefore planned rather than actual, probable rather than definite.

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