Budgeting Budgeting Theory Public Sector Budgeting Theory and Strategy
Main Types of Budget Environment and Objectives Overview of the Relationship between Budgeting and Strategy
Formulation, Long Term Planning and Control The Strategy Formulation Process: Theory Long Term or Strategic Planning in
the Public Services Medium Term Planning Short Term Planning Integrating Long Term with Medium and Short Term
Planning Integrating Medium Term Planning with Annual Budget Setting Sources of Further Information
March 2008
Public Sector Budgeting Theory and Strategy
This section summarises the main types of budget, identifies how budgeting links in with long and medium term planning,
and demonstrates how budgeting can be used in the effective management of a public sector body.
Main Types of Budget
Budgets can cover a variety of activities and purposes. Each budget type will be produced for a specific reason and there will
be differences in content and approach:
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budgets can be produced for either capital or revenue; resource budgets (e.g. for labour) can also be produced. This
would be seen as a way of planning or controlling labour inputs;
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budgets can be produced for sales, income and revenues;
working capital budgets, e.g. for stock or cash. It is essential that cash flow is effectively managed and the optimum
benefit obtained from cash resources. Budgets for stock, debtors and creditors can be seen as a way of controlling
the use of current assets and liabilities;
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aggregate or consolidated budgets can be prepared for the organisation as a whole;
budgets can be subjective based (i.e. what expenditure is on, e.g. wages, premises or supplies) or objective based
(i.e. what the budget is being spent on, e.g. the cost charged to a particular service or activity). The latter is usually
preferred as it enables decision makers make rational choices but the former is simpler from the control perspective.
These budgets can be produced at multiple levels throughout the organisation for example, at a service level, for a
group of services or a single unit.
Environment and Objectives
Public and private sector organisations operate in different environments and some of the approaches taken to budget
setting will differ. Some of the essential differences between the two sectors are summarised in the table below.
Private and public sector objectives - a comparison
Private sector
Public sector
Market driven
Resource constrained (i.e. funded by taxation)
Resources influenced by market demand
Resources controlled by government through grant
settlements
Reliance upon external sales
Activity generally determined politically
Need for flexibility
Fixed budgets
Profit oriented
Service/community oriented
Single or limited number of objective(s)
Multi (and often conflicting) objectives
Outputs identifiable and measurable
Outputs subjective and qualitative
Decisions made by:
Decisions made by:
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Shareholders
Customers
Workforce
Management
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Electorate
Service Users
Employees
Management
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Board
Politicians
The boundaries between the two sectors have however become less apparent in recent years due to the effects of
externalisation, competitive tendering, the development of both internal and external trading activities and an increasing
emphasis on partnerships amongst both statutory agencies and the private sector.
Nevertheless these key differences will influence the approach which public sector bodies take to budgeting particularly in
relation to the need for processes and procedures to be adapted to reflect the external environment in which they operate
and translate this into the setting of budget requirements.
Satisfying external and internal environments
In common with private sector organisations those operating in the public sector must also adapt their budgeting processes
to reflect their internal and external environments.
Public sector budget preparation will be influenced by a number of internal factors including:
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the proposed income and expenditure of the organisations services;
the revenue consequences of any proposed capital expenditure;
the use of balances and reserves;
contributions from trading activities and any surpluses or deficits from the collection fund (local authorities only);
growth and savings.
Public sector bodies do not operate in a vacuum and their actions have a significant effect on the national economy as they
are funded by some form of taxation. They also have an effect on the Public Sector Borrowing Requirement (PSBR) by
borrowing money to fund expenditure.
By aggregating budgets throughout the public sector central government can then monitor its activities against its plans or
targets (as set through Comprehensive Spending Reviews and Public Service Agreements) and take appropriate action to
ensure that these are met.
The revenue expenditure of public bodies is funded at national level by either taxation or fees/charges and at local
government level by government grants, local taxation (council tax and NNDR) and fees/charges. Statutory frameworks also
exist to ensure that public sector organisations set balanced budgets. Balanced budgets are ones where the organisation’s
estimated revenue expenditure can be met from all sources together with contributions from reserves.
In contrast to the regime in place in the late 1980s and 1990s, the government has since lessened its controls for local
authorities, particularly over the capital funding regime with the introduction of the Prudential Code.
The government is also seeking to reduce the regulation around the number of specific grants and the development of local
area agreements (LAA) brings together a variety of different funding streams across the public sector. However, the
government has still retained the ability to cap authorities whose council tax increases are deemed to be excessive.
Objectives of public sector budgeting
Budgeting in the public sector context shares many similarities with the private sector but contains a greater focus on the
relationship with policy development, performance monitoring and statutory objectives. The key objectives of public sector
budgeting are:
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assisting in planning expenditure to meet policy requirements;
policy implementation and control;
measuring and monitoring performance;
to determine the total expenditure of the organisation and ensure that it is consistent with total revenues (e.g. fixing
the rate of local taxation);
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provide the basis for authorising expenditure and collection of fees and charges;
provide the basis for budgetary control;
satisfaction of statutory requirements.
Current developments in the public sector and their impact on budgeting theory
Over recent years the public sector has faced many challenges due to the rapid pace of change both in the way services are
delivered and in organisational structures and relationships. These changes have meant that the finance and budgetary
function has had to adapt itself to accommodate radically different ways of working and delivering services and to play a key
role in developing and maintaining an effective. As new policy developments are introduced the need for effective
governance and budgetary control arrangements to ensure probity and sound financial management remain undiminished.
Examples of these changes which have impacted, and continue to impact on, budgeting and its application include:
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the dawn of Best Value in 1997 and the development of the Best Value Accounting Code of Practice in local
government which requiring local authorities to report on a consistent basis using common approaches to service
and expenditure classification;
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the spread of formal agreement concerning service delivery targets and the development of the local area
agreements (LAAs) which closely tie in budgets with strategic planning and service improvement;
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the pooling of local authority and NHS budgets under the Health Act 1999 and other partnership arrangements
which require new ways or working and an understanding of how the financial and budget processes operate in
other sectors;
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duties on local authorities to keep their finances under review, maintain adequate levels of reserves and take
corrective action when overspends are identified;
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the move away from centrally prescribed credit approvals to a prudential regime of capital controls which gives local
authorities more freedom to set their own borrowing limits and apply resources with less government intervention
(Local Government Act 2003);
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the comprehensive performance assessment (CAA from in 2008) which compares and assesses the corporate
performance of local authorities including their approaches to budgetary control and financial planning. High
performing authorities are entitled to greater freedoms and flexibilities and experience fewer restrictions on how
they spend government grants;
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the increasing devolution of budgets in the NHS with the introduction of smaller primary care trusts as the
commissioning bodies for significant proportion of health spending;
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the impact of changes to the local government finance distribution regime and the changes in the methodology of
the regime.
These issues are explored in greater detail elsewhere in this information stream, particularly in the External Environment to
Budgeting sections but are a key consideration in the development of effective budgeting regimes within the UK public
sector.
Overview of the Relationship between Budgeting and Strategy Formulation, Long Term Planning and
Control
The budget is a financial and quantitative statement of an organisation’s activities which is prepared prior to a definitive
period of time. It provides managers and policy makers with financial information to assist them in taking strategic decisions
for which they are responsible.
In any large organisation, and particularly in the public sector, there will be conflicting policy objectives all of which will have
different resource implications which may have either capital or revenue consequences.
An effective budgeting process should allow all of the financial implications of alternative policy objectives to be assessed
thereby enabling policy makers to appraise them and compare the costs against available resources.
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As External Environment to Budgeting has illustrated, public authorities are not only restricted by resource implications but
also by the external environment and political context in which they operate. The budget allows policy makers to assess their
alternative plans and identify their priorities within their affordable limits.
Budgets are a key element of effective strategy planning. Medium and Long Term Financial Planning covers the differences
between, and objectives of, long term or strategic planning, medium term and short term financial planning.
The budget is a financial/resource representation of corporate objectives and also a plan of action for the period covered.
Once the budget is adopted by a public authority it's delivery is placed within the remit of the accountable management who
will have approval to incur expenditure in line with stated financial regulations and a scheme of delegation.
The budget forms the basis of a controlling mechanism for the various resources of a public authority. Budgetary control can
be applied at all managerial levels provided that managers are made accountable for the budgets for which they are
responsible. The budget can also highlight variations from expectations so that senior management can take remedial action
to ensure that expenditure is contained within the budget and remains consistent with corporate objectives and policies.
The Strategy Formulation Process: Theory
There are many different definitions of strategy. Strategy can be thought of in terms of determining the direction in which
the organisation needs to go. Some writers would also consider that it encompasses the actions necessary to ensure that the
strategy is followed.
Strategy formulation is the process where executives evaluate an organisation's strengths and weaknesses in light of
opportunities and threats present in the environment and decide on strategies that fit the organisations core competencies
and environment opportunities.
The rational model for strategy formulation suggests a logical sequence which involves analysing the current situation,
generating choices in terms of products and markets, making choices and then implementing the chosen strategies.
Typically this may include the following different stages of strategy formulation and implementation:
1. Determination of the organisational mission
The mission of an organisation is its defining purpose. In the case of a chocolate manufacturer the mission could be “to sell
the best chocolate in Europe”. In the case of a public service organisation it could for instance be to provide the best possible
welfare services to the population of a region/area.
2. Determination of organisational goals
An organisation's goal state the intentions behind the organisation's actions. Consideration needs to be given to the following
factors:
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what the mission of the organisation is;
who its key stakeholders are;
what type of activities the organisation should be undertaking;
what services the organisation is required to undertake under government legislation and which are discretionary;
what services and goods it should provide;
to whom services or goods should be provided.
Thus for instance a goal of the public service organisation could be to provide support to elderly people discharged from
hospital into the community.
Most UK local authorities and public sector bodies will have identified core values or priorities in recent years which define
their core performance objectives over the medium to long term.
3. Determination of objectives
These will be quantified long term and short term performance targets which the organisation wishes to achieve.
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Corporate objectives relate to the organisation’s activities as a whole and will normally be set by the Executive Board,
Cabinet or other senior committee of an organisation.
Once the corporate objectives have established they need to be broken down into subsidiary areas for the component units
of the organisation. These unit objectives relate to the specific objectives of individual services or business units within an
organisation, e.g. a service department.
These should be SMART – Specific , Measurable, Attainable, Relevant and Time Bound. e.g. the service will provide three
hours per week of support in the home for 1,000 elderly clients during the next year.
4. External appraisal
External appraisal involves analysing the environment in which an organisation operates in terms of the risks and
uncertainties it faces, its current competitive position, and opportunities or threats which it needs to address.
In the case of a company this would include considering the demand from consumers and the actions of competitors. In the
case of public service bodies political, social and economic trends are of major importance. Also the aims and objectives of
other bodies need also to be considered when planning activities and resources. For example, the objectives of local
government will be significantly influenced by the local strategic partnership, the health and voluntary sectors and central
government.
5. Internal appraisal
Internal appraisal entails examining the resources that an organisation possesses in order to assess its strategic capability so
that choices of future strategies can be made. This will enable management to decide what resources and skill bases are
required for each potential activity and which ones the organisation currently possesses.
6. Corporate appraisal
This is the bringing together of the internal and external appraisal, and a consideration of where the organisation stands in
terms of its mission, aims and objectives. It is likely that gaps will be identified and that new strategy options will need to be
generated to plug those gaps.
7. Generation of options
The next stage is to identify possible courses of action or strategies that enable objectives to be achieved. Strategies are
concerned with matching the capabilities of an organisation with its environment.
Porter has identified a model that outlines the three types of core strategy which an organisation can follow:
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cost leadership, i.e. being the lowest cost producer or in local government terms charge the lowest council tax or
provide maximum value for money;
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differentiation, i.e. seeking a unique dimension in its service provision which is valued by residents or consumers;
focus, i.e. targeting resources at particular user groups or stakeholders and not attempting to be all things to all
people. A service could for example be aimed at a particular target group or a specific geographic area.
According to Porter an organisation also needs to determine the direction it wishes to take, e.g.
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withdrawing from providing certain goods or services;
targeting existing resources more effectively at existing service users;
targeting resources at different markets or service users;
developing new services for existing or new service users;
doing nothing.
Organisations then need to consider how this direction is to be pursued, e.g. internal development or partnership working or
joint ventures with other organisations. In the local government context political decision making will determine strategic
policies, e.g. is externalisation favoured in principle over in house provision and vice versa.
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Public sector funding regimes similarly allocate proportionately greater levels of resources to regions or authorities with
higher levels of deprivation where need is assumed to be more intense.
8. Evaluation of strategic options
In order to judge the shortlisted strategies Johnson and Scholes have suggested that they be examined by reference to their
suitability (e.g. do they fit within the organisation's objectives or exploit its strengths or avoid weaknesses), feasibility (e.g.
are there enough resources available to deliver them) and acceptability (e.g. is the level of risk acceptable or indeed are
they politically acceptable).
It is essential those strategic options which offer the greatest likelihood of achieving the organisation’s objectives are
chosen.
9. Decisions on strategy
The next stage is to select those strategic options which have the greatest potential for achieving the organisation's
objectives and develop long term plans to ensure their implementation.
10. Strategy implementation
Strategy implementation includes long term and short term resource planning and budgeting. Plans for developing new
services, methods of delivery and alternative locations for delivery need to be established. These long term plans should
then be co-ordinated and translated into financial terms by projecting the financial impact of current and future activities for
several years. They provide a statement of the key initial targets and actions required by an organisation to achieve its
strategic plans.
Capital expenditure plans will also normally originate from the long term planning process.
Once completed the long term plan should be continually reviewed and revised to ensure its continued relevance.
Long Term or Strategic Planning in the Public Services
Long term or strategic planning requires organisations to specify objectives to which the future operations and resources of
an organisation should be directed and covers a period of three years or longer. Its primary purpose is to enable
organisations to:
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identify issues and activities which cannot normally be undertaken within the existing organisation, e.g. partnership
working, externalisation of service provision;
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establish key priorities for core services so that resource allocation can be targeted to meet these;
consider organisational change to establish new ways of working where existing processes cannot respond, e.g. the
efficiency agenda, NHS structural reorganisation, e-government and customer first initiatives;
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forecast changes in population, demographics or employment opportunities which may impact on the demand for
services;
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look beyond the normal ways of working, e.g. changing political values and cultures, and looking beyond
organisational boundaries to the external environment.
Long term plans require the collection and analysis of a considerable volume of information on facts and opinions about the
past, present and future and an assessment of the effects of quite small changes in any of a number of variable factors.
At times it is also necessary to balance the input going into such factors with the likely benefits to be obtained from them.
For each objective it is desirable that there is a clear statement of policy, levels of need with assessments of potential
shortfalls, and existing inputs in terms of capital revenue and human resources.
Until recently long term planning has not been particularly well developed in the UK public sector, primarily due to ongoing
uncertainties about political, economic and resourcing factors as well as financial settlements being announced on an annual
basis.
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Such long term commitments have tended to focus on particular services, e.g. economic development and regeneration,
without being seen in the wider context of the organisational whole. The move to three year settlements in many parts of
the public sector will increase the need for more medium and long term planning.
Despite these difficulties long term or strategic planning is important in providing a catalyst for future policy and
development and provides the framework against which an organisations short and medium term budgets should be
produced as well as identifying significant issues at an early stage.
Medium Term Planning
Medium term plans tend to be tactical in nature and provide more detail on the policies and projects required to achieve the
strategic aims of an organisation. In the UK public sector they normally cover a period of around three years.
Medium term financial planning is explored in practical terms under Medium and Long Term Financial Planning focusing in
particular on the methodology used by the CIPFA Scottish Directors of Finance in the publication 'Integrating Strategic
Planning with 3 Year Budgeting' (IPF, 2001) which provides a suggested step by step methodology for the preparation of
such plans. For a summary of the publication see Integrating Medium Term Planning with Annual Budget Setting below.
The main purposes of medium term budgets in the public sector are:
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to display the cumulative effects of existing financial commitments - both revenue and capital - to act as a base for
future changes in service provision;
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to assist in plotting the longer term financial consequences of different projects to assist in policy choice;
to enable priorities to emerge in the light of what is possible within existing resources;
to reflect the continuing burden of service provision and policy changes;
to review the relative speed at which different services can be developed;
to ensure continuity of forward planning;
to forecast taxes and charges so that decision makers can indicate (political) acceptability.
Short Term Planning
These are plans which have a duration of up to one year, e.g. an organisation's annual budget. There are seven key stages
which form the basis of an effective short term planning approach:
1.
communicating details of the budget policy and guidelines to those responsible for budget setting;
2.
determining those factors which restrict output or constrain funding;
3.
for trading activities preparation of the sales or income budget;
4.
initial preparation of budgets;
5.
negotiation of budget with key decision makers;
6.
co-ordination and review of budgets;
7.
ongoing review of budgets.
An examination of how these can be applied to the public sector both in terms of medium term planning and the annual
budget setting process is undertaken in Medium and Long Term Financial Planning.
Integrating Long Term with Medium and Short Term Planning
Long term planning is concerned with translating the strategy of the organisation into realistic resource plans. The figure
below outlines a simplified process for linking long term planning with annual budgeting and their joint roles within the
planning and control process.
Figure
7
Title: Link Between Long Term or Strategic Planning and Short/Medium Term Budgeting
Implementation of the long term plan
The budget identifies the implementation of the approved activities within the long term plan over the short term. The
budget translates the long term plans and the capital budget into an operating plan.
In most cases when the annual budget is prepared most of the decisions that affect that financial year will have already been
prepared. Therefore the budget is not something which is generated from scratch but is developed within the context of the
ongoing business.
Integration of medium term financial planning and annual budget setting in Local Government
The Best Value regime required local authorities and related bodies to produce meaningful medium term budgets over a
three year forward period. The key features of such a plan identified by the Best Value taskforce in June 1997 were:
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a mechanism which delivers a firm indication to councils as to the level of funding available in future years;
a planning mechanism which generates targets for a three year period;
a process to draw financial planning processes together and ensure consistency;
a mechanism which produces budgets over three years which are meaningful at the level of service delivery;
a process which allows the outturn expenditure and outputs delivered to be measured against budgeted expenditure
and targets.
HM Treasury, through its comprehensive spending reviews, has attempted to set similar medium term plans linked to the
delivery of specific national targets. The Audit Commissions 'use of resources' assessment examines through its 'key line of
enquiry' (KLoE) that "the council’s medium term financial strategy, budgets and capital programme are soundly based and
designed to deliver its strategic priorities".
'Integrating Strategic Planning with 3 Year Budgeting' (IPF, 2001) by the CIPFA Scottish Directors of Finance expanded on
these features and developed a step by step methodology for the preparation of such plans. The guidance from the
publication is summarised in Integrating Medium Term Planning with Annual Budget Setting. The figure below also derived
from the Scottish Directors of Finance publications sets out a possible annual timetable to illustrate how this might work in
practice for a typical local authority.
Figure
Title: Aligning Service Planning and Budgeting - A Potential Timetable for Local Government
There are several key stages in the budgeting process:
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communicating details of budget policies and guidelines to those responsible for preparing budgets;
determining those factors which restrict outputs or limit expenditure;
preparation of the budget for key front line services linked to assumptions on client numbers and intensity of use;
initial preparation of budgets for support costs and administrative functions;
negotiation of budgets with politicians, committee/board members and senior officers;
co-ordination and review of budget;
approval of budgets;
ongoing review of budgets.
Integrating Medium Term Planning with Annual Budget Setting
Source - Integrating Strategic Planning with 3 Year Budgeting - CIPFA Scottish Directors of Finance (IPF, 2001)
This guidance dates from 2001 and therefore a number of developments have since occurred which may result in some of
the references not being current. However, the principles outlined in the publication are still valid when considering medium
term planning.
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Step 1 - Forecasting Resources & Commitments
In estimating future resources in the public sector practitioners should:
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develop a mechanism to predict future levels of aggregate external financing which takes into account all known and
assumed factors. The basis initially will be the Government's 3 year projections;
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monitor the implications of proposed changes to the grant distribution mechanism proposed by central government
paying particular reference to data and formulae changes which may impact on the organisation;
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consider levels and movements in balances and reserves;
assess the impact of any movement or trend in the level of Council Taxes or other revenue raising sources including
the effect of revaluations;
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consider the revenue implications of the new system for prudential indicators to determine local authority borrowing
In identifying future commitments it is desirable that:
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a base position for the forthcoming year allowing for the full effect of partial or one off costs or savings in the
current year's budget is identified;
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any known material changes are allowed for;
assumptions are made regarding future price movements;
the effects of government spending priorities and the impact of targeted or ring fenced funds are considered.
Step 2 - Planning
The production of corporate plans, departmental service plans and asset management plans has become more commonplace
in UK public sector bodies in recent years. Their key role is to assist in the establishment of clear service priorities at the
start of the budget setting process.
If a firm link between the long term or strategic plan and the budget is to be established then the following outputs need to
be produced:
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the plan should separate long term aspirations from those achievable in the short term;
the plan should identify key priorities and aims of the organisation;
service plans should clearly demonstrate the financial consequences;
the main outputs from service plans should be measurable targets that are implementable.
Step 3 - Aligning Budgeting and Planning - The Annual Budget Setting Process
Organisations should have a process that allows budgets and service plans to be developed concurrently. This is particularly
important in terms of financial constraint and service reduction to ensure that priority areas are protected. Realistically in
these circumstances organisations should concentrate on financial analyses of major policy initiatives and significant shifts in
service provision rather than attempting to cost the full service plan.
Traditionally many local authorities have had no formal consideration or guidelines before detailed budgeting starts and the
entire process was concentrated into a few months. Corporate planning aligns the timetable for the preparation of service
plans and budgets and is also critical in linking the two processes. This is illustrated by the following example of a seasonal
timetable which links both.
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SPRING - Service committees, leader, Mayor, Cabinet or Board produces financial guidelines based on the medium
term financial plan.
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SUMMER - prepare budget strategy and identify policy options for growth and savings.
AUTUMN - prepare draft service plans in the lead up to the local government finance settlement.
WINTER - refine service plans and budgets to reflect the implications of the settlement and agree estimates with key
stakeholders.
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FEBRUARY - Assembly, Executive or Committee formally approves budget and fixes level of taxation. Service plans
to be considered by Cabinet/Board as soon as possible after budget approval.
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ONGOING - Maintain a continuous process.
A more dynamic representation of an annual budget timetable which is linked to a coherent approach to corporate planning
is set out in an above figure.
Step 4 - Budgeting at the Point of Service Delivery
The production of a three year budget is likely to prompt the consideration of a number of issues:
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budget format;
level of detail;
flexibility between years;
budget drivers;
inflation treatment.
Budget Format
Should the budgets be fixed for a three year period or subject to annual review?
Level of Detail
Should year 2 and 3 budgets be prepared at a summarised or detailed level? The former is likely to be preferred.
Flexibility Between Years
Any medium term budget is likely to include a system of internal budget flexibility which allows carry forwards of
underspends to future years. A fully developed framework needs to address key questions relating to the scope, application
and approval of budget carry forward. In ideal circumstances:
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the rules of flexibility should be approved by members and their role clearly defined;
underspend or savings in one year should not automatically trigger an automatic change to the budget in the
following year;
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budget holders should be offered incentives to identify savings beyond prescribed limits;
a mechanism for dealing with the funding of overspends outside the control and influence of budget holders should
be considered.
Budget Drivers
There are a number of key areas which drive budgets and will impact on any plan:
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revenue or capital implications of best value reviews;
government priorities and the impact of changes in the local government finance distribution system;
the trend for ring fencing and targeting resources in specific service areas;
the ongoing revenue implications of new capital schemes.
The Treatment of inflation
There are three potential options in treating inflation - each has its own merits but it is important that a consistent approach
is adopted across the entire budget:
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budget in volume terms and compute the budget at constant prices;
budget in cash terms and cash limit budgets based on estimated inflation levels;
budget in cash terms but allow inflationary increases as and when they become apparent.
Step 5 - Performance Review
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An assessment of performance against planned actions and targets will highlight issues which need to be addressed in future
plans and budgets. For this to be achievable:
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initial plans and targets must be measurable and achievable;
assessment of performance against targets must be made on a timely basis;
assessments must provide a clear indication of further actions required to address poor performance.
An effective system of performance review should also:
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prompt regular reviews and assess performance at least quarterly;
determine reasons for failure;
ensure performance review information is available in time to feed into next year's budget and planning process.
Sources of Further Information
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Competitive Advantage (Porter M., 1985)
Exploring Corporate Strategy (Johnson G. and Scholes K., 1999)
Integrating Strategic Planning with 3 Year Budgeting: Scottish Directors of Finance (IPF, 2001)
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