Budgeting: a management tool for financial planning and control

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BUDGETING: A MANAGEMENT TOOL FOR FINANCIAL PLANNING AND CONTROL

Nearly everyone prepares and uses budgets of some sort, even though many of the people who do so may not recognize what they are doing as budgeting. For example, most people make estimates of the income to be realized over some future time period and plan expenditures for food, clothing, housing, and so on. As a result of this planning, spending will usually be restricted by limiting it to some predetermined, allowable amount. In this type of action, a budget is used as a control device. At other times, individuals use estimates of income and expenditures to predict what their financial condition will be at some specific future time. The budgets involved here may exist only in the mind of the individual, but they are budgets nonetheless in that they involve plans of how resources will be acquired and used over some specific time period.

The budgets of a business firm serve much the same functions as the budgets prepared informally by individuals. Business budgets tend to be more detailed and to involve more work in preparation (mostly because they are formal rather than informal), but they are similar to the budgets prepared by individuals in most other respects. Like personal budgets, they assist in planning and controlling expenditures; they also assist in predicting operating results and financial condition in future periods. accounting management controlling budgeting

The terms planning and control are often confused, and occasionally they are used in such a way as to suggest that they mean the same thing. Actually, they are two quite distinct concepts. Planning involves the development of future objectives and the preparation of various budgets to achieve these objectives. Control involves the steps taken by management to assure that the objectives set down at the planning stage are attained, and to assure that all parts of the organization function in a manner consistent with organizational policies. To be completely effective, a good budgeting system must provide for both planning and control. Good planning without effective control is time wasted. On the other hand, unless plans are laid down in advance, there are no objectives toward which control can be directed.

Accounting fulfills two purposes:

-- the stewardship function

-- the management function.

The management function can be broken down into:

* planning;

* coordinating;

* communicating;

* decision-making;

* controlling.

Budgets help to achieve all five of these functions.

¦ The budgets produced by a business are “plans expressed in money”. The budgets show what management hopes to achieve in a future time period in terms of overall plans as well as departmental plans.

¦ The individual budgets are intertwined with each other -- they depend on each other and influence each other. There is a need to ensure that the individual budgets are not contradictory or in conflict.

¦ Because of the inter-dependency and the coordination of the budgets, managers must communicate with each other when preparing budgets -- they must also communicate the plans to staff below and management above.

¦ The nature of forecasting means that decisions have to be made. If profits are to increase then decisions must be made regarding sales; production levels etc.

¦ Budgets will be compared with actual results. Remedial action can then be taken when actual results are worse than budgeted results. In cases where actual results are better than those budgeted, examples of good practice may be identified and copied elsewhere in the organization.

One of the great values of budgeting is that it requires managers to give planning top priority among their duties. Moreover, budgeting provides managers with a vehicle for communicating their plans in an orderly way throughout an entire organization. No one has any doubt about what the managers want to accomplish or how they want it done.

Other benefits of budgeting are:

1. It provides managers with a way to formalize their planning efforts.

2. It provides definite goals and objectives that serve as benchmarks for evaluating subsequent performance.

3. It uncovers potential bottlenecks before they occur.

4. It coordinates the activities of the entire organization by integrating the plans and objectives of the various parts. By so doing, budgeting ensures that the plans and objectives of the parts are consistent with the broad goals of the entire organization.

But along with the advantages that budgeting has, everyone should remember about its limitations.

* Budgets are only as good as the data being used -- if data is inaccurate the budget will be of little use. Should one departmental budget be over-optimistic or pessimistic this will have a “knock-on effect” on other associated budgets.

* Budgets might become an over-riding goal -- this could lead to a misuse of resources or incorrect decisions being made.

* Budgets might act as a demotivator if they are imposed rather than negotiated.

* Budgets might be based on plans that can be achieved easily -- so making departments/managers appear to be more efficient than they really are. There is also a possibility that this could also lead to complacency and/or under-performance.

* Budgets might lead to departmental rivalry.

Budgets covering acquisition of land, buildings, and other items of capital equipment (often called capital budgets) generally have quite long time horizons and may extend 30 years or more into the future. The later years covered by such budgets may be quite indefinite, but at least management is kept planning ahead sufficiently to ensure that funds will be available when purchases of equipment become necessary. As time passes, capital equipment plans that where once somewhat indefinite come more sharply into focus and the capital budget is updated accordingly. Without such long-term planning an organization can suddenly come to the realization that substantial purchases of capital equipment are needed, but find that no funds are available to make the purchases. Operating budgets are ordinarily set to cover is one-year period. The one year period should correspond to whatever fiscal year the company is following, so that the budget figures can be compared with the actual results. Many companies divide their budget year into four quarters. The first quarter is then subdivided into months, and monthly budget figures are established. These near term figures can usually be established with considerable accuracy. The last three quarters are carried in the budget are quarterly totals only. As the year progresses, the figures for the second quarter are broken down into monthly amounts, then the third quarter figures are broken down and so forth. This approach has the advantage of requiring a constant review and reappraisal of budget data.

Continuous or perpetual budgets are becoming very popular. A continuous or perpetual budget is one that covers a 12-month period but which is constantly adding a new month on the end as the current month is completed. Advocates of continuous budgets state that this approach to budgeting is superior to other approaches in that it keeps management thinking and planning a full 12 months ahead. Thus, it stabilizes the planning horizon. Under other budget approaches the planning horizon becomes shorter as the year progresses.

The master budget is a network consisting of many separate budgets that are interdependent. The most important ones are the sales budget, the production budget, the purchases budget, the debtors' budget, the creditors' budget, cash budget.

The sales budget is generally the first budget to be prepared since most businesses are sales led. It shows predicted sales and revenues that are expected to be generated for the budget period. Once the sales budget has been drawn up the other budgets can be prepared using the information from the sales budget. If the sales budget is inaccurate, these inaccuracies will filter those and make the other budgets inaccurate too.

The budget will be based on sales forecasts for the budgeted period. Sales forecasts are very difficult to prepare because there are so many variables that are out of the control of the managers preparing the budget.

These variables could include:

* actions of customers -- customers changing to or from other suppliers

* actions of competitors -- competitors increasing or decreasing their price

* the state of the economy -- the economy in a state of (boom or bust)

* governmental action -- changes in the levels of taxation; changes in government spending; imposition of sanctions etc.

The production budget is prepared to determine whether the required future levels of production necessary to satisfy the anticipated, the level predicted sales are attainable. It decides on the quantities of finished goods that must be produced to meet expected sales plus any increase in the stock levels that might be required.

The purchases budget is required to determine the quantities of purchases required either for resale or for use in a production process. The calculation to be used is similar to that used in compiling a production budget.

The debtors' budget forecasts the amount owed to a business by credit customers at the end of each month. The debtors' budget is linked to the production budget; to the sales budget; and to the cash budget. It will also take into account the length of credit period that is allowed on outstanding customers' balances.

The creditors' budget forecasts the amounts that will be owed to creditors at the end of each month. It is linked to the purchases budget (i.e. purchases of components or raw materials in the case of manufacturing business or purchases of goods for resale in the case of retailing business) and to the cash budget.

The cash budget shows estimates of future cash incomes and cash expenditures. It is usually prepared monthly and includes both capital and revenue transactions. It is drawn up to help management be over of any potential shortages or surpluses of cash resources that could occur; thus allowing management to make any necessary financial arrangements.

The preparation of a cash budget:

* helps to ensure that there is always sufficient cash available to allow the normal activities of the business to take place

* will highlight times when the business will have cash surpluses, thus allowing management time to arrange short-term investment of those surpluses in order to gain maximum return

* will highlight times when the business might have cash deficits, thus allowing management to arrange short-term alternative sources of finance through the arrangement of overdraft facilities or the arrangement of extended periods of credit or the re-structuring of existing longer-term depts.

Just like all the individual ingredients that are put together to make a successful meal, after all the separate budgets are prepared they are drawn together to prepare the master budget.

This provides a summary of all the planned operations of the business for the period covered by the budgets. It is a sum of all the individual budgets prepared by the different parts of the business.

It is made up of:

-- a budgeted manufacturing account (where appropriate)

-- a budgeted trading account

-- a budgeted profit and loss account

-- a budgeted balance sheet.

Cash budget (cash-flow budget, cash-flow forecast) -- бюджет коштів -- a budget that summarizes the expected cash inflows and the expected cash outflows of an organization over a budget period, usually prepared on a monthly basis. It is the result of the analysis in cash-flow terms of the functional budgets and the capital budget, adjusted by other cash-flow items, such as interest, tax, and dividend payments. It is used as a planning aid to determine when cash surpluses are likely to be available for investment or when cash deficits are likely to arise requiring additional finance.

Master budget -- головний бюджет, майстер-бюджет -- the final coordinated overall budget for an organization as a whole, which brings together the functional budgets, the capital budget, and the cash-flow budget, as well as the budgeted profit and loss account and balance sheet for the period.

Production budget (operating budget) -- виробничий бюджет -- a budget set for the production function of an organization under a system of budgetary control, which includes, inter alia, the production volumes and the production cost to be incurred in a budget period. It will usually provide an analysis of the budgets by product and by accounting period.

Purchases budget -- бюджет закупівлі -- a budget set for the purchasing function of an organization under a system of budgetary control, which plans the volumes and cost of the purchases to be made in a budget period. It will usually provide an analysis of the budgets by material and by accounting period.

Sales budget -- бюджет продажів -- a budget set for the sales function of an organization under a system of budgetary control; it includes, inter alia, the sales volumes and the sales revenues to be achieved in a budget period. It will usually provide an analysis of the budgets by product, market segment, and by accounting period.

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