Hello everyone, in the previous topic we were talking about Reporting in Management. Today we are going to talk about Budgeting in management, its importance, types, essentials, advantage, and disadvantages.

WHAT IS BUDGETING?

INTRODUCTION

A budget is defined as the formal expression of plans, goals, and objectives of management that covers all aspects of operations for a designated time period.

A budget is a tool providing targets and direction. Budgets provide control over the immediate environment, help to master the financial aspects of the job and department and solve problems before they occur. Budgets focus on the importance of evaluating alternative actions before decisions actually are implemented.

A budget is a financial plan to control future operations and results. It is expressed in numbers, such as rupees, dollars, units, pounds, hours, manpower, and so on. It is needed to operate effectively and efficiently.

Budgeting, when used effectively, is a technique resulting in systematic, productive management. Budgeting facilitates control and communication and also provides motivation to employees.

Budgeting allocates funds to achieve desired outcomes. A budget may span any period of time. It may be short-term (one year or less), intermediate-term (two to three years), or long-term (three years or more).

Short-term budgets provide greater detail and specifics. Intermediate budgets examine the projects the company currently is undertaking and start the programs necessary to achieve long-term objectives.

Long-term plans are very broad and may be translated into short-term plans. The budget period varies according to its objectives, use, and dependability of the data used to prepare it. The budget period is contingent on business risk, sales and operating stability, production methods, and the length of the processing cycle. Effective budgeting requires the existence of-

1. Predictive ability.
2. Clear channels of communication, authority, and responsibility.
3. Accounting generated should be accurate and reliable.
4. It should have compatibility and understandability of information.
5. Support at all levels of the organization i.e. upper, middle, and lower.

Some of the leading definitions of the word “BUDGET” are quoted below-

According to CIMA (Chartered Institute of Management Accountants), ” A budget is a plan quantified in monetary terms prepared and approved prior to a defined period of time, usually showing planned income to be generated and, expenditure to be incurred during the period and the capital to be employed to attain a given objective.”

According to Keller & Ferrara, “A budget is a plan of action to achieve stated objectives based on predetermined series of related assumptions.”

According to G.A.Welsh, “A budget is a written plan covering projected activities of a firm for a definite time period.”

WHY IS BUDGETING IMPORTANT?

Budgeting is important because it can save us a lot of bucks and can organize a lot of things for us. Budgeting is not about saying don’t spend here, don’t spend there, cut back on this, never eat out, etc. It’s about being liberated to start deiced what we want to do instead of just reacting to every situation.

In other words, Budgeting is a key management tool for planning, monitoring, and controlling the finances of a project or organization. It estimates the income and expenditures for a set period of time for our project or organization. Our budget can serve a number of important purposes, including-

1.  Monitoring the income and expenditures over the course of a year (or a specific project time frame).
2. Helping to determine if adjustments need to be made in programs and goals.
3. Forecasting income and expenses for projects, including the timing and the availability of income (such as additional grant funds).
4. Providing a basis for accountability and transparency.

TYPES OF BUDGETS

It is necessary to be familiar with the various types of budgets to understand the whole picture and how these budgets interrelate. The types of budgets are briefly explained below-

1. Master Budgets

A master budget is an overall financial and operating plan for a forthcoming calendar or fiscal year. It is usually prepared annually or quarterly. A master budget is actually a number of sub budgets tied together to summarize the planned activities of the business. The format of the master budget depends on the size and nature of the business.

2. Operating and Financial Budgets

The operating budget deals with the costs for merchandise or services produced. The financial budget examines the expected assets, liabilities, and stockholders’ equity of the business. It is needed to see the company’s financial health.

3. Cash Budget

The cash budget is for cash planning and control. It presents expected cash inflow and outflow for a designated time period. The cash budget helps management keep cash balances in reasonable relationship to its needs and aids in avoiding idle cash and possible cash shortages. The cash budget typically consists of four major sections.

1. Receipts section, which is the beginning cash balance, cash collections from customers, and other receipts.

2. Disbursement section, comprised of all cash payments made by purpose.

3. Cash surplus or deficit section, showing the difference between cash receipts and cash payments.

4. Financing section, providing a detailed account of the borrowings and repayments expected during the period.

4. Static or Fixed Budget

The static or fixed budget is budgeted figures at the expected capacity level. Allowances are set forth for specific purposes with monetary limitations. It is used when a company is relatively stable. Stability usually refers to sales. The problem with a static budget is that it lacks the flexibility to adjust to unpredictable changes.

In industry, fixed budgets are appropriate for those departments whose workload does not have a direct current relationship to sales, production, or some other volume determinant related to the department’s operations. The work of the departments is determined by management decisions rather than by sales volume.

Most administrative, general marketing and even manufacturing management departments are in this category. Fixed appropriations for specific projects or programs not necessarily completed in the fiscal period also become fixed budgets to the extent that they will be expended during the year. Examples are appropriations for capital expenditures, major repair projects, and specific advertising or promotional programs.

5. Flexible or Expense Budget

The flexible or expense budget is most commonly used by companies. It allows for variability in the business and for unexpected changes. It is dynamic in nature rather than static. Flexible budgets adjust budget allowances to the actual activity. Flexible budgets are effective when volumes vary within a relatively narrow range. They are easy to prepare with computerized spreadsheets such as Excel.

The four basic steps in preparing a flexible or expense budget are-

1. Determine the relevant range over which activity is expected to fluctuate during the coming period.

2. Analyze costs that will be incurred over the relevant range in terms of determining cost behavior patterns (variable, fixed, or mixed).

3. Separate costs by behavior, determining the formula for variable and mixed costs.

4. Using the formula for the variable portion of the costs, prepare a budget showing what costs will be incurred at various points throughout the relevant range.

6. Incremental Budgeting

Incremental budgeting looks at the increase in the budget in terms of percentages without considering the whole accumulated body of the budget. They are also self-contained, self-justified increments of projects. Each one specifies resource utilization and expected benefits. A project may be segregated into one or more increments. Additional increments are required to complete the project. Manpower and resources are assigned to each increment.

7. Capital- Expenditure Budget

This budget stands for the expenditure on all fixed assets for the duration of the budget period. This budget is normally prepared for a longer period than the other functional budgets. It includes items like new buildings, land, machinery, and intangible items like patents, etc. This budget is designed under the observation of the accountant which is supported by the plant engineer and other functional managers. At the time of preparation of this budget, some important information should be observed they are-

• Overfilling on the production facilities of certain departments.

• A long-term business policy with regard to technical developments.

• Potential demand for certain products.

8. Zero Base Budgeting

The ‘Zero-Base’ refers to the starting point of the budget. It starts with a presumption that the budget for the next period is ‘zero’ until the demand for a function, process, or project is not justified for a single penny. The assumption is that without such justification, no expenditure will be allowed. In effect, each manager or functional head is required to carry out a cost-benefit analysis of each of the activities, etc. under their control and for which they are responsible.

The method of ZBB suggests that the business should not only make decisions about the proposed new programs but it should also, regularly, review the suitability of the existing programs.

ESSENTIALS OF EFFECTIVE BUDGETING

1. Support of Top Management

If the budget structure is to be made successful, the consideration by every member of the management not only is fully supported but also the impulsion and direction should also come from the top management. No control system can be effective unless the organization is convinced that the management considers the system to be important.

2. Team Work

This is an essential requirement if the budgets are ready from “the bottom up” in a grassroots manner. The top management must understand and give enthusiastic support to the system. In fact, it requires education and participation at all levels. The benefits of budgeting need to be sold to all.

3. Realistic Objectives

The budget figures should be realistic and represent logically attainable goals. The responsible executives should agree that the budget goals are reasonable and attainable.

4. Excellent Reporting System

Reports comparing budget and actual results should be promptly prepared and special attention focused on significant exceptions i.e. figures that are significantly different from expected. An effective budgeting system also requires the presence of a proper feedback system.

5. Structure of Budget Team

This team receives the forecasts and targets of each department as well as periodic reports and confirms the final acceptable targets in form of a Master Budget. The team also approves the departmental budgets.

6. Well-defined Business Policies

All budgets reveal that the business policies formulated by the higher-level management. In other words, budgets should always be after taking into account the policies set for a particular department or function. But for this purpose, policies should be precise and clearly defined as well as free from any ambiguity.

7. Integration with Standard Costing System

Where standard costing system is also used; it should be completely integrated with the budget program, in respect of both budget preparation and variance analysis.

8. Inspirational Approach

All the employees or staff other than executives should be strongly and properly inspired towards the budgeting system because we know Human beings by nature do not like any pressure and they dislike or even rebel against anything forced upon them.

ADVANTAGES AND DISADVANTAGES OF BUDGETING SYSTEM

Budgeting involves cost and time to prepare. The benefits of budgeting must outweigh the drawbacks. A budget can be advantageous because of these reasons-

1. It has links, objectives, and resources.

2. Communicates to managers what is expected by them. Any problems in communication and working relationships are identified.

3. Establishes guidelines in the form of a road map to proceed in the right direction.

4. Improves managerial decision-making because it emphasizes future events and associated opportunities.

5. Encourages delegation of responsibility and enables managers to focus more on the specifics of their plans, how realistic the plans are, and how such plans may be effectively achieved.

6. Provides an accurate analytical technique.

7. Provides better management of subordinates. For example, a manager can use the budget to encourage salespeople to consider their clientele in long-term strategic terms.

8. Fosters careful study before making decisions.

9. Helps management become aware of the problems faced by lower levels within the organization. It promotes labor relations.

10. It allows thinking about how to make operations and resources more productive, efficient, competitive, and profitable which also leads to cost reduction.

11. Allows management to monitor, control, and direct activities within the company. Performance standards act as incentives to perform more effectively.

12. Points out deviations between budget and actual, resulting in warning signals for changes or alterations.

13. It helps to identify on timely basis weaknesses in the organizational structure.

14. There is early notice of dangers or departures from forecasts. The formulation and administration of budgets pinpoint communication weaknesses, assigns responsibility, and improves working relationships

15. Provides management with foresight into potential crisis situations so alternative plans may be instituted.

A budget can be disadvantageous because of these reasons-

1. A budget may reward managers who set modest goals and penalize those who set ambitious goals that are missed.

2. There is judgment and subjectivity in the budgeting process.

3. Managers may consider that budgets redirect their flexibility to adjust to changing conditions.

4. A budget does not consider quality and customer service.

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Grooming Urban.

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