Basic Framework Of Budgeting

Abstract

The terms budget and budgeting are commonly heard in the everyday lives of people.  An ordinary housewife thinks of how to “make both ends meet,” that is, how she can budget the combined family income for her family’s needs.  An employee thinks of how he should budget his monthly salary so that he would have enough funds until the next pay day.  A student thinks of how he should budget his allowance.  In the news, debates in Congress and the Senate about the national budget for a certain fiscal year are often heard.

This paper deals with budgets as well as the procedures and other concepts involved in the budgeting process, though the discussions focus on business budgeting rather than on the non-business activities mentioned in the preceding paragraph.  Consequently, this paper shall discuss the nature and characteristics of budgets, the importance and functions of budgeting, the basic procedures used in preparing budgets, and how budgets are used for planning, control, and performance evaluation.

For starters, a budget is a plan, expressed in quantitative terms, on how to acquire and use the resources of an entity during a certain future period.  It refers to a certain entity or to a specific activity of an entity.  Budget is for a specific future period and is said to be quantitative.

Introduction

Not many people are aware that budgeting is applied almost everyday in their lives.  An ordinary employee apportions his monthly salary to have enough money until the next payday.  A typical homemaker allots the family income to sustain the needs of her family.  Students also plan their expenses according to their allowances.  Evidently, people have always been inclined to budgeting; however, its importance is quite taken for granted.  Even in businesses, whatever the size may be, budgeting functions as an essential factor in the achievement of success.  Many businesses rely on budgeting to obliterate time pressure as they prepare for future and foreseen problems before they happen.

What is Budgeting?

Accordingly, budgeting is a tool of profit planning, which involves determining of goals and objectives to increase profit, as well as enrich performance.  Budgeting determines where the financial resources of an organization will be appropriated and how these financial resources will increase in cases where an organization does not have any cash flow to recompense.  Budgeting functions as a significant element for the organization’s total income to equal or exceed its losses.  On the other hand, a budget is the plan comprised in budgeting that ensures financial stability, control, as well as financial decisions.  A budget is often interchanged with a forecast.  However, the two terms are quite different.  A forecast is a prediction of a future trend or event in a business while a budget is a proposed result of the future that the business aims to accomplish.

Three Main Elements of Budgeting

Budgeting involves three main elements.  One is sales revenue, which is determined to be a budget’s foundation.  Normally, accurate estimate of forecasted sales is difficult to regulate.  It is necessary to make the actual past sales figures as basis for estimate.  Thus, calculation of related expenses vital in achieving the organization’s goals follows the targeting of the desired sales.

Another element is the total costs, which includes fixed and variable costs.  Just as estimating sales revenue, it is likewise difficult to estimate costs since they are very diverse.  An organization should be able to consider the occurrences of inflation and price increases.

The third and most significant element of budgeting is profit.  To make a return on cash investment, profit should be adequate.  During the preparation of budget, an organization should add the expected return of investment to its desired profit.  To ensure that the rate of return in the investment is the correct figure, an organization is advised to seek counsel from an accountant or a professional banker. 

Functions of Budgeting

The two important budgeting functions include planning and control.  When the term budgeting is mentioned, the first thing that comes into people’s minds is planning, which may be considered as the greatest contribution of budgeting to management.  The entire budgeting process involves planning – from the development of ideas, setting of goals, selection of strategies, programs, and procedures in attaining such goals, up to the preparation of the formal budget.  Planning provides the basis for the second major function of budgeting, that is, control.

The control function of budgeting involves the comparison of actual results of operations with the budgeted figures.  The objective is not merely to minimize costs but also to monitor activities and take the necessary corrective actions if any, when variances between actual results and planned figures are noted.  The control phase gives the feedback necessary in developing budgets for the next budget period.  More so, this control phase enables managers to learn from their mistakes and gain experience in improving operational efficiency and effectiveness.

Budgeting within an Organization

Budgeting has various functions in an organization.  It is considered as an analytical tool to assess an organization’s performance, where it serves as motivator for coordination and communication.  This is done through preparing a budget for each interrelated division of the organization.  In the process, members of the different divisions may be able to share ideas, as well as objectives, resulting to coordinated activities and organizational goals.

Budgeting also works as an effective framework for performance evaluation to identify and eradicate inefficiencies.  Through the comparison of budgeted figures and the actual outcomes of operations, the organization is able to survey the performance of each of its segments or divisions.  To determine whether to take necessary corrective actions, deviations or variances in the budgeted figures from the actual outcomes or results of operations should be accounted, evaluated, and probed.  The deviations or variances may also provide necessary information to develop more effective budgeting for future periods.

Moreover, the following justifies the significance of budgeting in an organization’s structure:

1. In new business, budget statements, in addition to business plans are often required by potential funders and investors.
2. Budgeting helps an organization manage its financial resources.
3. In some cases, budgeting gives an organization the assertiveness of making profit.
4. Budgeting helps in the easy detection of problems before they arise including need for finance, among others.
5. For long-established organizations, budgeting helps in monitoring performance through assessing if the organization meets its targets through previous budgets.
6. Budgeting also contribute in the improvement of an organization’s decision making, meeting goals and objectives, and increasing employee motivation. 

Advantages of Budgeting

The budgeting process is an essential tool in planning, revenue, and expense.  The preparation of a budget incorporates any period, which normally takes a year to develop.  Most organizations that initiate budgeting do the preparation on a quarterly basis.  However, budgets for the next two to five years may also be prepared ahead of time.  Preparation of budget for projects beyond five years would already be impractical.

Most firms use budgets because they are aware of the advantages that may be derived from budgeting, among which are as follows:

• Budgeting compels periodic planning.  Through budgeting, the members of the organization are forced to plan on how to acquire and use the firm’s scarce resources.  This results into a more efficient and effective utilization of such resources.
• Budgeting enhances coordination, cooperation, and communication.  Budgets prepared for the different segments of the organization are usually interrelated with each other.  In the process of preparing such budgets, members of the different organizational segments are enabled to exchange their ideas and objectives thereby giving them an opportunity to communicate with each other.  Moreover, such segments are forced to coordinate their activities and cooperate with each other toward the attainment of the organizational goals.
• Budgeting forces quantification of plans and proposals.  Budgets, as already mentioned, are plans expressed in quantitative terms.  Though it may be difficult to quantify all plans and business proposals, budgeting compels people in the organization to express their plans in terms of dollars and other units of measure to make them more meaningful and much easier to evaluate.
• Budgeting provides a framework for performance evaluation.  Actual results of operations are compared with the budgeted figures to monitor the organization’s or the organizational segment’s performance.  Any deviations of actual figures with the planned or budgeted amounts are noted, evaluated, and investigated to determine the necessary corrective action, if any.  Deviations or variances also provide feedback information that is important in developing budgets for the succeeding budget period.
• Budgeting enables members of the organization to be aware of business costs.  Ordinarily, only the accountants and financial executives are concerned about the cost implications of business activities and decisions.  Other managers have their own areas of concern: output for production managers, sales volume for sales managers, etc.  During the budgeting process, however, these managers who are given participation in developing the budget become aware of the possible cost consequences of their planned activities, thereby allowing such managers to conduct a cost-benefit analysis of their proposals.
• Budgeting satisfies some legal and contractual requirements.  In some cases, budgets are prepared because the firm is required to do so.  For instance, government agencies, some charitable institutions, and not-for-profit organizations are required to prepare a budget and operate within such budget.  Still in other cases, financial institutions such as bank as well as government lending arms and regulatory agencies require business firms to submit budgets before a loan or a project is approved.  In this case, budgeting is employed out of necessity and not really because of the advantages that may be derived from it.
• Budgeting directs the firm’s activities toward the achievement of organizational goals.  In the budgeting process, specific operational goals for each segment as well as the goals of the organization as a whole are formally established and incorporated in the budgets.  Knowing that these budgets are to be used as one of the basis for performance evaluation, the different unit managers will try to operate within this framework and should they be successful, the result is attainment of the company’s goals according to plans.

Limitations of Budgeting

Though there are a lot advantages that can be derived from budgeting, it has some drawbacks and limitations.  First, since budgeting means planning for the future, the plan itself as well as the figures therein, are merely estimates requiring a certain amount of judgment.  Nobody can predict what exactly will happen in the future.  Hence, future situations may warrant revision or modification of plans.

Second, to be successful, a budgetary system requires the cooperation and participation of all the members of the organization.  Should any of these members lose enthusiasm in carrying out the plans or should any member fail to coordinate and cooperate with each other, the entire budgetary system will fail.

Third, some managers thing that budgets restrict their movements and limit their decision making power.  Some are even afraid that such budgets may be used against them if they fail to work in accordance with the plans contained in the budget.  These factors make it difficult to sell the idea of budgeting to some people in the organization.

Finally, the development and installation of a good budgetary system may be time consuming and too costly for some organizations such that the benefits that can be derived from budgeting may be outweighed by its costs.

Budget Programs

• Self-imposed Budget – In any budgeting program, communication, responsibility, and cooperation is vital, and these are further magnified in participative or self-imposed budget.  In this program, the supervisors and managers draft their own budgets, subject to review of a higher level of management.  The immediate superiors would thoroughly review the details of the budget, and if certain items necessitate revision, it would be discussed and a compromise would be attempted to come up with a compromised that is acceptable to all parties involved.  This type of program presents several advantages such as the treatment of all individuals in any level as part of the budget team; realistic and accurate figures are likely since the individual well-versed with the activity is the one preparing the budget; the tendency to work within the budget is high since this is prepared by the individual and not just imposed on them; and, in case the budget is not attained, the individual shoulders the sole responsibility since he or she is the one who prepared it.

• Continuous or Perpetual Budget – This is commonly practiced by most firms nowadays.  In continuous or perpetual budgeting, firms divide their annual budgets into budgets for shorter periods, like monthly, quarterly, etc.  As soon as a quarter or a month is completed, a quarter or month is added so that there is a budget for a year in advance at all times.  As each quarter or month is added, the budget for the entire year is checked and the necessary revisions are made.  These revisions at regular intervals keep the whole organization on the alert for changes which would possible affect the budget.
• Operating Budget – This is no other than the budgeted or projected income statement. It contains the projected revenues, costs, and expenses as well as the forecast net income figure for a certain budget period.  The development of a formal operating budget usually starts with the determination of some limiting factors, which is either internal or external  Internal factors include productive capacity limitations such as lack of enough factory space, machine hours, and labor hours.  These factors prevent the company form producing enough volume of product to meet the sales requirements.  External factors, on the other hand, include lack of supplies or materials that may likewise limit the company’s productive capacity.  Ordinarily however, external factors involve the market per se, that is, the demand for the firm’s products.  In this case, the company cannot sell all it wants to sell, despite the fact that it can afford to manufacture as many units of products as it wants to produce.

If the factors so determined limit the firm’s productive capacity, the operating budget is developed by first preparing the production budget.  This production budget is then used as the basis for preparing all other budgets in the entire master plan including the sales budget.  In most cases, however, the limiting factors affect sales, not production.  In this case, the development of the operating budget starts with the preparation of a sales forecast, which eventually is formalized and made into a sales budget.

• Budget Committee – Some firms create a budget committee, which is usually composed of the sales manager, the production manager, the chief engineer, the treasurer and the controller.  The budget committee’s principal functions include formulating and deciding on general policies relating to the firm’s budgetary system; requesting, reviewing, and revising (if necessary) individual budget estimates from the different segments of the organization; approving budgets and subsequent revisions therein; receiving, evaluating, and analyzing budget, reports; and recommending necessary actions to improve operational efficiency and effectiveness.
• Human Factors in Budgeting – The management’s enthusiasm and commitment play very important roles in the success of a budget program.  This may be as simple as reminding the employees to stick within the budget to a thorough, formal review of figures periodically.  Projecting an enthusiastic approach, especially by the higher management, is contagious.  More importantly though, the budget must not be used as a weapon to pressure the employees, lest use against them.  It should be remembered that one usual comment shadowing the importance of budget is that some companies use this to bring out the optimum capability of an employee.  It may function as such tool, but it likewise contributes to the stress of the employee that would eventually result to burn-out and worst, to losing some of the best people in the firm.  Since budget is an objective, reaching or exceeding the target is best accompanied by benefits.  This goes on to say that the managers should be rewarded for such an achievement.  It is an open secret it retailing firms that when sales managers, even sales agents, upon reaching or exceeding the desired figures, is rewarded by additional perks or bonuses, and for some, even promotions.  Approaching the budget as a thoroughfare to good benefits likewise minimizes the pressure that comes along with it. 

Challenges in Budget Implementation

The organization and installation of a budgetary system for a firm are greatly influenced or affected by such firm’s organizational structure.  For multi-segmental organizations, all managers are held responsible for the preparation and implementation of the budget for their respective sections, although the final responsibility for such budgets and the consolidated budget for the organization as a whole rests with the executive management.

The implementation of budgets is based on the following principles, which serves as guidance for the adeptness of the budgets.  Reward systems should be instigated as motivation for all individuals involved in the attainment of the objectives.  Thus, provision of rewards for good and notable performance should always be encouraged.  By doing this, all the individuals in an organization will have a positive outlook concerning the whole budgetary system.

During the implementation process of budgeting, a reporting system should be established in order to obtain feedback on the outcomes of the operations where each individual or each organizational division is involved.  This performance reporting system is essential in monitoring, controlling, and assessing performance.

To develop an effective budgetary system, an organization must be able to comply with several fundamental principles.  First, individuals responsible for the budgeting should have sufficient and expounded knowledge in order to labor on the same goals, agenda, and assumptions.  Managers are expected to understand and fulfill their roles in the development of the budgetary system.  All the involved individuals should participate and cooperate in the process of budgeting.  These individuals will be responsible for the budget implementation and their performance will be evaluated based on the constructed budget.  Furthermore, in the course of preparing for the budgetary system, the individuals concerned should obliterate any anxiety and defensiveness.  This is done through provision of freedom and authority in every level of performance in each respective division.  In addition, developing budget should be created reasonably and accordingly with the objectives to stand a great chance of success.

The following are involved in the budgeting process based on the principles mentioned above:

• aiming a desired profit
• determining the organization’s operating expenses
• quantifying gross profit margin
• appraising sales revenues
• adjusting general figures or amounts

In the budgeting process, an organization should be able to create estimates to assess an operating budget.  These estimates are based on the past sales and cost amounts and will be able to present any price increases and other adjusting factors.  Take for example, a storeowner who spent $3,000 for advertising costs in the past two years.  The storeowner anticipates 3 percent price increase on the coming year.  In order to quantify the advertising costs for the coming year, the storeowner does the following:  $3000 multiplied by 3% equals $90, adds the amount to the original average cost, $3000 + $90 = $3090.  This is applicable for organizations that have been established for a year or so.  However, in a newly established organization, which naturally does not have any financial records, it may base its estimates on experience and adeptness of the industry.  The new organization should be able to consider the support of business consultants or professional accountants for the utilization of realistic estimates.

Summary

As defined earlier, a budget is a plan expressed in quantitative terms.  Budgeting, on the other hand, is a tool of profit planning, which involves determining of goals and objectives to increase profit, as well as enrich performance.  The two important budgeting functions include planning and control.  Planning involves development of ideas, setting of goals, selection of strategies, programs and procedures in attaining such goals, up to the preparation of the formal budget.  The control phase involves the comparison of actual results of operations with the budgeted figures.

Budgeting has several advantages. It compels periodic planning; enhances coordination, cooperation, and communication; forces quantification of plans and proposals; provides a framework for performance evaluation; enables members of the organization to be aware of business costs; satisfies some legal and contractual requirements; and directs the firm’s activities toward the achievement of the organizational goals.

Probably, the greatest achievement of budgeting is the integration of the objectives of the organization.  When all of the activities of an organization are coordinated to achieve a planned objective, as they are in a budgetary control system, then each member of the firm is made aware of the fact that it has a role to play in achieving the company-wide objectives.

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