What is Budgeting?
Classification of Budgeting control and standard costing systems are two essential tools frequently used by business executives for the purpose of planning and control. In the case of budgetary control, the entire exercise starts with the setting up of budgets or targets and ends with the taking of an action, in case the actual figures differ from the budgetary ones.
What is Budgeting Control?
Budgetary Control is a tool for management used to plan, carry out and control the operations of a business. Actual results are compared with budgeted objectives and variations between the two is noted and action is taken to eliminate or minimise the variations.
Table of Content
- 1 What is Budgeting?
- 2 What is Budgeting Control?
- 3 What is Budget?
- 4 Definition of Budgeting
- 5 Objectives of Budgeting
- 6 Importance of Budgeting
- 7 Disadvantages of Budgeting
- 8 Essentials of Budgeting
- 9 Process of Budgeting
What is Budget?
A budget is a financial plan for a business, prepared in advance.
A budget may be set in money terms, eg a sales budget of £500,000, or it can be expressed in terms of units, eg a purchases budget of 5,000 units to be bought.
Budgets can be income budgets for money received, eg a sales budget, or expenditure budgets for money spent, eg a purchases budget.
The budget we shall be focusing on in this article is the cash budget, which combines both income and expenditure, estimating what will happen to the bank balance during the time period of the budget.
Most budgets are prepared for the next financial year (the budget period), and are usually broken down into shorter time periods, commonly four-weekly or monthly. This enables budgetary control to be exercised over the budget: the actual results can be monitored against the budget, and discrepancies between the two can be investigated and corrective action taken where appropriate.
Definition of Budgeting
According to CIMA (Chartered Institute of Management Accountants) UK, 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.”
Cecil Gillespie defines budget as “a plan of operations, integrated and co-ordinated, comprising all phases of business activities and summarised to show the financial results of carrying out the plan”.
Keller & Ferrara defines Budget as “a budget is a plan of action to achieve stated objectives based on predetermined series of related assumptions.”
Objectives of Budgeting
Following are the objectives of budgeting:
- Measurement of Success
Planning has been defined as the design of a desired future position for an entity and it rests on the belief that the future position can be attained by uninterrupted management action. Detailed plans relating to production, sales, raw‐material requirements, labour needs, capital additions, etc. are drawn out.
By planning many problems estimated long before they arise and solution can be thought of through careful study. In short, budgeting forces the management to think ahead, to foresee and prepare for the anticipated conditions. Planning is a constant process since it requires constant revision with changing conditions.
Budgeting plays a significant role in establishing and maintaining coordination. Budgeting assists managers in coordinating their efforts so that problems of the business are solved in harmony with the objectives of its divisions. Efficient planning and business contribute a lot in achieving the targets.
Lack of co‐ordination in an organization is observed when a department head is permitted to enlarge the department on the specific needs of that department only, although such development may negatively affect other departments and alter their performances. Thus, co‐ordination is required at all vertical as well as horizontal levels.
Measurement of Success
Budgets present a useful means of informing managers how well they are performing in meeting targets they have previously helped to set.
In many companies, there is a practice of rewarding employees on the basis of their accomplished low budget targets or promotion of a manager is linked to his budget success record. Success is determined by comparing the past performance with previous period’s performance.
Budget is always considered a useful tool for encouraging managers to complete things in line with the business objectives. If individuals have intensely participated in the preparation of budgets, it acts as a strong motivating force to achieve the goals.
A budget serves as a means of communicating information within a firm. The standard budget copies are distributed to all management people provide not only sufficient understanding and knowledge of the programmes and guidelines to be followed but also give knowledge about the restrictions to be adhered to.
Control is essential to make sure that plans and objectives laid down in the budget are being achieved. Control, when applied to budgeting, as a systematized effort is to keep the management informed of whether planned performance is being achieved or not.
Importance of Budgeting
These are some important advantages of budgeting which is given below:
- Revision of Plans
- Effective Utilisation of Resources
- Consciousness and Motivate
- Maximization of Profits
- Cost Consciousness
- Credit Rating
- Finding deviations
- Clear-Cut Goals and Targets
- Avoid uncertainty
- Cost Reduces
Revision of Plans
Budgeting provides a tool through which managerial policies and goals are periodically evaluated, tested and established as guidelines for the entire organisation.It helps in the review of current trends and framing of future policies.
Budgeting gives planning a reality and sense. It enables the enterprise to clarify the goals and policy in operational and realistic terms.
Effective Utilisation of Resources
Budgeting helps in directing capital and other resources into the most profitable channels. It provides a means of ensuring that capital employed is kept at a minimum level consistent with the level of activity planned and that it is usefully employed; at the same time it ensures that maximum output is obtained.
Through budgeting the management substitutes a rational plan for snap decisions based upon intuition or ‘hunch’. This will certainly result in most efficient utilisation of resources. The financial handicaps of over or under investment in the various assets can be held to a minimum.
Consciousness and Motivate
Budgeting compels and motivates management to make an early and timely study of its problems. It generates a sense of caution and care, and adequate study among managers before decisions are made by them.
Maximization of Profits
The goal of budgeting is to minimise wastages of all kinds and make proper and fuller utilisation of the assets and resources of the business concern so as to achieve efficiency and profitability. Budgetary control directs enterprise activity towards maximisation of efficiency, productivity and profitability.
Budgetary control establishes a clear linkage and balance between the inputs such as assets, resources and time and the output in the form of production, performance and profits.
Budgets are studied by outside fund providers also such as banking and financial institutions, realising that management encourages cost consciousness and maximum utilisation of available resources.
Management which have developed a well ordered budget plans and which operate accordingly, receive greater favour from credit agencies.
Budget aids the management in obtaining funds from financial institution because it will provide the latter an insight into the problems of operation, the plans of the firm and an understanding of its financial requirements.
It reveals the deviations to management, from the budgeted figures after making a comparison with actual figures.
Budgeting keeps management informed in advance of conformance or lack of conformance to predetermined plans, objectives and policies. For this purpose, a comprehensive budgeting programme provides for comparison of actual performance against predetermined plans and objectives. This discrepancy in operations of the firm is detected and timely action is taken to remedy the situation before the same goes out of hand.
Clear-Cut Goals and Targets
It also forces the management to provide adequate and timely considerations to all factors before reaching important decisions. The active participation of the management of all levels in shaping the desired goals and the plans for achieving them has definitely healthy effect on interest, enthusiasm and morale.
The budget system provides an integrated picture of the firm’s operations as a whole. It enables the manager of each division to see the relation of his part of the enterprise to the totality of the firm. A production decision to alter the level of work-in-progress inventories can be traced through the entire budget system to show its effects on the firm’s overall profitability.
With the help of budgeting system the management can remove the cloud of uncertainty that exists in many enterprises among lower levels of management relative to basic policies and objectives.
Careful forecast of cash flow makes possible the avoidance of many difficulties and indeed serious financial embarrassment. Probable sources of difficulty can often be skirted or completely eliminated by appropriate adjustments in operating policies.
Budgeting helps in eliminating all sorts of wastage in different departments. Closer control of production costs, inventory and general administrative expenses can be exercised.
Disadvantages of Budgeting
These are limitations or disadvantages of budgeting which is given below:
- Lack of Absolute Accuracy
- Danger of Rigidity
- Impersonal Approach
- Not a Substitute for Management
- Time Factor
- Demotivate Employees
Lack of Absolute Accuracy
Since budgets are projections, they are based on various assumptions and parameters. Budget estimates are, therefore, devoid of absolute accuracy. Nevertheless, degree of inaccuracy inherent in estimates can be reduced with the help of modern forecasting techniques.
The strength and weakness of the budgetary programme depends, to a large measure, on the accuracy with which the basic estimates are made. In using budget estimates it is necessary to employ considered judgement in interpreting and using the results.
Danger of Rigidity
In many instances the management has mistakenly regarded budget estimates as the rigid dictates of policy and business operations are performed according to the original estimates. In adopting budgetary programme management should not forget that business situations can never be static and accordingly, budget techniques must continually be adapted to incorporate changing conditions within the concern.
The cost involved in installation as well as maintenance of the budgetary system becomes too heavy and only large sized concerns can afford to install if for reaping the benefits. Small concerns can ill afford to install such a system, as there should be some correlation between the cost of the system and the benefits obtained from it.
There is an erroneous impression that the budget system alone leads to success and guarantees future profits. There is no doubt that the budgets inject a sense of clarity, direction and purpose in the activities of the organisation, it is highly imperative that the business activity should be conducted with impersonal approach supplemented with proper management and administration.
Not a Substitute for Management
Budget is only a managerial tool and must be applied correctly for management to get benefited.
Budgeting cannot take the position of management but it is only an instrument of management. ‘The budget should be considered not as a master, but as a servant.’ It is totally misconception to think that the introduction of budgeting alone is enough to ensure success and to security of future profits.
Budgets cannot be executed automatically. Some preliminary steps are required to be accomplished before budgets are implemented.It requires proper attention and time of management. Management must not expect too much during the development period.
Employees who have had no part in agreeing and setting a budget which is imposed upon them, will feel that they do not own it. As a consequence, the staff may be demotivated. Another limitation is that employees may see budgets as either a ‘carrot’ or a ‘stick’, ie as a form of encouragement to achieve the targets set, or as a form of punishment if targets are missed.
Essentials of Budgeting
These are important essentials of effective budgeting:
- Support of Top Management
- Team Work
- Realistic Objectives
- Excellent Reporting System
- Formation of Budget Committee
- Cleanly defined Business Policies
- Integration with Standard Costing System
- Inspirational Approach
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.
This is an essential requirement, if the budgets are ready from “the bottom up” in a grass root 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.
The budget figures should be realistic and represent logically attainable goals. The responsible executives should agree that the budget goals are reasonable and attainable.
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 feed‐back system.
Formation of Budget Committee
This team receives the forecasts and targets of each department as well as periodic reports and confirms the final acceptable targets in form of Master Budget. The team also approves the departmental budgets.
Cleanly 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 particular department or function. But for this purpose, policies should be precise and clearly defined as well as free from any ambiguity.
Integration with Standard Costing System
Where standard costing system is also used, it should be completely integrated with the budget programme, in respect of both budget preparation and variance analysis.
All the employees or staff other than executives should be strongly and properly inspired towards budgeting system. Human beings by nature do not like any pressure and they dislike or even rebel against anything forced upon them.
Process of Budgeting
These are important steps for process of budget:
- Definition of objectives
- Location of the key (or budget) factor
- Appointment of controller
- Budget Manual
- Budget period
- Standard of activity or output
Definition of objectives
A budget being a plan for the achievement of certain operational objectives, it is desirable that the same are defined precisely. The objectives should be written out; the areas of control demarcated; and items of revenue and expenditure to be covered by the budget stated. This will give a clear understanding of the plan and its scope to all those who must cooperate to make it a success.
Location of the key (or budget) factor
There is usually one factor (sometimes there may be more than one) which sets a limit to the total activity. For instance, in India today sometimes non-availability of power does not allow production to increase inspite of heavy demand. Similarly, lack of demand may limit production. Such a factor is known as key factor. For proper budgeting, it must be located and estimated properly.
Appointment of controller
Formulation of a budget usually required whole time services of a senior executive; he must be assisted in this work by a Budget Committee, consisting of all the heads of department along with the Managing Director as the Chairman. The Controller is responsible for coordinating and development of budget programmes and preparing the manual of instruction, known as Budget manual.
Effective budgetary planning relies on the provision of adequate information to the individuals involved in the planning process. Many of these information needs are contained in the budget manual. A budget manual is a collection of documents that contains key information for those involved in the planning process.
The period covered by a budget is known as budget period. There is no generalrule governing the selection of the budget period.In practice the Budget Committee determines the length of the budget period suitable for the business.
Normally, a calendar year or a period co-terminus with the financial year is adopted.The budget period is then sub-divided into shorter periods; it may be months or quarters or such periods as coincide with period of trading activity.
Standard of activity or output
For preparing budgets for the future, past statistics cannot be completely relied upon, for the past usually represents a combination of good and bad factors.
Therefore, though results of the past should be studied but these should only be applied when there is a likelihood of similar conditions repeating in the future. Also, while setting the targets for the future, it must be remembered that in a progressive business, the achievement of a year must exceed those of earlier years. Therefore, what was good in the past is only fair for the current year.
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