Topic 1: Basics in Budgeting

Key terms and concepts: • Budget

– A quantitative plan for acquiring and using resources over a specified time period .

– A detailed plan, expressed in quantitative (monetary) terms, that specifies how resources will be acquired and used during a specified period of time. It is prepared in advance of that time period and is based on the agreed objectives for that period of time, together with the strategy planned to achieve those objectives.

• Budgeting – The process of expressing quantified resource requirements into time-phased

goals.

• Budgetary planning and control – Specialist techniques to quantify the strategy of the enterprise.

• Budget period – An interval of time (usually 12 months) into which the project period is divided

for budgetary and funding purposes.

Key terms and concepts: • Budget slack (padding the budget)

– The influence of behavior to “pad” or manipulate a budget by misstating expected revenues and/or expenses. A “slack” or cushion is provided in order to avoid an unfavorable variance at the end of the budget year. This is typically done by overstating budget expense amounts and/or understating budget revenues.

– Also known as controller’s reserve or controller’s cushion.

• Budgetary system – A system which serves the needs of management in making judgments and

decisions, exercising planning and control and achieving effective communication and motivation.

• Budget manual – A document setting out procedures and instructions for preparing budgets.

• Budget committee – A group of people brought together to manage each stage of the budgetary

process. They are responsible for overall policy matters relating to the budget program and for coordinating the preparation of the budget.

Composition of the Budget Committee:

• President

• Vice president

– VP sales

– VP production

– VP purchasing

• Controller

Comprises the senior managers

who are responsible for

designing strategic decisions.

Functions of the Budget Committee:

• Establish priorities, make financial policies, and monitor implementation of policies on a periodic basis.

• Identify and deal with issues or problems that may appear in the budget.

• Assigning budget authority and inviting employee participation.

• Administering the budget that best serves the needs of the company’s stakeholders by ensuring that the budgets support corporate strategy.

• Selecting the budget period. • Implementing the budget. • Evaluate any necessary changes (via feedback) throughout

the life of the budget , increasing and decreasing fund designation as necessary.

Sequence of the budgetary process • Communicate the details of objectives and strategy to those

responsible for preparation of budgets and coordinate the overall linkage of objectives and strategy.

• Communicate the details of budget preparation procedures to those responsible for preparation of budgets and respond to concerns or questions.

• Determine the limiting factor which restricts the overall budget flexibility and forms the focus of the budget cascade and evaluate the impact of the limiting factor.

• Prepare an initial set of budgets. • Negotiate budgets with line managers. • Coordinate and review budgets. • Accepts budgets in final form. • Carry out ongoing review of budgets as they are

implemented.

Objectives/concepts/purposes of budgeting systems:

• Planning

• Control

• Facilitating communication and coordination

• Allocating resources

• Controlling profit and operations

• Evaluating performance and providing incentives

Advantages of budgeting: • It forces managers to plan. It provides definite objectives for evaluating

performance at each level of the organization. Budgets force managers to think about and plan for the future. Without budgeting, managers would spend all their time dealing with day to day emergencies.

• It provides information that can be used to improve decision making. The budgeting process provides a means of allocating resources to those parts of the organization where they can be used most effectively.

• It provides a standard for performance evaluation. Control is achieved when actual results are compared with budgeted results. Large levels of discrepancies will force managers to correct the situation and may result to significant cost savings.

• It improves communication and coordination. Budgets communicate management’s plans throughout the organization. (Fosters organizational communication).

• It is less costly as it focuses more on prevention measures rather than correcting measures. Management and other employees spend less time solving unanticipated problems and more time on positive measures and preventable actions.

Advantages of budgeting:

• The budgeting process can uncover potential bottlenecks before they occur.

• Budgets coordinate the activities of the entire organization by integrating the plans of its various parts. Budgeting helps to ensure that everyone in the organization is pulling in the same direction. They facilitate congruence between organizational and personal goals.

• Results in greater management awareness of the entity’s overall operations and the impact on operations of external factors, such as economic trends.

• Budgets define goals and objectives numerically that can serve as benchmarks for evaluating actual and subsequent performances.

Disadvantages of budgeting:

• Budgeting can be very time consuming.

• May cause undue pressure.

• Budgetary slack may occur.

• Department may not be able to achieve its budget.

• They are only concerned about financial outcomes.

• May restrict business activities, which may end up in losing business.

Limitations of budgeting:

• It uses estimates as a basis of the budget plan.

• In order to fit with the changing circumstances, the budgetary program must be continually adapted. Normally, for attaining a reasonably good budgetary program, it takes several years.

• A budget plan cannot be executed automatically. It needs enthusiastic participation in all levels of management.

Types of budgets:

• Master budget (Profit Plan)

• Budgeted financial statements (Pro forma financial statements)

• Cash budget

• Capital budget

Requisites of a good budgetary program:

• There should be a clearly defined organizational structure where areas of responsibility are emphasized.

• Employees should participate in the budgeting process.

• There should be adequate accounting records and procedures for the purpose of relying on the measurement of performance.

• Budgetary control needs to be flexible so that plans and objectives may be revised.

• An awareness of the uses and potential problems of the program should be spread by the top management.

Types of budgetary systems:

• Zero-based budget

– Budgets that require managers to estimate sales, production, and other operating data as though operations are being started for the first time, so as to have a fresh view of operations each year.

– Two major budgets using zero based approach are the static budget and flexible budget.

Types of budgetary systems:

• Fixed/static budget

– It shows the expected results of a responsibility center for only one activity level. Once the budget has been determined, it is not changed, even if the activity changes.

– Used by many service companies and for some functions of manufacturing companies such as purchasing, engineering, and accounting.

Types of budgetary systems:

• Flexible budget

– It shows the expected results in a responsibility center for several activity levels.

Types of budgetary systems: • Incremental budget

– Budgets that are prepared using a previous period’s budget or actual performance as a basis with incremental amounts added for the new budget period.

– Advantages: • Relatively simple to operate and easy to understand.

• Consistency and saves time.

• Impact of change can be observed quickly.

– Disadvantages: • Assumes activities and methods of working will continue in the same

way when they might change.

• No incentive for developing new ideas.

• Budgets may become outdated and irrelevant.

• Budgetary slack may always be there and may never be reviewed.

Types of budgetary systems:

• Periodic budget

– Budget that is prepared for a fixed period of time, normally one year.

Types of budgetary systems:

• Continuous/perpetual/rolling budget

– A 12 month budget that rolls forward one month (or one quarter) as the current month (or quarter) is completed. One month (or quarter) is added to the end of the budget as each month (or quarter) comes to a close

Short-term vs. Long-term budgets: • Short-term budget (Current budget / Annual operating

plan) – A budget which covers a period of one year (or the normal

operating cycle, whichever is longer) or less than one year. – Much more detailed than long-term strategic plans. Long

term goals must be restated in terms of what it wants to accomplish during the next year. The short-term goals identified in its annual operating plan are the basis of an organization’s operating budgets for the year.

• Long-term budget (Strategic planning) – A budget which covers a period of usually five to ten years. – Means by which long-term goals can be met. These goals

must not be vague, they must set specific tactical targets and timetables, and assign operating responsibility for achieving the goals to specific personnel.

Contents of a budget manual: • Introductory explanation of the budgetary planning and control process,

including a statement of the budgetary objectives and desired results. • A form of organizational chart to show who is responsible for the

preparation of each functional budget and the way in which the budgets are interrelated.

• Length of the budget period. • Timetable for the preparation of each budget to prevent the formation of

bottleneck with the late preparation of one budget holding up the preparation of all others.

• Formats to be used for the budget. • Method of accounting to be adopted. • Procedures for preparation of financial statements and procedure for

reporting. • Circulation lists for drafts. Copies of all forms should be completed by those

responsible for preparing budgets, with explanations concerning their completion.

• Information concerning key assumptions to be made by managers in their budgets, eg: inflation rate, key exchange rates.

• Arbitration procedures where conflicts begin to show themselves.

Advantages of preparing the budget manual:

• It provides a coordinated plan where everybody knows his/her responsibilities.

• Problems and difficulties are settled quickly and easily. However, matters that cannot be settled from the manual may be dealt with by the Budget Controller of the full Budget Committee.

• New employees can be introduced to the Company’s methods and procedures easily.

• Methods and procedures are standardized . The budget manual ensures the best methods and procedures of any work. More attention is therefore paid to study and select the most efficient methods and procedures.

• It persuades all levels of management that budgetary control is worthwhile and essential.

Methods of constructing a budget:

• Top-down mandated approach

• Bottom-up approach (participative)

Top-down budgeting

• Budgeting method where the budget is imposed from top management with little participation by lower-level managers

• Also known as “imposed budgeting”

Advantage and disadvantage of top-down mandated approach:

• Advantage:

– Timeliness. It is quicker to develop budgets using the top-down approach.

• Disadvantage:

– Imposing expectations from above and then penalizing employees who do not meet these expectations will generate resentment rather than cooperation and commitment.

Participative or grass roots budgeting

• Also known as bottom-up or self-imposed budgeting

• A self-imposed budget is a budget that is prepared with the full cooperation and participation of managers at all levels.

• Usually, the process is done by asking those who will ultimately implement the budget about their inputs. This gives them greater sense of ownership of the resulting budget.

Advantages of bottom-up approach

• Advantage: – Empowerment. Individuals at all levels are recognized

as members of the team whose views and judgment are valued by top management.

– Budgets are often more accurate and reliable than estimates prepared by top managers who have less intimate knowledge of markets and day to day operations.

– Higher employee motivation. They also create commitment.

– Eradication of the excuse managers may make for not meeting the budget.

Potential problem of bottom-up approach (participative budgeting):

• Lower level managers may allow too much budgetary slack, resulting in suboptimal performance.

Budgets prepared by lower level managers should be scrutinized by higher levels of managers. Questionable items should be discussed and modified as appropriate.

Stages of a budget cycle

• Budget preparation

• Budget execution

• Budget evaluation

Example of a typical budget cycle: