7.3: Introduction to Budgeting and Budgeting Processes (2024)

The budget—Forplanning and control

Time and money are scarce resourcesto all individuals and organizations; the efficient and effectiveuse of these resources requires planning. Planning alone, however,is insufficient. Control is also necessary to ensure that plansactually are carried out. A budget is a tool that managersuse to plan and control the use of scarce resources. A budget is aplan showing the company’s objectives and how management intends toacquire and use resources to attain those objectives.

Companies, nonprofit organizations,and governmental units use many different types of budgets.Responsibility budgets are designed to judge the performance of anindividual segment or manager. Capital budgets evaluate long-termcapital projects such as the addition of equipment or therelocation of a plant. This chapter examines themasterbudget, which consists of a planned operatingbudget and a financial budget. The planned operating budget helpsto plan future earnings and results in a projected incomestatement. The financialbudget helps management plan the financing ofassets and results in a projected balance sheet.

The budgeting process involvesplanning for future profitability because earning a reasonablereturn on resources used is a primary company objective. A companymust devise some method to deal with the uncertainty of the future.A company that does no planning whatsoever chooses to deal with thefuture by default and can react to events only as they occur. Mostbusinesses, however, devise a blueprint for the actions they willtake given the foreseeable events that may occur.

A budget: (1) shows management’soperating plans for the coming periods; (2) formalizes management’splans in quantitative terms; (3) forces all levels of management tothink ahead, anticipate results, and take action to remedy possiblepoor results; and (4) may motivate individuals to strive to achievestated goals.

Companies can use budget-to-actualcomparisons to evaluate individual performance. For instance, thestandard variable cost of producing a personal computer at IBM is abudget figure. This figure can be compared with the actual cost ofproducing personal computers to help evaluate the performance ofthe personal computer production managers and employees who producepersonal computers. We will do this type of comparison in a laterchapter.

Many other benefits result from thepreparation and use of budgets. For example: (1) businesses canbetter coordinate their activities; (2) managers become aware ofother managers’ plans; (3) employees become more cost conscious andtry to conserve resources; (4) the company reviews its organizationplan and changes it when necessary; and (5) managers foster avision that otherwise might not be developed.

The planning process that results in aformal budget provides an opportunity for various levels ofmanagement to think through and commit future plans to writing. Inaddition, a properly prepared budget allows management to followthe management-by-exception principle by devoting attention toresults that deviate significantly from planned levels. For allthese reasons, a budget must clearly reflect the expectedresults.

Failing to budget because of theuncertainty of the future is a poor excuse for not budgeting. Infact, the less stable the conditions, the more necessary anddesirable is budgeting, although the process becomes moredifficult. Obviously, stable operating conditions permit greaterreliance on past experience as a basis for budgeting. Remember,however, that budgets involve more than a company’s past results.Budgets also consider a company’s future plans and express expectedactivities. As a result, budgeted performance is more useful thanpast performance as a basis for judging actual results.

A budget should describe management’sassumptions relating to: (1) the state of the economy over theplanning horizon; (2) plans for adding, deleting, or changingproduct lines; (3) the nature of the industry’s competition; and(4) the effects of existing or possible government regulations. Ifthese assumptions change during the budget period, managementshould analyze the effects of the changes and include this in anevaluation of performance based on actual results.

Budgets are quantitative plans for thefuture. However, they are based mainly on past experience adjustedfor future expectations. Thus, accounting data related to the pastplay an important part in budget preparation. The accounting systemand the budget are closely related. The details of the budget mustagree with the company’s ledger accounts. In turn, the accountsmust be designed to provide the appropriate information forpreparing the budget, financial statements, and interim financialreports to facilitate operational control.

Management should frequently compareaccounting data with budgeted projections during the budget periodand investigate any differences. Budgeting, however, is not asubstitute for good management. Instead, the budget is an importanttool of managerial control. Managers make decisions in budgetpreparation that serve as a plan of action.

The period covered by a budget variesaccording to the nature of the specific activity involved. Cashbudgets may cover a week or a month; sales and production budgetsmay cover a month, a quarter, or a year; and the general operatingbudget may cover a quarter or a year.

Budgeting involves thecoordination of financial and nonfinancial planning to satisfyorganizational goals and objectives. No foolproof method exists forpreparing an effective budget. However, budget makers shouldcarefully consider the conditions that follow:

• Top management support Allmanagement levels must be aware of the budget’s importance to thecompany and must know that the budget has top management’s support.Top management, then, must clearly state long-range goals and broadobjectives. These goals and objectives must be communicatedthroughout the organization. Long-range goals include the expectedquality of products or services, growth rates in sales andearnings, and percentage-of-market targets. Overemphasis on themechanics of the budgeting process should be avoided.
• Participation in goalsetting Management uses budgets to show how it intends toacquire and use resources to achieve the company’s long-rangegoals. Employees are more likely to strive toward organizationalgoals if they participate in setting them and in preparing budgets.Often, employees have significant information that could help inpreparing a meaningful budget. Also, employees may be motivated toperform their own functions within budget constraints if they arecommitted to achieving organizational goals.
• Communicating resultsPeople should be promptly and clearly informed of their progress.Effective communication implies (1) timeliness, (2) reasonableaccuracy, and (3) improved understanding. Managers shouldeffectively communicate results so employees can make any necessaryadjustments in their performance.
• Flexibility If significantbasic assumptions underlying the budget change during the year, theplanned operating budget should be restated. For control purposes,after the actual level of operations is known, the actual revenuesand expenses can be compared to expected performance at that levelof operations.
• Follow-up Budget follow-upand data feedback are part of the control aspect of budgetarycontrol. Since the budgets are dealing with projections andestimates for future operating results and financial positions,managers must continuously check their budgets and correct them ifnecessary. Often management uses performance reports as a follow-uptool to compare actual results with budgeted results.

The term budget has negativeconnotations for many employees. Often in the past, management hasimposed a budget from the top without considering the opinions andfeelings of the personnel affected. Such a dictatorial process mayresult in resistance to the budget. A number of reasons mayunderlie such resistance, including lack of understanding of theprocess, concern for status, and an expectation of increasedpressure to perform. Employees may believe that the performanceevaluation method is unfair or that the goals are unrealistic andunattainable. They may lack confidence in the way accountingfigures are generated or may prefer a less formal communication andevaluation system. Often these fears are completely unfounded, butif employees believe these problems exist, it is difficult toaccomplish the objectives of budgeting.

Problems encountered with such imposedbudgets have led accountants and management to adopt participatorybudgeting. Participatorybudgeting means that all levels of managementresponsible for actual performance actively participate in settingoperating goals for the coming period. Managers and other employeesare more likely to understand, accept, and pursue goals when theyare involved in formulating them.

Within a participatory budgetingprocess, accountants should be compilers or coordinators of thebudget, not preparers. They should be on hand during thepreparation process to present and explain significant financialdata. Accountants must identify the relevant cost data that enablesmanagement’s objectives to be quantified in dollars. Accountantsare responsible for designing meaningful budget reports. Also,accountants must continually strive to make the accounting systemmore responsive to managerial needs. That responsiveness, in turn,increases confidence in the accounting system.

Although many companies have usedparticipatory budgeting successfully, it does not always work.Studies have shown that in many organizations, participation in thebudget formulation failed to make employees more motivated toachieve budgeted goals. Whether or not participation works dependson management’s leadership style, the attitudes of employees, andthe organization’s size and structure. Participation is not theanswer to all the problems of budget preparation. However, it isone way to achieve better results in organizations that arereceptive to the philosophy of participation.