- Learn what a budget is and the importance to an organization - The advantages of budgeting - Explain responsibility accounting - Learn how to choose a budget period - Discuss what a self-imposed budget is - Explain what human factors are involved in budgeting [SLIDE 1] Budgeting is an essential part of planning for an organization. It helps management control, evaluate, and report on operations. A budget is the quantitative expression of a proposed plan of action by management for a forthcoming specified time period. It generally includes both financial and non-financial aspects of the plan, and it serves as a blueprint for the company to follow. Budgets are created to match an organization's goals with the resources necessary to accomplish those goals. A summary of a company's budget plans is called a master budget. The master budget, which culminates from a cash budget, a budgeted income statement, and a budgeted balance sheet, formally lays out the financial aspects of management's plans for the future and assists in monitoring actual expenditures relative to those plans. During the budgeting process, managers evaluate operational, tactical, value chain, and capacity issues; assess how resources for operating, investing, and financing activities are currently being used and how they can be efficiently used in the future; and develop contingency budgets as business conditions change. Managers also use budget information to control daily operations, measure and report on performance outcomes, and allocate resources wisely and as aid to coordinate what needs to be done to implement that plan. The use of budgets to control an organization's activities is called budgetary control. Let's look at some of the advantages of budgeting and how they benefit an organization. [SLIDE 2] Budgets are an integral part of management control systems. There are several advantages to organizations that use budgeting for planning and control.
  1. They help communicate management's plans throughout the organization.
  2. They force managers to think about and plan for the future. Without a budget, managers would spend a lot of time dealing with emergencies.
  3. Budgets are a means for allocating resources to those parts of the organization where they are used most effectively.
  4. They can uncover potential bottlenecks before they occur.
  5. They assist in coordinating the activities of the organization by integrating the plans of its various parts, by ensuring that everyone in the organization is moving in the same direction.
  6. Budgets define goals and objectives for the organization that serve as benchmarks for evaluating performance. Budgets can overcome two limitations of using past performance as a basis for judging actual results. One limitation is that past results often incorporate past miscues and substandard performance. The other limitation of using past performance is that future conditions can be expected to differ from the past. This is why many companies also evaluate their performance relative to their peers. Using only the budget to evaluate performance creates an incentive for subordinates to set targets that are relatively easy to achieve. Of course, managers at all levels recognize this incentive and therefore work to make the budget more challenging to achieve for the individuals who report to them. Still, the budget is the end product of negotiations among senior and subordinate managers. At the end of the year, senior managers gain information about the performance of competitors and external market conditions. This is valuable information that they can use to judge the performance of subordinate managers.
As you can see there are several advantages for organizations that use budgets to plan and control activities. [SLIDE 3] While budgets are important to an organization, managers have to be made responsible for budgets to work effectively. We call this responsibility accounting. The premise underlying responsibility accounting is that managers should be held responsible for those items and only those items that they can actually control to a significant extent. This enables the organization to react quickly to deviations from the budget plan and to learn from feedback received. Budgets enable a company's managers to measure their actual performance against predicted performance for their area of control. One of the most valuable benefits of budgeting is that it helps managers gather information for improving future performance. When actual outcomes fall short of budgeted or planned results, it prompts thoughtful senior managers to ask questions about what happened and why and how this knowledge can be used to ensure that such shortfalls do not occur again. This probing and learning is one of the most important reasons why budgeting helps improve performance. Research shows that the performance of employees improves when they receive a challenging budget. They view not meeting it as a failure. Most employees are motivated to work more intensely to avoid failure than to achieve success (they are loss-averse). As employees get closer to a goal, they work harder to achieve it. Creating a little anxiety improves performance. However, overly ambitious and unachievable budgets can actually de-motivate employees because they see little chance of avoiding failure. As a result, many executives like to set demanding, but achievable, goals for their subordinate managers and employees. By giving managers ownership, they feel more involved in the organization and motivated to achieve budget goals. However, we need to remember that the point of not meeting a goal is not to penalize the individual but to learn from the feedback and improve. [SLIDE 4] The motive for creating a budget should guide a manager in choosing the period for the budget. For example, consider budgeting for a new product. If the purpose is to budget for the total profitability of this new product, a 5-year period (or more) may be suitable and long enough to cover the product from design to manufacturing, sales, and after-sales support. In contrast, consider budgeting for a new limited edition product, which is expected to run for a few months. If the purpose is to estimate all cash outlays, a 6-month period from the planning stage to the final production should suffice. The most frequently used budget period is 1 year, which is often subdivided into quarters and months. We generally call these budgets, "operating budgets." The budgeted data for a year is frequently revised as the year goes on. At the end of the second quarter, management may change the budget for the next two quarters in light of new information obtained during the first 6 months based on performance to the budget. This approach has the advantage of requiring periodic review and reappraisal of budget data throughout the year. Businesses are increasingly using rolling budgets. A rolling budget, also called a continuous budget or rolling forecast, is a budget that is always available for a specified future period. It is created by continually adding a month, quarter, or year to the period that just ended. There is always a 12-month budget (for the next year) in place. Rolling budgets constantly force organization management to think about the forthcoming 12 months, regardless of the quarter at hand. This approach keeps managers focused at least one year ahead so that they do not become too narrowly focused on short-term results. [SLIDE 5] The success of a budget program depends on the way a budget is developed. Generally, budgets with managers actively participating in the preparation of their budgets are more successful than if managers have one imposed on them from top management. In fact, many managers believe that being empowered to create their own self-imposed budgets is the most effective method of budget preparation. A self-imposed budget or participative budget, as shown in the slide above, is a budget that is prepared with the full cooperation and participation of managers at all levels of the organization. This participative approach is more in line with the theory of responsibility accounting that we discussed earlier in this lesson. Self-imposed budgets offer a number of advantages to an organization and include:
  1. Individuals at all levels of the organization are recognized as members of the team.
  2. Budget estimates prepared by front-line managers are often more accurate and reliable than estimates prepared by top managers who have less knowledge of markets and day-to-day operations.
  3. Motivation is generally higher when individuals participate in setting their own goals than when the goals are imposed from above. Self-imposed budgets create commitment.
  4. A manager who is not able to meet a budget that has been imposed from above can always say that the budget was unrealistic and impossible to meet. With a self-imposed budget, managers cannot use this excuse.
There is one important limitation of self-imposed budgeting. Lower-level managers may allow too much budgetary slack and will have a natural tendency to submit a budget that is easy to attain (i.e., the manager will build slack into the budget). For this reason, budgets prepared by lower-level managers should be scrutinized by higher levels of management. Questionable items should be discussed and modified as appropriate to minimize unsatisfactory performance. Each level of responsibility in an organization should contribute its unique knowledge and perspective in a cooperative effort to develop an integrated budget. Nevertheless, a self-imposed approach to setting budgets works best when all managers understand the organization's strategy. Unfortunately, most companies do not follow the budgeting process we have described. Typically, top managers initiate the budgeting process by issuing profit targets. Lower-level managers are directed to prepare budgets that meet those targets. The difficulty is that sometimes the targets set by top managers may be unrealistically high. Unfortunately, top managers are often not in a position to know whether the targets are appropriate. Admittedly, a self-imposed budgeting system may lack sufficient strategic direction but top managers should be cautious about imposing unattainable fixed targets from above. [SLIDE 6] In addition to how a budget is prepared, success of a budget program also depends on three important factors.
  1. Top management must be enthusiastic and committed to the budget process.
  2. They must also not use the budget to pressure employees or blame them when something goes wrong.
  3. Budgets must have highly achievable targets when managers are rewarded based on meeting budget targets.
The human aspects of budgeting are extremely important. The budget should be used as a positive instrument to assist in establishing goals, measuring operating results, and isolating areas that need attention. A budget is supposed to motivate people and coordinate their efforts. This is undermined if managers become preoccupied with the technical aspects or it is used in a rigid and inflexible manner to control employees. In the next lesson, we will cover all the aspects of preparing a master budget that formally relays a company's sales, production, and financial goals.