Chapter 32 - Budgets
Lesson Objective: To understand what are budgets and its different methods
Budgeting is a key financial process in any company. Budgeting is a detailed financial plan for a future time period taking into account the financial needs and the consequences of the plan. Both, costs and profit centers usually have 12-month budgets that are broken down by month.
The main benefit of a budget is that it allows to assess the performance of each part of the organization to which budget has been allocated to.
There are many reasons why companies plan budgets:
It aids on target-setting as it brings a real element (limitation) to targets - the budget itself;
Budgets consider priorities and act as a limitation: centers cannot go off budget;
Managers and centers are accountable for following though the budget;
When allocating budgets different departments and centers are required to coordinate;
Monitoring and controlling: budgets are tools for keeping on track;
Budgets and targets are not set on stone - they can be modified when any of them turn out to be unrealistic;
Budgets allow for variance analysis to take place: the calculation of the difference between the budget and the actual performance and the analysis of reasons leading to that difference (performance assessment).
Let's look in to a few key features of budgets:
Budgets # forecasts: budgets are plans that use forecasts to create aims for the company to fulfil - not a prediction!
Budgets can be set for sales, capital expenditure, labor costs, profit, etc.;
The process of budgeting needs to include subordinates of high-level managers so that the ones who are actually going to work towards achieving it are involved in the process of planning them (motivation) - this is called delegated budgets (giving authority over setting and achieving budgets to the ones involved) > Herzberg.
Coordination between departments when establishing budgets is essential. This should avoid departments making conflicting plans.
Stages in Preparing Budgets:
Preparation of the organization objectives:
Organization objectives are based on previous year performance, external changes likely to impact the business, sales forecasts;
Identification of key factors likely to influence the growth of the business:
Allocate sales budget;
Prepare secondary budgets based off the sales budget:
Coordination to ensure consistency:
Creation of the master budget:
Master budget submitted to board’s approval.
After approved, the master budget is usually broken down into short periods (monthly) to be used as a motivating target.
There are 3 different ways to go about budgeting:
Incremental budgeting;
Zero budgeting;
Flexible budgeting.
Let's start by understanding incremental budgeting, a simple technique that uses last year’s budget as the basis and makes adjustments for the coming year:
It does not consider unforeseen events;
It puts pressure on staff to increase productivity;
It does not require departments to justify their whole budgets for next year, it just asks them to justify the change year-on-year of their budgets;
Used in very competitive industries where the cost budget needs to always be reduced and the sales budget increased.
The second method is zero budgeting where the year's budget is set to zero and then different centers and departments have to argue their case to receive any finance:
Time-consuming since there needs to be a review/analysis of the work and budget which will be assigned to each center/department each year;
It allows for changing external situations to be reflected on the yearly budget if well argued, which is positive.
Finally, flexible budgeting which allows for budgets to change according to sales and production:
It varies according to the company’s needs;
It is good because a company or a department of a company needs may not be static;
Takes into consideration variable costs.
Example: Although costs budgeted seem to have decreased it did so because output felt so there is no real gain for the business. The decrease in cost was at a lower proportion compared to the fall in output (20% drop in output but only 10% drop in cost):
Flexible budgeting comes in to adjust to a more realistic budget given the output/sales level: a 20% drop in materials cost given the 20% drop in output.
It seems like this company has become less efficient as the output went down. Why would that be?
Let's wrap up this session by looking at the limitations budgeting comes with:
Training needs must be offered: managers with responsibility in budget will need extensive training and education to keep up with their accountability;
New projects budgeting: major projects require frequent revisions given their complexity.
To-Do-List:
Activity 32.2
Chapter 32 - Budgets
Commentaires