Basics
One Budgeting of management's major responsibilities is planning. As explained in Chapter 14, planning is
the process of establishing enterprise-wide objectives. A successful organization makes both
long-term and short-term plans. These plans set forth the objectives of the company and the
proposed way of accomplishing them.
A budget is a formal written statement of management's plans for a specified future time period,
expressed in financial terms. It normally represents the primary method of communicating
agreed-upon objectives throughout the organization. Once adopted, a budget becomes an
important basis for evaluating performance. It promotes efficiency and serves as a deterrent to
waste and inefficiency. We consider the role of budgeting as a control device in Chapter 21.
Budgeting and Accounting
Accounting information makes major contributions to the budgeting process. From the
accounting records, companies can obtain historical data on revenues, costs, and expenses. These
data are helpful in formulating future budget goals.
Normally, accountants have the responsibility for presenting management's budgeting goals in
financial terms. In this role, they translate management's plans and communicate the budget to
employees throughout the company. They prepare periodic budget reports that provide the basis
for measuring performance and comparing actual results with planned objectives. The budget
itself, and the administration of the budget, however, are entirely management responsibilities.
The Benefits of Budgeting
The primary benefits of budgeting are:
1. It requires all levels of management to plan ahead
basis.
2. It provides definite objectives for evaluating performance at
3. It creates an early warning system for potential problems so
changes before things get out of hand.
4. It facilitates the coordination of activities within the busines
the goals of each segment with overall company objectives. T
integrate production and sales promotion with expected sales.
5. It results in greater management awareness of the entity's ov
impact on operations of external factors, such as economic tre
6. It motivates personnel throughout the organization to meet p
A budget is an aid to management; it is not a substitute for management. A budget cannot operate
or enforce itself. Companies can realize the benefits of budgeting only when managers carefully
administer budgets.
Essentials of Effective Budgeting
Effective budgeting depends on a sound organizational structure. In such a structure, authority
and responsibility for all phases of operations are clearly defined. Budgets based on research
and analysis should result in realistic goals that will contribute to the growth and profitability of
a company. And, the effectiveness of a budget program is directly related to its acceptance by all
levels of management.
Once adopted, the budget is an important tool for evaluating performance. Managers should
systematically and periodically review variations between actual and expected results to
determine their cause(s). However, individuals should not be held responsible for variations that
are beyond their control.
Length of the Budget Period
The budget period is not necessarily one year in length. A budget may be prepared for any
period of time. Various factors influence the length of the budget period. These factors include
the type of budget, the nature of the organization, the need for periodic appraisal, and prevailing
business conditions. For example, cash may be budgeted monthly, whereas a plant expansion
budget may cover a 10-year period.
The budget period should be long enough to provide an attainable goal under normal business
conditions. Ideally, the time period should minimize the impact of seasonal or cyclical
fluctuations. On the other hand, the budget period should not be so long that reliable estimates
are impossible.
The most common budget period is one year. The annual budget, in turn, is often
supplemented by monthly and quarterly budgets. Many companies use continuous 12-month
budgets. These budgets drop the month just ended and add a future month. One advantage of
continuous budgeting is that it keeps management planning a full year ahead.
The Budgeting Process
The development of the budget for the coming year generally starts several months before the
end of the current year. The budgeting process usually begins with the collection of data from
each organizational unit of the company. Past performance is often the starting point from which
future budget goals are formulated.
The budget is developed within the framework of a sales forecast. This forecast shows potential
sales for the industry and the company's expected share of such sales. Sales forecasting involves
a consideration of various factors: (1) general economic conditions, (2) industry trends, (3)
market research studies, (4) anticipated advertising and promotion, (5) previous market share, (6)
changes in prices, and (7) technological developments. The input of sales personnel and top
management is essential to the sales forecast.
In small companies like Positively-You.com, the budgeting process is often informal. In larger
companies, a budget committee has responsibility for coordinating the preparation of the budget.
The committee ordinarily includes the president, treasurer, chief accountant (controller), and
management personnel from each of the major areas of the company, such as sales, production,
and research. The budget committee serves as a review board where managers can defend their
budget goals and requests. Differences are reviewed, modified if necessary, and reconciled. The
budget is then put in its final form by the budget committee, approved, and distributed.
A recent study by Willard &
Shullman Group Ltd. found
that fewer than 14% of
businesses with fewer than
500 employees do an annual
budget or have a written
business plan. In all, nearly
60% of these businesses have
no plans on paper at all. For
many small businesses the
basic assumption is that, As
long as I sell as much as I can,
and keep my employees paid,
I'm doing OK. A few small
business owners even say that
they see no need for budgeting
and planning. Most small
business owners, though, say
that they understand that
budgeting and planning are
critical for survival and
growth. But given the long
hours that they already work
addressing day-to-day
challenges, they also say that
they are just too busy to plan
for the future.
Budgeting and Human Behavior
A budget have can a significant impact on human behavior. It may inspire a manager to higher
levels of performance. Or, it may discourage additional effort and pull down the morale of a
manager. Why do these diverse effects occur? The answer is found in how the budget is
developed and administered.
In developing the budget, each level of management should be invited to participate. This
bottom-to-top approach is referred to as participative budgeting. The advantages of
participative budgeting are, first, that lower-level managers have more detailed knowledge of
their specific area and thus are able to provide more accurate budgetary estimates. Second, when
lower-level managers participate in the budgeting process, they are more likely to perceive the
resulting budget as fair. The overall goal is to reach agreement on a budget that the managers
consider fair and achievable, but which also meets the corporate goals set by top management.
When this goal is met, the budget will provide positive motivation for the managers. In contrast,
if the managers view the budget as being unfair and unrealistic, they may feel discouraged and
uncommitted to budget goals. The risk of having unrealistic budgets is generally greater when
the budget is developed from top management down to lower management than vice versa.
Participative budgeting does, however, have potential disadvantages. First, it is more timeconsuming (and thus more costly) than a top-down approach, in which the budget is simply
dictated to lower-level managers. A second disadvantage is that participative budgeting can foster
budgetary gaming through budgetary slack. Budgetary slack occurs when managers
intentionally underestimate budgeted revenues or overestimate budgeted expenses in order to
make it easier to achieve budgetary goals. To minimize budgetary slack, higher-level managers
must carefully review and thoroughly question the budget projections provided to them by
employees whom they supervise. Illustration 20-1 graphically displays the appropriate flow of
budget data from bottom to top in an organization.
Flow of budget data from lower levels of management to top
levels
Ethics Note
Unrealistic budgets can lead to unethical
employee behavior such as cutting corners
on the job or distorting internal financial
reports.
For the budget to be effective, top management must completely support the budget. The budget
is an important basis for evaluating performance. It also can be used as a positive aid in
achieving projected goals. The effect of an evaluation is positive when top management tempers
criticism with advice and assistance. In contrast, a manager is likely to respond negatively if top
management uses the budget exclusively to assess blame. A budget should not be used as a
pressure device to force improved performance. In sum, a budget can be a manager's friend or a
foe.
the Organization
Not too long ago, in an effort
to revive its plummeting
stock,
management determined and
publicly announced bold new
financial goals for the coming
year. Unfortunately, these
goals were not reached.
The next year the company
got a new CEO who promised,
We will not over promise,
and we will deliver. The new
budgets were developed with
each operating unit setting
what it felt were optimistic but
attainable goals. In the words
of one manager, using this
approach created a sense of
teamwork: We're all going
forward with our arms locked
together.
Source:
AOL Time Warner's New
Math,
2002, pp. 98102.
Budgeting and Long-Range Planning
Budgeting and long-range planning are not the same. One important difference is the time
period involved. The maximum length of a budget is usually one year, and budgets are often
prepared for shorter periods of time, such as a month or a quarter. In contrast, long-range
planning usually encompasses a period of at least five years.
Helpful Hint
In comparing a budget with a longrange plan:
1. Which has more detail?
2. Which is done for a longer period
of time?
3. Which is more concerned with
short-term goals?
A second significant difference is in emphasis. Budgeting focuses on achieving specific shortterm goals, such as meeting annual profit objectives. Long-range planning, on the other hand,
identifies long-term goals, selects strategies to achieve those goals, and develops policies and
plans to implement the strategies. In long-range planning, management also considers anticipated
trends in the economic and political environment and how the company should cope with them.
The final difference between budgeting and long-range planning relates to the amount of detail
presented. Budgets, as you will see in this chapter, can be very detailed. Long-range plans
contain considerably less detail. The data in long-range plans are intended more for a review of
progress toward long-term goals than as a basis of control for achieving specific results. The
primary objective of long-range planning is to develop the best strategy to maximize the
company's performance over an extended future period.
The Master Budget
study objective 3
Identify the budgets that comprise the
master budget.
The term budget is actually a shorthand term to describe a variety of budget documents . All of
these documents are combined into a master budget. The master budget is a set of interrelated
budgets that constitutes a plan of action for a specified time period.
The master budget contains two classes of budgets. Operating budgets are the individual budgets
that result in the preparation of the budgeted income statement. These budgets establish goals for
the company's sales and production personnel. In contrast, financial budgets are the capital
expenditure budget, the cash budget, and the budgeted balance sheet. These budgets focus
primarily on the cash resources needed to fund expected operations and planned capital
expenditures.
Illustration 20-2 pictures the individual budgets included in a master budget, and the sequence in
which they are prepared. The company first develops the operating budgets, beginning with the
sales budget. Then it prepares the financial budgets. We will explain and illustrate each budget
shown in Illustration 20-2 except the capital expenditure budget. That budget is discussed under
the topic of capital budgeting in Chapter 23.
Illustration 20-2 Components of the master
budget
before
you go
on...
Do it!
Budget Terminology
Use this list of terms to complete the sentences that follow.
Long-range
planning
Sales forecast
Master budget
Solution