Budgets

Understand Budget and the Budgeting System

Business organizations Opens in new window develop strategies as a basis to compete in their operating environment. Budgets are a key component of the organization’s planning and control system, providing the mechanism to translate organizational goals into financial terms.

  • Budgets, more specifically, are forecasts of future revenues and expenditures.
  • Budgeting is the process of gathering information to assist in making those forecasts.

Once established, budgets provide a control tool to ensure that organizational members work to achieve the organizational goals that create organizational value.

Budgeting can be a very costly process. Managers and entrepreneurs often spend up to 20 percent of their time on budgeting. The popularity of budgeting, however, indicates that the perceived benefits of budgeting are greater than its costs.

Information needed to run an organization is widely dispersed throughout the organization. No one person, such as the owner or president, has all the knowledge required to make efficient decisions.

The information held by any specific individual is referred to as specialized knowledge.

The janitor has the specialized knowledge about which floors need cleaning more frequently, while the president has the specialized knowledge of the new products she plans to introduce next year.

The benefits of budgeting result from control and making planning decisions. For planning purposes, the budgeting process generates and communicates information to improve coordination.

The budgeting process Opens in new window is the initial step to implement change in an organization in response to changes in its environment and in customer preferences.

The control benefits of budgets include assigning of responsibilities and scarce resources, providing goals to motivate managers, and establishing performance measures to reward managers.

In the remainder of this post, we outline the role of budgeting for planning decisions and control.

Budgeting for Planning Decisions

Budgets play an integral role in making planning decisions. One purpose of budgeting is to transfer information to the individuals making decisions within the organization.

Managers near the top of an organization’s hierarchy must make major, long-term planning decisions.

Yet, some of the information necessary to make those decisions is located with managers lower in the hierarchy.

To improve major, long-term decisions, the information located lower in the hierarchy must filter up to top-level management. The budgeting process Opens in new window attempts to fulfill this role by encouraging the bottom-up flow of information.

An example of the bottom-up flow of information in the budgeting process is the collection of expenditure requests by the central administration of the university from the various departments.

The head of each department knows the needs of that department, and those needs are communicated to the central administration through the budgeting process Opens in new window. Central administration reviews these requests and selects those with the most merit, and, in the process, learns about the priorities of each department.

Lower-level managers of the organization must also make decisions.

To improve their decisions, lower-level managers could use information located with top-level managers. Top-level managers have aggregated information from the various parts of the organization and the outside environment.

To allow lower-level managers to make both more informed decisions and decisions that are coordinated with other managers within the organization, top-level management must communicate its information and plans from the top-down.

For example, the top managers of a bottle-manufacturing firm must communicate production requirements to the managers of the different manufacturing facilities. The top-level managers have information on global demand for bottles and use this information to determine production requirements for each of the manufacturing facilities.

Budgeting for Control

Budgets also play an important role in control. The budget is used frequently to assign responsibilities by allocating resources to different managers. Giving a manager an advertising budget of $2 million authorizes the manager to consume $2 million of the firm’s resources on advertising.

The level of responsibility given to the manager determines how the advertising budget can be spent.

With more constraints in the budget, a manager has fewer opportunities to make decisions.

The numbers in the budget are also used as goals to motivate organization members. Budgeted numbers become targets for managers.

For example, the manager of a manufacturing plant producing tennis racquets is allocated $1.5 million to make 10,000 racquets.

The 10,000 racquets represent a goal for the plant manager, who is expected to work hard and manage well to achieve the goal.

Once the budget is set, it becomes the target by which preferences is evaluated and rewarded.

In setting the budget, some experts argue that the budget should be “tight” but achievable. If budget goals are achieved too easily, they provide little incentive to expend extra effort. If budgets are unachievable, they provide little motivation.

The rewards for achieving the budgeted goals motivate the desired behavior. If budgeted numbers are achieved, the manager is rewarded through bonuses or other privileges.

The manager of tennis racquet plant strives to achieve the goal of manufacturing 10,000 racquets for $1.5 million, knowing that rewards are based on achieving the budget.

The difference between a budgeted performance measure and an actual performance measure is called the variance.
  • An unfavorable variance occurs when actual costs are greater than the budgeted costs, or actual revenues are less than budgeted revenues.
  • A favorable variance occurs when actual costs are less than the budgeted costs, or actual revenues are greater than budgeted revenues.

Variances are commonly calculated in monthly reports to identify whether an organization is achieving its goals.

Large favorable or unfavorable variances are commonly investigated to determine the reason for the variances and to correct any problems that may exist.

Numerical Example

Ayala Telecom has the following budgeted and actual results for the month of July:

Ayala Telecom
July Profit Statement
BudgetedActual
Revenues$450,000$454,000
Cost of Goods Sold(235,000)(248,000)
General administraton(80,000)(132,000)
Selling expenses(90,000)
Profit$ 35,000$ (16,000)

Calculate the variances for each of the items in the monthly report and describe them as favorable or unfavorable. Which item appears to warrant investigation?

Solution

The variances are the difference between the budgeted and actual amounts:

Ayala Telecom
July Profit Statement
BudgetedActualVariance
Revenues$450,000$454,000$ 4,000 F
Cost of Goods Sold(235,000)(248,000)13,000 U
General administraton(80,000)(132,000)52,000 U
Selling expenses(100,000)(90,000)10,000 F
Profit$ 35,000$ (16,000)$ 51,000 U

The actual general administration expense account is much different than expected and has the largest variance.

Large unfavorable variances are generally the focus of an investigation if the cause of the problem is unknown.

For example, a large variance might result from changes such as new rental agreements, additional staff hired but not budgeted for, or operational changes due to unforeseen circumstances.

The investigation might pinpoint the underlying causes that will need attention. The other accounts have similar variances but might also be investigated.

Budgeting systems are an administrative device that contributes to the achievement of organizational goals. In particular, these systems link knowledge with the responsibility to make planning decisions.

Budgets are also used to distribute responsibilities and to measure and reward performance for control.

This series further analyses various budgeting devices, such as short-term versus long-term budgets Opens in new window, line-item budgets Opens in new window, budget lapsing Opens in new window, and flexible budgets Opens in new window.

These are important budgeting devices used in most organizations.