Learning Outcomes
- Understand objectives of budgeting
The budgeting process involves planning for future profitability because earning a reasonable return on resources used is a primary company objective. A company must devise some method to deal with the uncertainty of the future. A company that does no planning whatsoever chooses to deal with the future by default and can react to events only as they occur. Most businesses, however, devise a blueprint for the actions they will take given the foreseeable events that may occur.
A budget: (1) shows management’s operating plans for the coming periods; (2) formalizes management’s plans in quantitative terms; (3) forces all levels of management to think ahead, anticipate results, and take action to remedy possible poor results; and (4) may motivate individuals to strive to achieve stated goals.
Companies can use budget-to-actual comparisons to evaluate individual performance. For instance, the standard variable cost of producing a personal computer at IBM is a budget figure. This figure can be compared with the actual cost of producing personal computers to help evaluate the performance of the personal computer production managers and the employees who produce personal computers. Often, this type of analysis is called benchmarking.
Many other benefits result from the preparation and use of budgets, For example:
- Businesses can better coordinate their activities
- Managers become aware of other managers’ plans
- Employees become more cost-conscious and try to conserve resources
- The company reviews its organization plan and changes it when necessary
- Managers foster a vision that otherwise might not be developed.
The planning process that results in a formal budget provides an opportunity for various levels of management to think through, solidify, quantify, and document future plans. In addition, a properly prepared budget allows management to follow the management-by-exception principle, which means devoting attention to results that deviate significantly from planned levels. For all these reasons, a budget must clearly reflect the expected results.
Failing to budget because of the uncertainty of the future is a poor excuse for not budgeting. In fact, the less stable the conditions, the more budgeting becomes necessary and desirable, although the process becomes more difficult. Obviously, stable operating conditions permit greater reliance 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 expected activities. As a result, budgeted performance is more useful than past performance as a basis for judging actual results.
A budget should describe management’s assumptions relating to (1) the state of the economy over the planning horizon; (2) plans for adding, deleting, or changing product lines; (3) the nature of the industry’s competition; and (4) the effects of existing or possible government regulations. If these assumptions change during the budget period, management should analyze the effects of the changes and include this in an evaluation of performance based on actual results.
Budgets are quantitative plans for the future. However, they are based mainly on past experience adjusted for future expectations. Thus, accounting data related to the past play an important part in budget preparation. The accounting system and the budget are closely related. The details of the budget must agree with the company’s ledger accounts. In turn, the accounts must be designed to provide the appropriate information for preparing the budget, financial statements, and interim financial reports to facilitate operational control.
Management should frequently compare accounting data with budgeted projections during the budget period and investigate any differences. Budgeting, however, is not a substitute for good management. Instead, the budget is an important tool of managerial control. Managers make decisions in budget preparation that serve as a plan of action.
The period covered by a budget varies according to the nature of the specific activity involved. Cash budgets may cover a week or a month; sales and production budgets may cover a month, a quarter, or a year, and the general operating budget may cover a quarter or a year.
