Budgets Take On Many Forms And Serve Several Functions Accounting Essay

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All organizations need to carefully plan their financial affairs well in advance to be financially successful in the future. These plans are generally expressed as "budgets."  A budget is a detailed financial plan that quantifies future expectations and actions relative to acquiring and using resources'. (Budgeting: Planning for Success, http://www.principlesofaccounting.com/chapter%2021.htm)

Forms and Functions:

Budgets take on many forms and serve several functions. The basis for detailed sales targets, inventory production, staffing plans, staffing plans, cash investment/borrowing, capital expenditures, etc. is provided by the budgets. They help to establish a benchmark against which actual results can be compared and corrective measures developed.  Budgets assist the manager to go ahead with the execution and spending plans. Budgets also help managers to provide guidance to investors and also convince banks to extend credit. (Budgeting: Planning for Success, http://www.principlesofaccounting.com/chapter%2021.htm)

Formal budgets are a rarity in small organizations. The owner or manager can likely manage only by reference to a general mental budget.  But for Medium and larger organizations, reliance on budgets is invariable.  This is also true for businesses, government, and non-profit organizations.  The budget provides a formal quantitative expression of expectations.  It is an important part of the planning and control process.  Without a budget, an organization is likely to be highly inefficient and ineffective.

Budgets are usually prepared for the coming/next financial year (the budget period), and are broken down into shorter time periods, generally four-weekly or monthly. This enables budgetary control to be exercised over the budget: the actual results can be compared with the budget, and any discrepancies between the two can be looked into and required corrective action can be taken where appropriate. (N Kayali, AS Accounting for AQA, Budgeting and Budgetary Control, http://www.osbornebooks.co.uk/files/af_as_chapter_19_1.pdf)

Some of the benefits and drawbacks of budgeting chartered down by N Kayali (AS Accounting for AQA, http://www.osbornebooks.co.uk/files/af_as_chapter_19_1.pdf) are:

Benefits of Budgets

Assists in Planning

When the objectives throughout a business are formalised, a business can ensure that its plans are achievable. It can then decide what is needed to produce the output of goods and services, and also make sure that everything is available at the right time.

Helps to communicate and coordinate

When a budget is made for the business firm, it considers all the departments within a firm and is aligned with the business strategy, thus all the managers and employees will be working towards the same end. When the budget is being set, any anticipated problems should be resolved and any areas of potential confusion clarified. All departments should be in a position to play their part in achieving the overall goals.

Monitor and Control

A significant outcome of producing a budget is that the management can use budgetary control for monitoring and comparison to the actual results, so that necessary action can be taken to modify the operation of the business as time passes. The firm could also decide to change the budget if it becomes unachievable.

Budget figures

Control & take action Actual figures

Monitor & Compare

Assists in Decision-making

The budget gives a picture of the capacity of a firm, thus allowing the managers to make decisions on how much output is possible to achieve. Also, the costs of outputs can be decided and necessary changes can be made where appropriate.

Helps to motivate

When a budget is passed, it is agreed upon by all departments in a business. Thus, it can be used as a motivating tool to incline managers and employees in achieving the objectives of the business. The budget can be also linked to bonuses, given on the basis of if and when the targets are achieved.

Limitations of budgets and budgetary control:

The benefit of the budget must exceed the cost

The budgeting process is a complex process and maybe burdensome for small companies who lack the time and resources required, with only limited benefits. Also, a loan from the bank would require a budget as part of the business plan. In such a case, the benefit of producing the budget should exceed the cost of producing it.

The budget may Demotivate

When the budget is imposed on employees who have had no part in agreeing and setting a budget, they might tend to feel like they don't own it. As a result, the staff may be demotivated.

Inaccuracy of Budget Information

Information incorporated into budgets needs to be as accurate as possible. A budget can be set by anybody, but the more inaccurate it is, the less it can be used by the business as a planning and control mechanism. All steps in a budgeting process need to be approached with caution. Attention should be given to the estimate of sales, which is often the starting point of budgeting process, and also costs.

Budgets may be set at too low a level

When the budget is set in a way so as to seem easy to achieve, it will be of no benefit to the firm and will lead to lower levels of output and higher costs than before the budget was established. Budgets should be set at realistic levels, which make the best use of the resources available.

Budgets may lead to dysfunctional management

One of the drawbacks of a budget could be that one department of the business may over achieve against the budget and create problems elsewhere. For example, a production department might achieve extra output that the sales department finds difficult to sell. To avoid such dysfunctional management, budgets need to be set at realistic levels and linked and co-ordinated across all departments within the business.

Some of the methods of Budgeting are:

Incremental Budgeting

Incremental budgeting is a traditional method, widely used in commercial organisations and in the public sector. Incremental budgeting bases the budget for a department or function on that of the previous period, adjusting for inflation by a percentage increase. (N Kayali, http://www.osbornebooks.co.uk/files/af_as_chapter_19_1.pdf)

In incremental budgeting, specific changes such as expansion plans or reduction in activities, is allowed. Sometimes the previous year's actual costs may be used as a starting point, rather than the budget, particularly if the actual costs were lower.

Advantages of incremental budgeting:

The budget is stable and change is gradual and planned

Operation of the system is system and it is also easy to understand.

Managers can run their departments on a consistent basis

Conflicts can be avoided if departments can treated without bias, coordination between budgets is easier to achieve

Impact of change can be seen quickly.

Disadvantages of incremental budgeting:

There is no incentive to try to reduce costs - on the contrary, spending up to the budget is encouraged by this method, so that next year the level of budget is maintained

Incremental budgeting assumes that there would be no change in the methods of working, hence there is no incentive for bring up new ideas.

Over time, the budgets cannot be related to, as the level of activity and the type of work varies.

Over time, the priority for resources also changes from the time that the budget was set.

'Budgetary slack' may be built into the budgets, which is never reviewed - this implies that managers have overestimated their requirements in the past, in order to obtain a budget which is easier to work to, and which will allow them to obtain favourable results.

Incremental approach may not lead to the best use of its resources, as these problems can occur in a similar fashion throughout the organization. A department which has been allotted a greater share of the total capital available for a number of years may no longer be of the same importance to the organisation, when other departments which are gradually increasing in importance will need a greater share.

'Traditional budgeting as an instrument of corporate management is increasingly seen as an obstacle to progress by managers'. (jeurgen)

The following methods of Budgeting are preferred over the traditional approach:

Results Based Budgeting(RBM)

Results-based budgeting has now been in use for a number of years in both the public and private sectors of several developed and developing countries. Results based budgeting is a management approach which focuses on achieving results. It is a broad management strategy that aims at changing the way companies operate, with focus on improved performance and obtaining of results. RBB is about formulating programme budgets that are driven by a number of desired results which are articulated at the outset of the budgetary process, and against which actual performance is measured at the end of a biennium. (Neelam S Kumar, http://www.cga.nic.in/pdf/ResultBasedBudgeting1.pdf)

Along the definition of RBB offered by the Secretary General of the United Nations, (http://www.unjiu.org/data/reports/1999/en99_03.pdf) RBB is a 'Programme budget process in which:

(a) Programme formulation revolves around a set of predefined objectives and expected results

(b) Expected results justify the resource requirements which are derived from and linked to outputs required to achieve such results

(c) Actual performance in achieving results is measured by objective performance indicators.'

This definition captures the main features of RBB, namely: objectives, expected results, outputs, and performance indicators.

RBB is the third type of budgeting that has emerged. The results-based budget is in large measure an evolutionary improvement on the programme budget. Both types of budget provide for resource allocations by specific programmes, with work plans and an indication of priorities. Often programme budgets have included elements related to expected results and strategic planning. The distinguishing feature of the results-based budget is its primary focus on expected results and the use of performance indicators to measure achievement of those results.

Traditional budgeting framework vs Results based budgeting

Traditional approach

Figure sourced from article by Neelam S Kumar on Results Based Budgeting (http://www.cga.nic.in/pdf/ResultBasedBudgeting1.pdf)

Performance Based Budgeting

Performance budgeting is a system of planning, budgeting, and evaluation that emphasizes the relationship between money budgeted and results expected. (Government of Alberta,http://www.finance.alberta.ca/publications/measuring/results_oriented/module5_overview.pdf)

Performance budgeting:

Focuses on results

Individual departments are held accountable according to performance standards.

Is flexible

Money is often allocated in lump sums rather than line-item budgets. This gives managers the flexibility to determine which way would be best suited to achieve results.

Is inclusive

It involves policymakers, managers, and often citizens in the budget discussion for the identification of spending priorities, development of business strategies and evaluation of performance.

Has a long-term perspective

By recognizing the relationship between strategic planning and resource allocation, performance budgeting focuses more on longer time horizons.

Common characteristics of performance budgets include:

Identifies the goals, missions and objectives.

Develops and integrates performance measures into the budget.

Links strategic planning information with the budget.

Expenditures are disaggregated into very broad areas (like personnel, capital outlays and operating expenses) rather than more specific line-items.

The Figure below illustrates why performance budgeting is an integral part of an on-going process that focuses on government accountability and performance improvement.

Figure sourced from: (Government of Alberta,http://www.finance.alberta.ca/publications/measuring/results_oriented/module5_overview.pdf)

There are 3 ways in which performance information can be incorporated. Businesses or governments can:

Allocate resources based on results.

Improve internal management of a given level of resources.

Use performance measures in financial reporting.

Contrast to Traditional Budgeting Methods:

Performance budgeting represents a significant departure from traditional line-item budgeting.

A line-item budget is primarily a tool for controlling expenditures. The figure below shows the line-item budget typically spelling out the level of spending allowed for specific purposes. Departmental spending should be within these amounts unless budget amendments are approved. As the fiscal year progresses, departmental spending must be within these amounts unless formal budget amendments are approved. If one department overspends, that cannot be automatically used to supplement another category.

Figure sourced from: (Government of Alberta,http://www.finance.alberta.ca/publications/measuring/results_oriented/module5_overview.pdf)

Though line-items are helpful in supporting managers with internal control, they are not as useful as a policy or decision making tool. The administrative officials are assured that the money is being spent only for approved purposes, but a clear picture of what is being accomplished with that money is not drawn.

Other drawbacks of line-item budgets include:

The focus is on making marginal changes from year to year.

Management not given required flexibility to address changing situations, resulting in in inefficient and uneconomical activities.

In contrast, performance budgeting has more of a policymaking orientation. It:

The following figure shows a performance budget giving a clearer picture of what the department does and what it is expected to accomplish with the funds budgeted.

Figure sourced from: (Government of Alberta,http://www.finance.alberta.ca/publications/measuring/results_oriented/module5_overview.pdf)

Beyond Budgeting Model


The introduction of new management instruments such as the 'Balanced Scorecard' which focuses on better internal coordination of strategic targets and their realization, and value based management which focuses on better orientation of the company to expectations of the investors, has led to the creation of a framework for more flexible performance management geared towards strategy and the capital market. But what is missing is a transition to flexible operational planning and measure management.

The Beyond Budgeting model fills exactly this gap. As a result of beyond budgeting, planning and management process is simplified and more flexible, with simultaneous reduction in efforts. Beyond Budgeting provides new possibilities for strategic enterprise management with a transition to flexible resource allocation. (Jurgen H. Daum, 2002, http://www.juergendaum.de/articles/beyond_budgeting.en.pdf)

The Beyond Budgeting Model overcomes barriers of other methods and creates a flexible, adaptable organization that gives local managers the self-confidence and freedom to think differently, make decisions rapidly, and collaborate on innovative projects with colleagues in multifunctional teams both within the company and outside it. (SAP, http://www.juergendaum.com/news/beyondbudgeting.pdf)

The Beyond Budgeting model comprises of 12 principles as shown in the figure below:


Principles 1 to 6 are concerned with the performance management climate of the company. They involve both the design of the organization and the delegation of power and responsibility to people who are close to customers. Principles 7 to 12 are concerned with the processes of performance management. A key element is that goals, measures, and rewards are not tied together in a performance contract.