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A budget is a financial plan and a list of all planned expenses and revenues. It is a plan for saving, borrowing and spending. A budget is an important concept in microeconomics, which uses a budget line to illustrate the trade-offs between two or more goods. In other terms, a budget is an organizational plan stated in monetary terms.
The purpose of budgeting is to:
1. Provide a forecast of revenues and expenditures, that is, construct a model of how our business might perform financially if certain strategies, events and plans are carried out.
2. Enable the actual financial operation of the business to be measured against the forecast.
3. Establish the cost constraint for a project, program, or operation.
Budget helps to aid the planning of actual operations by forcing managers to consider how the conditions might change and what steps should be taken now and by encouraging managers to consider problems before they arise. It also helps co-ordinate the activities of the organization by compelling managers to examine relationships between their own operation and those of other departments. Other essentials of budget include:
* To control resources
* To communicate plans to various responsibility center managers.
* To motivate managers to strive to achieve budget goals.
* To evaluate the performance of managers
* To provide visibility into the company's performance
Sales budget - an estimate of future sales, often broken down into both units and dollars. It is used to create company sales goals.
Production budget - an estimate of the number of units that must be manufactured to meet the sales goals. The production budget also estimates the various costs involved with manufacturing those units, including labor and material. Created by product oriented companies.
Cash flow/cash budget - a prediction of future cash receipts and expenditures for a particular time period. It usually covers a period in the short term future. The cash flow budget helps the business determine when income will be sufficient to cover expenses and when the company will need to seek outside financing.
Marketing budget - an estimate of the funds needed for promotion, advertising, and public relations in order to market the product or service.
Project budget - a prediction of the costs associated with a particular company project. These costs include labour, materials, and other related expenses. The project budget is often broken down into specific tasks, with task budgets assigned to each. A cost estimate is used to establish a project budget.
Revenue budget - consists of revenue receipts of government and the expenditure met from these revenues. Tax revenues are made up of taxes and other duties that the government levies.
Expenditure budget - includes spending data items.
IMPORTANCE OF BUDGET
1) Controls our spending:
Even if you want to spend you cannot since you have already budgeted how much you are going to spend on each items like groceries, entertainment, phone bills etc.
2) Helps savings:
If you spend less you are bound to save more thus by budgeting you save more money. An important part of budgeting is that at the end of each month you know how much you have spent and how much you have saved. If you find that your expenses are more and you have not saved enough then the next moth you will try harder to save more. Thus you will be motivated to save more. Budgeting also helps to plan for your retirement. You must leave aside some amount of money from your income for retirement savings plan.
3) You learn to live within your means:
By preparing a budget you know your financial position and you will maintain your lifestyle accordingly, you will learn to live within your means and not squander money.
4) Controls and manages debt:
Since budgeting promotes savings you are not likely to take loans but if it is necessary to take a loan for e.g. housing loan then by budgeting you make provisions to repay this loan on time and thus it helps in managing and controlling debt.
5) Builds a secured future:
By budgeting you save more and plan more thus you are planning for a secured future. You know that you are prepared to face any financial situation in future.
BEHAVIOURAL ASPECTS OF BUDGETING
A budget can be defined as a 'quantified plan relating to a given period'. Although budgets are often stated in terms of money, they need not be, and can also relate to quantities made and sold, numbers of employees to be recruited, or weights of material to be consumed. Quantification is important because it adds precision and clarity to a plan.
This article looks at three aspects of budgeting, though there is considerable cross over between them:
â€¢ the purposes of a budgets, including motivation and evaluation
â€¢ budgets as objectives.
â€¢ how to set a budget
PROBLEM ASSOCIATED WITH BUDGET
Inevitably, if an organization is going to draft a budget which will be of any use whatsoever, it will have to make forecasts. These forecasts will not always be correct, but at least the organization has had to look ahead. It won't see every danger or opportunity, but looking ahead must be better than moving forward with eyes closed.
Forecasts are often based on the results of previous periods, updated for known changes. Statistical methods are sometimes used to forecast seasonal effects. Occasionally, specialist data might be purchased to help organisations take economic effects into account as economies improve or deteriorate.
Organisations need to beware of forecasts becoming self fulfilling prophecies. For example, if a downturn is anticipated and because of that sales budget are cut thus reducing employees' ability to sell, then there will be a downturn in sales. We will discuss later the difficult issue of budgets which motivate as opposed to a budget which we hope to achieve.
Once forecasts are completed, planning can be carried out. For example, if the forecast suggests a dramatic increase in demand, then new production facilities might have to be planned. However, it is important to be aware at the planning stage that the forecasts might not be correct, or even if they were correct at the time they were made, things can change. Detailed planning might even require the forecasting stage to be revisited to check estimates or to try to gather more evidence for estimates. Even if forecasting does not have to be reviewed, planning should, as far as possible, remain flexible, just in case the forecast isn't fulfilled. So, perhaps instead of acquiring new production facilities, it might be better to hire or subcontract initially to see if the forecast is right. If it is, then the organisation can go ahead and buy production facilities for the following period.
The planning of cash flows is particularly important. Cash flow forecasts are routinely produced but the organization which believes them unconditionally will have a short life. Plan for possible shortfalls; build in flexibility; have short term financing facilities planned and on call should things not turn out as well as expected.
In many ways, coordination is an aspect of planning, but it is worthy of a separate mention. What this heading really highlights is that there has to be a match between the organization's structure and ambition and the requirements for its success. In some businesses it is important to meet well-understood customer demands quickly and reliably, and in this context, strict budget targets and measurement can be vital to success. Other businesses might find that flexibility, adaptability and technical innovation are more important. If you don't know what customers require, then setting targets through budgets is less applicable - and might even be counter-productive because it can limit responses: it's not in the budget, so we can't do it.
A budget is a succinct and precise way of communicating targets to departments and employees or at least some aspects of what should be achieved. The problem is not what is specified in the budget, it's what's not specified. The budget might state explicitly that 2,000 units should be made in a period, but implicit in the target is that the units should be of a certain quality. The budget might be explicit about the labour rate per hour to be paid, but might not specify the skills that employees should have.
Unfortunately, but inevitably, employees will take most notice of explicit requirements and are liable to downgrade other important but unspecified factors. Of course, a lot will depend on how the budgets are imposed and how results are interpreted, but it is important for budgets to communicate requirements as comprehensively as possible.
A budget represents a target, and aiming towards a target can be a powerful motivator. However, whether the target will actually cause employees to do better is thought to depend on how difficult the target is perceived to be. Employees have different perceptions of targets, but generally it is thought that:
â€¢ if targets are very low, actual performance can be pulled down from where it might naturally have been
â€¢ if targets are habitually very high, then employees might give up and, again, performance can be reduced - if you know that no matter how hard you try you will fail to meet the target, it's easy to conclude that you might as well not try at all. So, the aim is to set budgets which are perceived as being possible, but which entire employees to try harder than they otherwise might have done. Of course, two employees can look at the same budget and have quite different impressions about how difficult it is, but we are unlikely to develop individual budgets tailored to individual psychologies. The concept of a 'motivating budget', however, is a powerful one, although the budget which is best for motivating might not represent the results which are actually expected. Managers can, and perhaps should, build in a margin for noble failure. The relationship between budget difficulty and actual performance is typically represented
â€¢ When the budget is very easy, actual performance is low. It has been pulled down by the low demands made of employees
â€¢ When a budget is set at the level of the expectations employees are likely to perform as expected.
â€¢ If a more difficult aspirational budget is set, employees will try harder, and if the budget is judged just right then their actual performance will be at its maximum, though often falling short of the budget.
Once budgets have been set as performance targets, inevitably performance will be evaluated. This can be simply a comparison of actual with budgeted performance or alternatively can be a more elaborate comparison of actual performance with flexed budget performance, as is found in variance analysis and operating statements. The evaluation stage is often one of the most contentious as it is here that performance is likely to be criticised and employees will be sensitive. There are many potential difficulties:
â€¢ The budget might simply have been wrong, unachievable from the outset.
â€¢ The budget might have become unachievable as the period progresses.
â€¢ Departments' performances could interfere with each other's.
â€¢ Elements of the budget could be incompatible so meeting one target means missing another.
â€¢ Although the right decision was made for long-term profitability, this had an adverse effect on the short-term budget.
THREE DISTINCT WAYS OF USING BUDGET INFORMATION WHEN EVALUATING PERFORMANCE:
1 Budget constrained style. Here, an employee's performance is primarily judged on their ability to continuously meet their budgets on a short-term basis. This criterion is held to be more important than all other desirable outcomes. So, for example, over-spending to get a machine repaired quickly so that an important order is shipped would be criticised because the repair budget was exceeded. Not surprisingly, this approach leads to very poor manager subordinate relationships and also encourages the manipulation and misreporting of information.
2 The profit conscious style. Here, employees are primarily judged on their ability to increase the long-term effectiveness of their departments. Budgets are not ignored, but they are regarded more as guidelines than strict targets and are interpreted flexibly. In the above example, the employee would be more likely to be praised for getting the machine repaired as that enabled the organization to meet customer requirements.
3 Non-accounting style. Here, budgetary information does not play a big part in evaluation. It's almost impossible to envisage any organization which is not now subject to financial and therefore budgetary restraints, but from time to time there are elements of an organizations where money is relatively unimportant. An example might be the budget required by an airline company to meet health and safety requirements, because the consequences of not doing so would be disastrous.
Benefit of budgetary planning and control
Maximization of Profits
Budgetary control in an organization leads to maximization of profits. Budgetary control involves fixing of different budgets concerning capital and revenue expenditure thus making the employees alert in the organization about costs and performance. The money is incurred on the important activities and resource is utilized optimally resulting to profit maximization.
Proper Planning, Co-ordination & Control
Budgetary control aims at proper planning, coordination and control in the organization. It sets standards of costs, i.e. budgets, and compares it with the actual results. Any deviation between the budgeted figures and the actual performance is known as variance. A negative variance means that actual cost exceeds the budgeted cost. It is an alarming situation for the management. Through budgetary control, management becomes aware about the performance of the enterprise and takes necessary corrective actions. It sets proper coordination among different departments in the organization so as to achieve the budgeted targets.
To Use the Forecasting Techniques
Budgetary control technique helps management use the forecasting techniques. There are three departments in the organization that work together for estimating and forecasting cost and expenditure. The accounting department provides previous years' data, the department of statistics provides tools and techniques of forecasting and the management department calculates the future projections of revenues and expenditures. Budgetary control technique helps these departments in planning budgets and coordinates with each other for better control on the operations.
Effective Utilization of Company's resources
Budgetary control eliminates misuse of money and company funds. Budgetary control involves fixing of various budgets and if any discrepancies arise, the responsible person will be accountable for his action. For example, a company selling mobile phones has fixed the target of selling 4 million units. The target is decided after consulting with the sales manager. After one year, if sales are just 1 million units, the sales manager must explain the shortfall in the number of units sold in the market below the budgeted level.
Incentive Schemes to the Employees
Budgetary control systems also provide various financial and non-financial incentives to the employees of the company for exceeding the budgeted level of performance. The comparison of budgeted and actual performance will facilitate the use of such schemes.