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The term budget is usually well understood by the layman. Many people, for example, budget for their own household expenses even if it is only by making a rough comparison between next month's salary and the next month's expenditure.
Main features of a budget
1 Policies. A budget is based on the policies needed to fulfil the objectives of the entity.
2 Data. It is usually expressed in monetary terms.
3 Documentation. It is usually written down.
4 Period. It relates to a future period of time.
Most entities will usually prepare a considerable number of budgets. A manufacturing entity, for example, would normally prepare sales, production and administration budgets. These budgets would then be combined into an overall known as a master budget. This will include a budgeted profit and loss account, a budgeted balance sheet and a budgeted cash flow statement.
Once a master budget has been prepared, it will be examined closely to see whther the overall plan can be accommodated. It might be the case, for example, that the sales budget indicates a large increase in sales. This will have required the production budgets to be prepared on the basis of this extra sales demand. The cash budget, however, might show that the entity could not finance the extra sales and production activity out of its budgeted cash resources, so additional financing arrangements will have to be made because obviously no entity would normally turn down the opportunity of increasing its sales.
Budgets are useful because they encourage managers to examine what they have done in relation to what they could do. However, the full benefits of a budgeting system only became apparent when it is used for control purposes. This involves making a constant comparison between the actual results and the budgeted results, and then taking any necessary corrective actions. This procedure is called budgetary control.
When the actual results for a period are compared with the budgeted results and it is seen that there are material or significant differences (called variances) then corrective action must be taken to ensure that future results will conform to the budget. This is the essence of budgetary control. It has several important features.
Important Features of Budgetary Control
1 Responsibilities. Managerial responsibilities are clearly defined.
2 Action Plan. Individual budgets lay down a detailed plan of action for a particular sphere of responsibility.
3 Adherence. Managers have a responsibility to adhere to their budgets once the budgets have been approved.
4 Monitoring. The actual performance is monitored constantly and compared with the budgeted results.
5 Correction. Corrective action is taken if the actual results differ significantly from the budget.
6 Approval. Departures from the budget are only permitted if they have been approved by senior management.
7 Variances. Those that are unaccounted for are subject to individual investigation.
Any variance that occurs should be investigated carefully. The current actual performance will be immediately brought back into line with the budget if it is considered necessary. Sometimes the budget itself will be changed, e.g. if there is an unexpected increase in sales. Such changes may, of course, have an effect on the other budgets and so cannot be done in isolation.
The Budget Procedure
The budget procedure starts with an examination of the entity's objectives. These may be very simple. They may include, for example, an overall wish to maximize profits, to foster better relations with customers, or to improve the working conditions of employees. Once an entity has decided on its overall objectives, it is in a position to formulate some detailed plans.
These will probably start with a forecast. These is a technical difference between a forecast and a budget. A forecast is a prediction of what is likely to happen, whereas a budget is a carefully prepared plan of what should happen.
The Budget Period
The main budget period is usually based on a calendar year. It could be shorter of longer depending on the nature of the product cycle. The fashion industry, for example, may adopt a shorter budget period of less than a year, while the construction industry may opt for a five year period. Irrespective of the industry, however, a calendar year is usually a convenient period to choose as the base period because it fits in with financial accounting requirements.
Besides determining the main budget period, it is also necessary to prepare budgets for much shorter periods. These are required for budgetary control purposes in order to compare the actual results with the budgeted results on a frequent basis. The sub-budget periods for some activities may need to be very short if very tight control is to be exercised over them, e.g. the cash budget need to be compiled on a weekly basis. In contrast, the administration budget may need to be prepared only quarterly.
The Budget Administration
The budget procedure may be administered by a special budget committee, or it may be supervised by the accounting function. It will be necessary for the budget committee to lay down general guidelines in accordance with the company's objectives, and to ensure that individual departments do not operate completely. The production department, for example, will need to know what the company is budgeting to sell so that it can prepare its own budget on the basis of those sales. However, the detailed production budget must still remain the entire responsibility of the production manager.
This procedure is in line with the concept of responsibility accounting. If the control procedure is to work properly, managers must be given responsibility for clear defined areas of activity, such as their particular cost centre. They are then fully answerable for all that goes on there. Unless managers are given completely authority to act within clearly defined guidelines, they cannot be expected to account for something for which they are not responsible. This means that, as far as budgets are concerned managers must help prepare, amend and approve their own cost centre's budget if the budgetary control system is to work.
The Budgeting Process
In commercial organizations, the first budget to be prepared is usually the sales budget. Once the sales for the budget period (and for each sub-budget period) have been determined, the next stage is to calculate the effect on production. This will then enable an agreed level of activity to be determined. The level of activity may be expressed in so many units, or as a percentage of the theoretical productive capacity of the entity. Once it has been established then departmental managers can be instructed to prepare their budgets on the basis of the required level of activity.
Let assume, for example, that 1000 units can be sold for a particular budget period. The production department manager will need this information in order to prepare his budget. This does not necessarily mean that he will budget for a production level of 1000 units because he will also have to allow for the budgeted level of opening and closing stocks.
The budgeted production level will then be translated into how much material and labour will be required to meet that particular level. Similarly, it will be necessary to prepare overhead budgets. Much of the general overhead expenditure of the company (such as factory administrative costs, head office costs and research and development expenditure) will be fixed and it will not be affected by the activity level. One type of overhead that may be affected by the activity level is the sales and distribution overhead budget because an increase in the number of units sold, for example, may involve additional delivery costs.
The Interrelationship of Budgets
Not all entities start budget process with sales. A local authority is a good example. It usually prepares a budget on the basis of what it is likely to spend. The total budgeted expenditure is then compared with the total amount of council tax (after allowing for grants and other income) needed to cover it. If the political cost of an increase in council tax appears to be too high then the council will require a reduction in the budgeted expenditure. Once the budget has been set, and the tax has been levied on that basis, departments have to work within the budgets laid down. However, since the budget will have been prepared on an estimate of the actual expenditure for the last two or three months of the old financial year, account has to be taken of any a surplus or shortfall expected in the current year. If the estimate eventually proves excessive, the local authority will have overtaxed. This means that it has got some additional funds available to cushion the current year's expenditure. Of course, if it has under taxed for any balance brought forward, departments might have to start cutting back on what they thought they could spend.
This process is quiet different in the private sector because the budgeted sales effectively determined all the other budgets. In a local authority it is the expenditure budgets that determine what the council tax should be, and is only the control exercised by the central government t and by the local authority itself that places a ceiling on what is spent.
Dyson, J.R. (2007) Accounting for Non-Accounting Students, 7th edition, Financial Times, Prentice Hall, London.
The full benefits of budgeting can only be gained if it is combined with a budgetary control system. The preparation of budgets is a valuable exercise in itself because it forces management to look ahead to what might happen, rather than to look back at what did happen. However, it is even more valuable if it is also used as a form of control.
Budgetary control enables actual results to be measured frequently against an agreed budget (or plan). Departures from that budget can then be quickly spotted, and agreed budget (or plan). Departures from that budget can then be quickly spotted, and steps taken to correct any unwelcome trends. However, the comparison of actual results with a fixed budget may not be particular helpful if the actual level of activity is different from that budgeted. It is advisable, therefore, to compare actual results with a flexed budget.
As so many functional budgets are based on the budgeted level of activity, it is vital that it is calculated as accurately as possible, since an error in estimating the level of activity could affect all the company's financial and operational activities. So it is important that any difference between the actual and the budgeted level of activity is investigated carefully.
Budgeting and budgetary control systems may be resented by managers and they might then react to the systems in such a way to protect their own position. This may not be of benefit to the entity as a whole.