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As Bhimany et al. stated in 2008 "A budget is a quantitative expression of proposed plan of action by management for a future time period and is an aid to the coordination and implementation of the plan. It can cover both financial and non-financial aspects of these plans and acts as a blue-print for the company to follow in the forthcoming period".
The budgeting system is a conventional way of handling and directing companies. Financial departments use the budgeting method to plan and organize them company's business activities in the following year of their company. Budget is a standard with which the actual data can be compared. (Joshi et al., 2003)
Some of the primary purposes of the budget are to motivate employees, allocate resources and coordinate operations within an organization. Budgeting is aimed to facilitate responsibility distribution and is used to evaluate performance (Libby & Lindsay, 2003).
Especially nowadays, because of the financial crisis that Greece and many other European countries are going through, businesses operating in those countries need to feel secured and protected. This is where budget gets involved in order to inform the management of the company on what will be the expenses for the upcoming year.
Main Purposes of Budgeting
Companies used budget at its very first years of existence as a control function only (Libby & Lindsay, 2003), but nowadays there are several objectives and purposes of the budget and the purposes differ from company to company. Drury (2004) mentions that the main purposes of budgeting are:
Companies must know that they act in the best way in order to achieve their goals and targets. This is where budget is coming to plan the future activities of the organization.
Planning budget is used to plan sales, financial issues, purchase of material, etc. Through planning, a company can be aware of how many recourses are needed, giving the possibility to plan inflows and outflows of liquidity.
The managers, who set a budget, must be aware of any future changes or problems that may occur. This gives the privilege to take actions in order to avoid that problem before it strikes the company (Granof & Khumawala, 2010).
All units within an organization are, more or less, dependent on each other. By using a budget the units have to cooperate and compromise when it concerns limited resources.
Every unit has their own budget and when these budgets are compiled, defects and inaccuracies are revealed. The budgets can be a way to discover coordination and cooperation problems.
The budget is meant to make it possible to see the organization as a whole and try to solve conflicts. If departments have different ways of doing things, the budget makes the departments' compromise and work together, in order to make the budget for the whole organization complete.
To reduce the risk of overcapacity within the company it is important to dimension the organization. By comparing budgets from departments they contribute to coordinate the size of production.
Budgets contribute to good communication through the exchange of information that takes place during the budgetary process.
The budget process enables employees to communicate and share their ideas with other workers within the organization. Through discussions, employees can share their opinions and ideas with each other.
For managers, the budget can be used to communicate and explain strategies and goals within the company to the employees. Furthermore it connects departments and gives insight and understanding for each other.
Budgets are aimed to facilitate resource allocation within companies, secure that the resources are being used effectively and that the right amount is distributed to the departments, which is crucial.
Units in the organization get different priorities. By distributing resources to units, resource allocation could be seen as a control tool. However, this sort of management requires that the managers take an active part in the budgetary process.
They need to be well informed about the factual questions and have all concerning facts and details.
The budget functions as a control system for performance evaluation. By setting budget targets the accountable are held responsible for reaching the objectives. Through a follow up of the budget, which means when the budget is being compared with the actual outcome, managers can be evaluated.
When follow-ups are made it is possible to discover variations from plan. Focusing and putting effort into deviations from plan is called "management by exception". By investigating the reasons to why the variations occur, actions can be taken. When budgets are made for shorter periods than a year, it can be valuable to make follow-ups every month and this enables changes if the actual outcomes vary from plan.
Hence, this requires that the original budgets are distributed correctly over the year and that managers have made an effort to make budgets as realistic as possible for every month. Analyzing the budget every year and examine if there are any large variations can facilitate to more usable budgets in the future.
Budgets are often used for distribution of responsibility. A study proved that using a budget for distributing accountability is more important than using it as a control tool.
During the budget process, responsibility is assigned to employees and it is vital that the managers clarify what is expected from the employees. A follow-up is being made to guarantee that the managers/employees have lived up to their commitment. It is a mutual commitment between the company and the accountable.
The company contributes with the resources needed and the accountable are responsible for doing what they said they would do. Further, the budget is a tool to make managers responsible for their actions and to work in the best interest of the organization.
In organizations the budget is used for setting targets for managers. It is common that managers receive a bonus if they are able to "stick to the budget" and reach the goals. The objectives indicate what is important in the organization and what it is trying to achieve. Different targets for each unit within the organization are aimed to show what is expected of them.
The objectives for the organization are being divided into goals for every department. When setting a budget for a decentralized organization it is a prerequisite that the main budget is divided into budgets for every unit. Drury (2004) states that there are three different kinds of targets for an organization: mission, corporate objectives and unit objectives.
The mission of an organization is the reason to why the company exists; it describes in general terms, which the customers are, and what the concept of the company is. Corporate objectives are specific goals for an organization and the board of directors often establish them, e.g. return on equity, market share etc.
Unit objectives are the goals for the units in the company. While corporate objectives are seen as goals for the organization as a whole, unit objectives are made for different parts of the organization.
Budgets are used as a motivation tool. When employees are involved in the budget and target setting-process, they are often more motivated to try to achieve the goals. By setting clear and defined targets based on the budget, employees understand what is expected of them and can therefore feel more motivated. Though, this requires that targets are set on an appropriate level and that they are challenging but realistic. Meanwhile, if the targets are too difficult to achieve they could instead be de-motivating.
The main purposes stated above are complemented with two purposes by Ax et al (2009):
The budget creates awareness about the organizations goals and to make workers understand the "big picture". Personnel can understand how their work is contributing to the organization as a whole instead of just seeing their own unit (Ax et al, 2009).
Commonly, organizations use the budget as an incitement for the employees. The budget becomes a benchmark for what is a sufficient level to reach. By comparing the budget with the actual outcome, a reward for the accountable can be made (Ax et al, 2009).
Budgeting is a time-consuming and costly job. The development of a budget includes many repetitive steps before the budget is finally approved. As an example, participative budgeting (which is supposed to be a better model) involves managers at all levels (and sometimes all of the employees) developing their own initial estimates for sales, costs, etc. This process requires lots of negotiations between managers at different levels until a budget evolves which is acceptable to all levels (Langfield-Smith, Thorne & Hilton, 2006).
Bartrum (2006) cites the Hackett Group's research to demonstrate that even the most efficient companies take 79 days to plan their budgets, while the worst take 210 days to complete the whole process.
The Ford Motor Company has calculated that they spent $1.2 billion annually for budgeting (BBRT, 2006). This is because it involves many people in the organization and absorbs up to 20-30 percent of top executives' and financial managers' time.
Steps in preparing a budget
According to Bragg (Bragg, 2011) these are the steps that should be done in order to prepare an efficient budget:
Update budget assumptions. Review and bring the assumptions which were used in the latest budgeting model to date.
Review bottlenecks. Determine what is constraining the company from generating further sales, and explain how this will influence any supplementary company revenue growth.
Available funding. Determine the most expected amount of funding that will be available during the budget period.
Step costing points. Determine whether any step costs will be sustained during the likely range of business activity in the upcoming budget period, and define the amount of these costs and at what activity levels they will be incurred.
Create budget package. Copy forward the basic budgeting instructions from the instruction packet used in the previous year. Update it by including the year-to-date actual expenses incurred in the current year, and also annualize this information for the full current year. Add a commentary to the packet, stating step costing information, bottlenecks, and expected funding limitations for the upcoming budget year.
Issue budget package. Issue the budget package individually, where possible, and answer any questions from recipients. Also state the due date for the first draft of the budget package.
Obtain revenue forecast. Obtain the revenue forecast from the sales manager, validate it with the CEO, and then distribute it to the other department managers. They use the revenue information as the basis for developing their own budgets.
Obtain department budgets. Obtain the budgets from all departments, check for errors, and compare to the bottleneck, funding, and step costing constraints. Adjust the budgets as necessary.
Obtain capital budget requests. Validate all capital budget requests and forward them to the senior management team with comments and recommendations.
Update the budget model. Input all budget information into the master budget model.
Review the budget. Meet with the senior management team to review the budget. Highlight possible constraint issues, and any limitations caused by funding limitations. Note all comments made by the management team, and forward this information back to the budget originators, with requests to modify their budgets.
Process budget iterations. Track outstanding budget change requests, and update the budget model with new iterations as they arrive.
Issue the budget. Create a bound version of the budget and distribute it to all authorized recipients.
Load the budget. Load the budget information into the financial software, so that you can generate budget versus actual reports.
Hope and Fraser (1997) argue that with the big changes in the business world, intellectual assets accounting for 80-90% of market capitalization. While many companies recognize that the underlying source of future cash flows increasingly comes from the effective management of intellectual assets, it is beyond the capability of budgets to properly account for these intellectual assets.
In other words, only 10-20% of a company's value can be analyzed by its budget. Banks in Scandinavia using budgets have an average 70% of cost/income ratio. In contrast, Svenska Handelsbanken, which does not utilize budgeting, has a 45% cost/income ratio (Hope & Fraser, 1997).
This shows that budgets add little or no value to shareholders' assets. Budgets are rigid, restricted and fixed to artificial period. The budget period can be too long to adapt today's dynamic and quickly changing market; conversely, the fiscal year may be a too short-term horizon for planning and steering some major activities of today's companies, like R&D, brand development or growing business relationships between partners and potential customers. So budgets can restrict or hinder business and organizational development in the long run while adding little, if any, value to the business.
How do budget enhances control?
Owing to the adverse consequences of violating budgetary mandates, both governments and not-for-profits can build safeguards into their accounting systems that help assure budgetary compliance. These include preparing journal entries both to record the bud- get and to give recognition to goods and services that have been ordered but not yet received. We begin the discussion by describing the basic books of account maintained by governments and not-for-profits and showing how they accommodate these safeguards.
The basic books of account of both governments and not-for-profits correspond to those of businesses. They consist, either in manual or electronic form, of:
Journals, in which journal entries are recorded. Most transactions are entered initially in a special journal, such as a property tax cash receipts journal, a parking fines cash receipts journal, a purchases journal, or a cash disbursements journal. Both no routine transactions and account totals from special journals are recorded in a general journal.
Ledgers, in which all balance sheet and operating accounts are maintained. The general ledger consists of control accounts that summarize the balances of the detailed subsidiary accounts that are maintained in subsidiary ledgers.
Key phases of budget cycle
Budgeting practices in neither governments nor not-for-profits are standardized; they differ from entity to entity. However, irrespective of whether the budget is of object classification or performance type, in most organizations budgeting is a continuous, four-phase process:
Legislative adoption and executive approval
Reporting and auditing
The budgetary control states:
The identification of controlled and non-controlled items
On the issue of the hierarchy of control
The effectiveness and impact of control
The importance of deviations and limits of control
The positive and negative aspects of Budgeting Control
Controlled and non-controlled items
The budgetary control requires:
The separation of spending controlled (elastic) and uncontrolled (inelastic) costs.
The separation of business centers or areas of responsibility.
Should endeavor to increase the controllable costs, otherwise we will end up in bureaucratic administration, which is remote from the centers of expenditure and therefore not aware of the real needs.
Hierarchy Of Control
Mainly, the content of feedback at different levels of government. The information about the result of the modulated according to the level of responsibility and authority in which the auditee is under budget.
Each officer is informed of the outcome of its area of â€‹â€‹responsibility and the lower. The separate and detailed information moves from the lower to the upper levels of government increasingly centralized and ensures the project evaluation in upper and central government on the state of the business.
Effectiveness Of Control
The effectiveness of control depends mainly
The acceptability of the budget of those who would have to implement.
The degree of power in relation to the responsibility assigned to each level of the hierarchy.
The responsibility must go hand in hand with responsibilities.
Easy flow and completeness of information. The budgetary control is simple, understandable, and documents the findings.
Signifocance Of Gaps
A deviation is significant when leading the administration to take corrective measures. Defining the boundaries of permissible differences are either statistically or empirically.
Deviations must answer the following questions:
Where are due
The factors that cause is accidental or not
They could provide
Positive and negative elements
The budget establishes quantitative and temporal action programs
The budget control gives specific content to power and responsibility of management.
The budgetary control system is an information and coordination activities.
The budgetary control minimizes time detection of errors and accelerates the process of solving.
There is also the possibility that the budget will cause problems in effective business and human relationships, based on faulty projections imposed by authoritarian no overall premise of objectives and a means of policing rather than encouragement of people in taking the right initiatives.
Setting The Target
The budget is based on normal and not standard. Serve short-term goals but must be aligned with a long-term strategic goal. When you enter this strategic objective all directions and plans of action programs seek to achieve.
Such strategic objectives are:
Increase market share
Reduction of production costs
Goal setting is necessary because:
Establishes a disciplined approach to solving problems
Enters single mindset in business
Coordinates the implementation of programs and budgets
The design can be long and short term.
The strategic goal is not structured problem but a vision.
The long design gives directions leading to vision.
Long-term programs covering a period of 3-5 years and up to 10 years.
The programs cover a short period of 6 months to 1 year.
The short programs are characterized by clarity, accuracy and detail items not characterize long.
It should however be noted that the