Profit does not just happen. It has to be planned. Budgets are drawn up with a view to influencing the course of future events, and these budgets are usually seen as a process that begins with the top level, or may even begin at the bottom, a bottoms up approach. It is a reiterative process, so if it is a bottoms up, bidding process then it is likely that the total bids will exceed the resources available, i.e although the departments may have set themselves good targets, there will not be enough people, equipment or finance available for each and every department to reach its target, and also each department is affected by others. So the plans of each department are brought together in a whole plan since the activity and outcomes of each department will have an effect on that of others.
Preparing a budget is vital, since without a plan there is no sense of direction or clarity of purpose at operating levels, but it is important to go about it the right way in order for the budget to be useful for the purposes it proposes. It needs to provide medium term financial plans for all functions of a business. These functions include marketing, production, distribution, administration, finance, labour, purchasing and research & development. The plan derived from a budget must show a link between short-term action and longer-term strategy. One of the first things required when drawing up a budget is to identify the principal budget factor, i.e the limiting factor which constrains the size and scope of an organisation’s operations at a given time. This can be sales demand, production capacity, raw materials or one from many other factors. In order for a budget to be consistent and provide benefits it is important to build it around and reconcile it to the principal budget factor. Effective planning can reap many benefits such as management not losing sight of future requirements despite pressures of day-to-day operations, information is made available on which financial decisions are able to be made, and conscious efforts are made to look for and create new opportunities to exploit.
Standard costing is another technique used to exercise planning and control. It is a “technique which uses standards for costs and revenues for the purposes of control through variance analysis” (CIMA Official Terminology) Budgets and standards are intended to motivate budget holders to achieve certain targets. Attainable standard is the main one used for the basis of control. It is based on what should be achieved under normal working conditions. It indicates the level of performance the organisation aspires to achieve and the resulting standard should be challenging but achievable. However, this is not always the case. If targets are too easy to achieve, it will not motivate, and if it is too difficult, then it is likely to de-motivate. This is where the role of a management accountant plays a part. His role is to ensure relevant data is recorded and collected, facilitates the planning process, provides information for control by budget holders along with other roles. So poor performance may be due to an unrealistic plan being set, or the standard may act as a perverse incentive e.g. buyer purchases cheap, but poor quality material to stay within standard; causing difficulties elsewhere in the organisation.
It is important to distinguish between an extrapolation, a forecast and a plan. An extrapolation simply being a prediction of what will happen, assuming present trends continue. A forecast takes a more realistic assumption that trends will change by foreseeable factors. These two are not planning although forecasting is an important part of the planning process. A plan must involve some kind of intervention to affect events, In order for it to be more likely that an organisation will achieve its targets. Failure to distinguish and assume that a forecast or an extrapolation is a budget can be fatal, and it is here where a budget starts to become pointless and no longer fulfils its purpose, lack of intervention. An organisation will most likely never achieve its targets if it fails to use information at its disposal in order to steer the organisation in the right direction towards them. Spotting weak areas, or areas where the target is unachievable and altering accordingly. The budget setting process can be characterised as authoritarian, consultative or participatory. In the authoritarian approach, budgets are just imposed on budget-holders by superiors. This will serve no purpose, since interaction is required to realise what the main targets should be, what targets are achievable and which are not at the present time. The Consultative approach asks budget-holders for their opinions, which are genuinely considered, but it is clear that the final decision on the budget setting lies with the superiors, and participatory is where budget-holders are involved in the final say on a budget, but the degree of involvement varies vastly, and with these three approaches there is a danger of pseudo-participation in budget setting, where that budget-holders are seemingly consulted and asked for their opinions on a budget, and even participate in the final decision, but in reality they are merely called upon as a formality and to ‘legitimise’ the decision that has essentially already been taken by the superiors. This can be very de-motivating right the way down the organisation, and is one key area where budgets can fall rendering them useless for their purpose. A process of genuine negotiation may well lead to a budget that is acceptable to both operating divisions and to the central organisation. A budget cast in conditions of fear and apprehension, however, can lead to attempts to create budget slack. This is exemplified by the readiness of employees to introduce improved working methods, it is understandable that more efficient working methods can be discovered through experience. Staff and management however may choose not to introduce them at the earliest opportunity. Instead they may keep them in reserve to cushion the effects of a tight budget at some time in the future. Behaviour like this is not in the best interests of the company as a whole, but it shows how budget preparation can lead to conflicts.
Crises can often occur where insufficient care has been taken with planning, and failure to update plans as circumstances change, since plans need to be changed when activity grows for the simple reason that growth requires added finance for labour, supply of materials and services.
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