BUDGETS AND BUDGETING

  Learning Objectives

After studying this chapter, you should be able to:

·      explain the concept of budgeting

·      explain the types of budgets

·      explain the concept of principal budget factor

·      distinguish between budgeting and forecasting

·      explain the objectives of budgeting

·      explain the factors to be considered in introducing budgets for the first time

·      explain what is meant by: budget committee and budget manual.

·      explain the behavioral factors in budgeting

·      prepare functional budgets, cash budgets and the master budget.

INTRODUCTION

At the beginning of the financial period of every organisation, whether the organisation is publicly or privately owned, it needs to develop its budget to guide its operations for the year ahead. Budgeting is therefore an important process of every organisation. How effectively the budgeting process is handled in an organization could define success or failure for the organisation.

Section One: Introduction to Budget

1.1         Definition of budget

A budget is a quantitative plan of the operations of an organisation or an   individual;

it identifies the resources and the commitments required to fulfill the organization‟s

individual‟s goals for theincludesbudgetedbothfinancialand nonperiod-. financial aspects of the planned operations.

1.1.1    What a budget is:

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A budget has the following features:

·      It is a plan in quantities

·      It must have objectives, and a clearly expressed means of achieving the stated objectives

·      The means to achieve the objectives are the resources required to fulfill those objectives. Thus there must be definite resources set aside to achieve the set objectives.

·      The set objectives must be achieved within a particular time frame. This time frame is termed the budget period.

1.1.2    What a budget is not: A budget is not:

·      only a narrative plan

·      only involving price increases in the budgeted period

·      only developed for states, governments may even be developed for individuals

·      only prepared by economists or accountants but everybody on this universe.

Budgeting is the process of preparing budgets.

1.2         Types of budgets

There are various types of budgets:

1.2.1    Long term Budgeting

This is also referred to as long range planning, strategic or corporate planning. It is a systematic and formalized process for purposely directing and controlling future operations towards desired objectives for periods extending beyond one year.

The planning process involves the following:

·      Identify objectives

·      Search for alternative courses of action

·      Gather data about the various alternatives

·      Evaluate the alternatives on the basis of cost-benefit relationships

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·      Select the optimum alternative and formulate these into plans

·      Implement the long range plans through annual budgets

·      Monitor the actual results

·      Respond to variances

1.2.2    Short –Term Budgeting

These are operational plans which generally cover one year and which form the basis of the annual budgets. They are detailed, containing well-defined targets, which translate into work plans and performance measurements for each unit in the business. Short–term budgets are a means of implementing strategic plans.

These are developed after due consideration of:

-              The prevailing business environment, internal and external

-              The available resources; physical, human and financial.

1.2.3    Annual budgets

The   annual   budget   translates-rangeplanintoshort -termtheoperatingcompany‟

targets. These are usually developed by    involving  all  people  responsible  for

achieving the targets they   contain.

1.2.3    Functional Budgets.

The functional budgets are the budgets developed for the operations of each function in the organization. Usually, the budget for the function that has the binding or effective budget factor or limiting factor is first developed bearing in mind the budget factor.

All the other functional budgets are subsequently developed from the budget of the function with the binding constraint. Most often, sales is the limiting budget factor. However this is not necessarily always the case. The following are examples of functional budgets

a.    Sales budget in quantity and in value

b.    Other sales related budgets

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i.             Selling and distribution cost budget

ii.           Advertising cost budget

iii.         Sales promotion cost budget etc.

c.    Production budget in quantity, and cost

d.    Other production related budgets

i.             labour usage and cost budget

ii.           Materials usage and cost budget

iii.         Material purchases budget

iv.                Production overhead budget.

v.            Production cost budget

e.    Service function budgets

i.             Administration cost budget

ii.           Personnel cost budget

f.     Policy Related Budgets

i.             Capital expenditure budgets

ii.           Research and development budgets

iii.         Advertising and promotional budge

iv.          Training and staff development budgets

1.2.4    The Cash Budget

The cash budget summarizes the cash flow effects of all of the functional and policy related budgets by coordinating them into one summarized statement.

1.2.5    Master budget

The master budget summarizes all the budgets into a coordinate projected financial statement comprising of:

 Budgeted trading, profit and loss account or income and expenditure account as the case may be;

 Budgeted balance sheet or statement of affairs; and  Budgeted cash flow statement for the period.

Other forms of budgeting such as fixed and flexible budgets, periodic and continuous budgets, incremental and zero based budgets etc. will be explained in the next chapter.

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1.3         Principal budget factor

The principal budget factor or limiting factor or key budget factor is a factor, which at any time is an overriding planning limitation on the activities of the organization. Examples of principal budget factors include: Staffing limitations, scarcity of materials and other logistics, limited financial resources, low sales demand, limited storage facilities etc.

1.4         Forecasting in budgeting

A forecast is a prediction or estimate of the events which are likely to occur in the future. The forecast becomes a budget only when management accepts it as the objective. Frequently, consideration of the forecast sales leads management to make adjustments to their plans so that the agreed sales budget differs from the original sales forecast.

Forecasting is very essential for facilitating budgeting. Budgeting for future profit or cash flows requires us to forecast future costs and revenues at different level of activities.

1.4.1    Methods of forecasting

Our study on forecasting is only an introductory one and therefore we will be brief on the various methods.

1.4.1.1              Industrial engineering method

These methods are based on the use of engineering analysis of the technological relationships between inputs and outs –for example

-              Methods study

-              Work sampling

-              Time and motion studies

Analyses are made based on direct observations of the underlying physical quantities required for an activity and the final results are then converted

into cost estimates. The procedure is as follows

 Establish quantities of input required of

Conditions That Are Suitable For the Application of Linear Regression

Analysis includes the following:

1.            Where the cost is significant for items that are not large the inspection of accounts method may be appropriate.

2.            Where it is not possible to specify the optimum amounts of inputs, the least square regression may be used, but for items like direct materials and direct labour, where it is possible to specify the optimum amounts of inputs, engineering methods may be used.

3.            Where cost data and activity levels relate to the same period;

4.            Where a sufficiently large number of observations have been obtained for relatively short term periods.

5.            Where allocated costs are excluded from the analysis

6.            Where observations from past periods that represent abnormal situations which are not expected to occur again in the future is excluded from the analysis

7.            The forecast is in respect of a range of activity level contained in the analysis.

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1.5        The objectives of budgeting

The following are some of the objectives of budgeting:

i.   To aid the planning of annual operations

ii.   To coordinate the activities of the various parts of the organization and to ensure that the parts are in synchrony or harmony with each other.

iii.   To communicate plans to the various responsibility center managers.

iv.    To motivate employees to strive to achieve targets

v.    To control activities

vi.    To evaluate the performance of managers

1.5.1    Planning

Budgets compel or force planning to take place. The result is that problems are anticipated before they arise and hasty decisions made on the spur of the moment based on expediency rather than reasoned judgment will be minimized. The annual budget also leads to the refinement of strategic plans

1.5.2    Co-ordination

The budget is a vehicle that synchronizes and harmonizes the separate plans of the

different units, sections and segments of the	organization.   Budgeting	compels	an
examination of the relationships between	various   operations   and	hence	the
resolution of any conflict.

1.5.3    Communication

Top management communicates its expectations to lower management through the budget, which is an executive order.

Much vital information about the organisation is communicated through the process of preparing the budget through the discussions during the budget preparation. The budgetary reports are a feed–back to management of performance levels.

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2.5.4    Motivation.

Realistic and attainable budgets serve as a standard of good performance and thus motivate staff to strive to achieve them. For a budget to motivate, all staff

	must participate in its development.
.5.5	Control
	Variance reports generated from the budgetary control system are a good
	control mechanism facilitating management by exception, which is efficient
	and cost effective. Budgets clarify the authority and responsibility of managers
	by setting budget limits to their	spending powers and setting targets to be
	achieved.

2.5.6    Performance Evaluation

Performance could be evaluated by measuring the success of achieving budgeted results. The budgets based on the accepted standards are the bench marks for measuring performance.

Section Two: The Budgeting Process

2.1         Introducing Budgeting for the First Time

When introducing a budgeting system for the first time, ensure that the following  are

in place.

·      There is a sound financial accounting system

·      Obtain top management backing for the system

·      Establish a budget committee

·      Design a budget manual.

2.1.1    Necessary Conditions for Successful Budgeting

1.    Top management support

2.  Involvement of line managers

3.  Appropriate accounting and information systems

4.  Budgets to be flexibly administered

5.  Realistic organization structure with clearly defined responsibilities

6.  Clearly defined long term corporate objectives

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7. Regular budget reviews when necessary

2.2        The Budget Committee

The Budget Committee is made up of members of senior management that oversees all budgetary matters. A typical budget committee includes the chief executive officer, heads of strategic business units and the chief finance officer. The committee sets or approves the overall budget goals for the organisation, and its major business units, directs and coordinates budget preparation, approves the final budget, monitors operations as the year unfolds, and reviews the operating results at the end of the period.

The budget committee also approves major revisions of the budget during the period. This committee usually consists of sectional or departmental managers and is usually serviced by the Budget Officer who normally is the finance officer. Apart from the above, the functions of the committee may include the following:

·      Determine Budget Policy Guidelines and selecting budget policies compatible with organizational goals and objectives

·      Establishing the budget timetable

·      Review budget estimates submitted by sectional heads

·      Facilitate the co-ordination of the budgets

·      Suggest amendments to Budgets and revising budget estimates when necessary

·       Approve budgets after amendments

·      Facilitate the generation of budgetary control reports

·      Analysing budget reports and recommending changes

·      Examine variances, recommend investigation of variances and recommend solutions to remedy off-standard performance.

·      Advise top management on all matters concerning the budget

2.3         The Budget Manual

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The Budget manual sets out the Budget Guidelines which are budgeting instructions, that the Budget Committee gives to guide departmental heads involved in the preparation of the budget so that they follow a particular goal, objective, technique, trend or method of estimating the income and expenditure variables.

The starting point in developing strategy. In developing the initial budgeting guidelines, the budget committee needs to consider developments that have occurred since

the adoption of the strategic business plan; general economic and the market trends; the goal of the organisation for the budgeting period; specific budgeting policies such as mandate for downsizing, reengineering, and special promotions; and the operating results of the year to date.

Thus, the Budget Manual sets out instructions on the responsibilities and procedures of budget preparation. The manual should specify the following:

·      Objectives of the budget

·      Functional budgets to be prepared

·      Membership of the budget committee

·      Organizational charts

·      Procedure for budget preparation

·      Budget time tables

·      Budget policy guidelines etc.

2.4         The Process of Preparing Annual Budgets

2.4.1    The Initial Budget Proposal

Based on the initial budget guidelines, each responsibility centre prepares its initial budget proposal.

A number of internal factors are considered by a budget unit in preparing an initial budget proposal. These include the following:

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 Changes in availability of equipment or facilities

 Adoption of new manufacturing processes

 Changes in product design or product mix

 Introduction of new product

 Changes in expectations or operating processes of other budget units that the budget unit relies on for its inputs materials or other operating factors

 Changes in other operating factors or in the expectations or operating processes in those other budget units that rely on the budget unit to supply them components

It is also important to consider some external variables such as:

·      Changes in the labour market

·      Availability of raw materials or components and their prices

·      The   industry‟s   outlook   for   the   y

·      Competitors‟   actions   etc.

2.4.2    Budget Negotiation

The officers in charge of budget units examine the initial budget proposals to see whether the proposal is within the budget guidelines. The officer also checks to see if the budget goals can be reasonably attained and are in line with the goals of the budget units at the next level up, and whether the budget operations are consistent with the budgeted activities of other budget units

Negotiations occur at all levels of the organisation. The role of the Budget Committee in the coordination is very critical. This process is perhaps the core of the budgeting process and takes the bulk of budgeting time.

2.4.3    Review and Approval of the budget

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As budget units approve their budgets, the budgets go through the successive levels of the organizational hierarchy until they reach the final level, when the combined unit budgets become the budget of the organisation. The budget committee reviews and gives final approval to the budget. The budget committee examines the budget for consistency with the budget guidelines, attainment of the desired short-term goals, and fulfillment of the strategic plan.

2.4.4    Revision of the budget

Procedures for budget revision vary from on organisation to the other. Once a budget has been approved, some organisations allow budget revisions only under special conditions; other organisations continuously update their budgets, by building into the budgeting system, quarterly or monthly revisions as may be deemed appropriate.

2.5         Behavioral Factors in Budgeting

We have already observed how important budgets are in the achievement of corporate goals. We must at the same time note that there are a lot of behavioral factors that influences the usefulness of budgets. Budgets must be effectively and flexibly administered by management for them to assist in planning, motivation and control.

In order to foster positive behavioral conditions, there should be employee participation in the development of budgets. Especially to be involved in the

budgetary process are employees   who     are     responsible     for     the

implementation of budgets.

Another important factor that promotes good behavioral consequences is when budgets are realistically attainable. Budgets must be tough but achievable. Unrealistic budgets lower employee motivation to achieve the budgets.

If budgets are used as reward or penal mechanism, it may lead to conflicts and organizational goals may not be achieved. Budgets should be used as cost control mechanism rather than as cost-cutting mechanism and should strive to

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achieve goal congruence by harmonizing corporate goals with those of individual employees in the organization. Where there are significant conflict between corporate and employee goals, organizational objectives may not be achieved.

Where budgets are flexibly administered and the process participatory, the following advantages may emerge:

·      Employees tend to accept the budget as their own plan of action and goal congruence is achieved

·      Participation tends to increase morale among employees

·      Employee cohesion increases morale and productivity.

The climate for operating the budgetary system should be structured so that individuals welcome it rather than being anxious and defensive. This requires that each individual be given the freedom and authority to influence and accept his or her own performance level and the responsibility for accomplishing it.

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