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Budgeting is the process of identifying, gathering, summarizing, and

communicating
financial
and
nonfinancial
information
about
an
organizations future activities. It is an essential part of the continuous is the
process of identifying, gathering, summarizing, and planning that an
organization must do to accomplish its long-term goals and intermediate
objectives
Careful planning is vital to the health of any organization. Failure to plan,
either
formally
or informally, can lead to financial disaster. Managers of businesses, whether
small
or
large, must know their resource capabilities and have a plan that details the
use
of
these
resources.
Budgeting plays a crucial role in planning and control. Plans identify
objectives
and
the
actions needed to achieve them. Budgets are the quantitative expressions
of
these
plans,
stated in either physical or financial terms or both. When used for planning, a
budget
is a method for translating the goals and strategies of an organization into
operational
terms. Budgets can also be used in control. Control is the process of setting
standards,
receiving feedback on actual performance, and taking corrective action
whenever
actual
performance deviates significantly from planned performance. Thus, budgets
can
be
used
to compare actual outcomes with planned outcomes, and they can steer
operations
back
on course, if necessary.
Advantages of Budgeting
Organizations realize many benefits from budgeting, including:
Budgets communicate managements plans throughout the organization.
Budgets force managers to think about and plan for the future. In the
absence
of
the
necessity to prepare a budget, many managers would spend all of their
time dealing with day-to-day emergencies.

The budgeting process provides a means of allocating resources to those


parts
of
the
organization where they can be used most effectively.
The budgeting process can uncover potential bottlenecks before they
occur.
Budgets coordinate the activities of the entire organization by integrating
the plans of its various parts. Budgeting helps to ensure that everyone in
the organization is pulling in the same direction.
Budgets define goals and objectives that can serve as benchmarks for
evaluating subsequent performance.

A budget is a financial plan of the resources needed to carry out tasks and
meet financial goals
Types of Budgets
The master budget is a comprehensive financial plan for the year and is
made up of various individual departmental and activity budgets. A master
budget
can
be
divided
into
operating and financial budgets. Operating budgets are concerned with
the income generating activities of a firm: sales, production, and finished
goods
inventories.
The

ultimate outcome of the operating budgets is a pro forma or budgeted


income
statement.
Note that pro forma is synonymous with budgeted and estimated. In
effect,
the
pro forma income statement is done according to form but with estimated,
not historical, data. Financial budgets are concerned with the inflows and
outflows
of
cash
and
with
financial position. Planned cash inflows and outflows are detailed in a cash
budget,
and
expected financial position at the end of the budget period is shown in a
budgeted,
or
pro
forma, balance sheet
The master budget is usually prepared for a one-year period corresponding
to
the
companys fiscal year. The yearly budgets are broken down into quarterly
and
monthly
budgets. The use of shorter time periods allows managers to compare actual
data
with
budgeted data as the year unfolds and to make timely corrections. Because
progress
can
be checked more frequently with monthly budgets, problems are less likely
to
become
too serious.

Most organizations prepare the budget for the coming year during the last
four
or
five months of the current year. However, some organizations have
developed a continuous budgeting philosophy. A continuous (or rolling)
budget
is
a
moving
12-month
budget. As a month expires in the budget, an additional month in the future

is
added
so
that the company always has a 12-month plan on hand. Proponents of
continuous budgeting maintain that it forces managers to plan ahead
constantly.

Strategic planning
Companies generally start the strategic planning process by stating their
critical success factors, which are the most important things for the company
to do to be successful. For example, Southwest Airlines relies on several
factors to maintain its competitive edge. It uses a point-topoint network of
routes instead of the hub and-spoke system used by most U.S. airlines, has
efficient gate turnaround, and uses only one type of plane. These factors
keep costs low and make Southwest a price leader.
Companies build on these critical success factors to expand operations. For
example, McDonalds has developed expertise in the fast-food business over
many years. McDonalds management has realized that its expertise and
worldwide reputation could be used to successfully expand throughout the
world. The company continues to use its competitive advantages (e.g., name
recognition, value, and consistency) to succeed in areas outside the United
States.
A master budget is part of an overall organization plan for the next year,
made up of three components:
Organizational goals: are the broad objectives management
establishes and company employees work to achieve. Such broad
goals indicate managements philosophy about the company.
The strategic long-range profit plan: Although a statement of goals is
necessary to guide an organization, it is important to detail the specific
steps required to achieve them. These steps are expressed in a
strategic long-range plan. Because the long-range plans look into the
intermediate and distant future, they are usually stated in rather broad
terms. Strategic plans discuss the major capital investments required
to maintain present facilities, increase capacity, diversify products
and/or processes, and develop particular markets

The master budget (tactical short-range profit plan): Long-range plans


are achieved in year-by-year steps. The guidance is more specific for
the coming year than it is for more distant years. The plan for the
coming year is called the master budget. The master budget is also
known as the static budget, the budget plan, or the planning budget.
The income statement portion of the master budget is often called the
profit plan. The master budget indicates the sales levels, production
and cost levels, income, and cash flows anticipated for the coming
year. In addition, these budget data are used to construct a budgeted
statement of financial position (balance sheet)
Budgeting is a dynamic process that ties together goals, plans, decision
making, and employee performance evaluation.

The Human Element in Budgeting


A number of factors, including their personal goals and values, affect
managers beliefs about the coming period. Although budgets are often
viewed in purely quantitative, technical terms, the importance of this human
factor cannot be overemphasized
Budget preparation rests on human estimates of an unknown future. Peoples
forecasts are likely to be greatly influenced by their experiences with various
segments of the company. For example, district sales managers are in an
excellent position to project customer orders over the next several months,
but market researchers are usually better able to identify long-run market
trends and make macro forecasts of sales.
The use of inputs from lower- and middle-management employees is often
called participative budgeting or grassroots budgeting. It has an obvious
cost; it is time consuming. But it also has some benefits; it enhances
employee motivation and acceptance of goals, and it provides information
that enables employees to associate rewards and penalties with
performance. Participative budgeting can also yield information that
employees know, but managers do not.
Some studies have shown that employees provide inaccurate data when
asked to give budget estimates. They might request more money than they
need because they expect their request to be cut. Employees who believe

that the budget will be used as a standard for evaluating their performance
may provide an estimate that will not be too hard to achieve

Characteristics of a Good Budgetary System


An ideal budgetary system is one that achieves complete goal congruence
and simultaneously creates a drive in managers to achieve the
organizations goals in an ethical manner. While an ideal budgetary system
probably does not exist, research and practice have identified some key
features that promote a reasonable degree of positive behavior. These
features include frequent feedback on performance, monetary and
nonmonetary incentives, participation, realistic standards, controllability of
costs, and multiple measures of performance.
Frequent Feedback on Performance
Managers need to know how they are doing as the year unfolds. Providing
them with frequent, timely performance reports allows them to know how
successful their efforts have been and gives them time to take corrective
actions and change plans as necessary. Frequent performance reports can
reinforce positive behavior and give managers the time and opportunity to
adapt
to
changing
conditions.
The use of flexible budgets allows management to see if actual costs and
revenues
are
in accord with budgeted amounts. Selective investigation of significant
variances
allows
managers to focus only on areas that need attention. This process is called
management
by exception
Monetary and Nonmonetary Incentives
A sound budgetary system encourages goal-congruent behavior. Incentives
are
the
means that are used to encourage managers to work toward achieving the
organizations
goals. Incentives can be either negative or positive. Negative incentives use
fear of punishment to motivate; positive incentives use rewards. Both

incentives
organization.

can

be

used

by

an

Participative Budgeting
Rather than imposing budgets on subordinate managers, participative
budgeting
allows
subordinate managers considerable say in how the budgets are established.
Typically,
overall objectives are communicated to the manager, who helps develop a
budget that will accomplish these objectives. In participative budgeting, the
emphasis is on the accomplishment of the broad objectives, not on individual
budget items
Participative budgeting communicates a sense of responsibility to
subordinate managers and fosters creativity. Since the subordinate manager
creates the budget, it is more likely that the budgets goals will become the
managers personal goals, resulting in greater goal congruence. In addition
to the behavioral benefits, participative budgeting has the advantage of
involving individuals whose knowledge of local conditions may enhance the
entire planning process.
The advantages of participative budgeting are as follows:

Improved quality of forecasts to use as the basis for the budget: Managers
who
are
doing a job on a day-to-day basis are likely to have a better idea of what
is
achievable,
what is likely to happen in the forthcoming period, local trading
conditions, etc.
Improved motivation: Budget holders are more likely to want to work to
achieve
a
budget that they have been involved in setting themselves, rather than
one
that
has
been
imposed on them from above.
Better results: being the executor of the budget the applicant can control
the
costs
better than any other manager.

Participative
mentioned:

budgeting

has

two

potential

problems

that

should

be

1. Building slack into the budget (often referred to as padding the budget)

2. Pseudo participation
The first problem with participative budgeting is the opportunity for
managers
to
build slack into the budget. Budgetary slack exists when a manager
deliberately underestimates revenues or overestimates costs. Either
approach increases the likelihood that the manager will achieve the budget
and
consequently
reduces
the
risk
that
the
manager
faces. Padding the budget also unnecessarily ties up resources that might be
used more productively elsewhere.
The second problem with participation occurs when top management
assumes total control of the budgeting process, seeking only superficial
participation from lower-level managers. This practice is termed pseudo
participation. Top management is simply obtaining formal acceptance of
the budget from subordinate managers, not seeking real input. Accordingly,
none of the behavioral benefits of participation will be realized.
Multiple Measures of Performance
Often, organizations make the mistake of using budgets as their only
measure of managerial performance. Overemphasis on this measure can
lead
to
a
form
of
dysfunctional
behavior called milking the firm or myopia. Myopic behavior occurs
when
a
manager
takes actions that improve budgetary performance in the short run but bring
long-run
harm to the firm.
There are numerous examples of myopic behavior. To meet budgeted cost
objectives
or profits, managers can reduce expenditures for preventive maintenance,
advertising,
and new product development. Managers can also fail to promote deserving
employees
to keep the cost of labor low and can choose to use lower-quality materials to
reduce
the
cost of materials. In the short run, these actions will lead to improved
budgetary performance, but in the long run, productivity will fall, market
share
will
decline,
and
capable
employees will leave for more attractive opportunities.

The best way to prevent myopic behavior is to measure the performance of


managers on several dimensions, including some long-run attributes.
Productivity,
quality,
and
personnel development are examples of other areas of performance that
could be evaluated. Financial measures of performance are important, but
overemphasis
on
them
can
be counterproductive.

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