A budget is a detailed plan showing the financial consequences of an organization’s operating activities for a specific future period. A budget acts as a financial model that summarizes future operations.
Budgets are usually viewed as a core component of an organization’s planning and control system.
The procedures and activities that are undertaken to develop a budget are known as the budgeting process.
The budget is a formal quantitative expression of the goals of management. The act of preparing a budget is called budgeting. The use of a budget to assist management in the controlling process is called budgetary control.
However, in the budgeting process, these three terms are sometimes used interchangeably.
Therefore, through the process of budgeting, management specifies the events that must take place to ensure that target profit and other objectives will be achieved.
A budget is usually drawn up for an annual period. The first step in the preparation of a budget is to look at actual expenditure and revenues for the previous year.
With a good accounting system, expenditure for the prior year will be broken down and reported in considerable detail.
Since many expenditures tend to vary with sales or volume of production, estimating these elements may be the most sensitive part of the entire budget. A good manager will base his entire budget on the advice received from his sales and marketing people.
Also, budgets should contain enough information presented in an orderly manner so that its purpose is communicated to the user. Too much information or too little information clouds the accuracy of the budget.
Purposes of the Budgeting Process
The budgeting process can serve five primary purposes. However, it should be noted that not all purposes are served by all budgeting systems.
For example, in some small businesses, planning and resource allocation may be the only intended purposes of the budgeting system.
The most obvious purpose of a budget is to set out a plan of action. The budgeting process forces the individuals within a business to plan.
For example, in formulating a quarterly budget for a five-star hotel, the hotel manager and reservations manager must collaborate to plan the staffing and supplies needed to meet anticipated demand for the hotel’s services.
Facilitating Communication and Coordination
For a business to plan operations effectively, communication and coordination must be effective between all managers. Significantly, the budgeting process provides a formal mechanism to enable this to take place.
For example, to plan pricing structures and the number of ticket sales, the sales manager for Virgin Blue or Qantas airlines must know the flight schedules developed by the airline’s route manager.
The budgeting process pulls together the plans of each manager in an organization.
Generally, a firm’s resources are limited and budgets provide one way of allocating resources among competing uses.
A large retailer, such as Coles Mayer, would use the budgeting process to consider the many alternative uses that could be made of its limited resources.
For example, managers running the company’s supermarkets would be competing for resources against managers operating its department stores and specialty stores. The budgeting process provides a forum for evaluating the uses of limited resources.
Controlling Profit and Operations
The budget can serve as a benchmark to allow comparison against actual financial results at all levels of a business.
For example, within a sales department, actual sales against budgeted sales may be reported on a weekly basis to help sales staff exercise some control over total sales.
Also, the budgeted costs of a customer service department may be compared with actual costs each month to point to areas where greater cost control is required.
As part of the budgeting process, standard costs are often developed for major production inputs (e.g., direct materials used in production) or activities. These ideal cost benchmarks help managers to control financial resources.
Evaluating Performance and Providing Incentives
Comparing actual results with budgeted results also helps managers evaluate the performance of individuals, departments, divisions, or the entire company.
Since budgets are used to evaluate performances, they can also be used to provide incentives for people to perform well.
For example, hotel managers at the Australian hotel chain All Seasons Hotels participate in a profit-sharing scheme that provides them with incentives to meet or exceed their budgeted profit goals.
Learn more about the concept of budgeting by knowing the features of a budget and understanding how budgets are classified.
Test your knowledge about the topic, we have prepared problems and solutions about budgeting and a quiz on Capital Budgeting below.
Production Budget: Practical Problems and Solutions
Cash Budgets: Practical Problems and Solutions
Capital Budgeting MCQs