Budgeting

• Budget

  A detailed plan for the acquisition and use of financial and other resources over a specified time period, usually in monetary terms and other quantitative terms such as production units and labour hours
• Reasons for producing budgets

  • To aid the planning of actual operations
  • To co-ordinate the activities of the organization
  • To communicate plans to various responsibility centre managers
  • To assign responsibility
  • To motivate managers
  • To control activities
  • To evaluate performance
• Types of Budget

  • Functional Budgets (Income and expenses - e.g. sales, production, direct material, direct labour, production overhead, selling and distribution overhead)
  • Cash Budget
  • Master Budget (Statement of Profit or Loss, Statement of Financial Position, Cash flow)
  • Production Budget (Quantity produced: Sales + Closing inventory - Opening inventory)
• How challenging should budget targets be?

  Employees are likely to be more motivated to perform if a target exists. As the budget target is made more difficult then employee performance will increase. However beyond a certain level of difficulty the budget target will appear impossible to achieve and performance will decline. Therefore challenging budgets that are possible, but unlikely, to be achieved are likely to have the most positive motivational effect on employees' performance.
• Who should prepare the budget?

  • Senior managers (produce a budget for the whole firm and then it is split into budgets for individual responsibility centres)
  • Junior managers (each produce a budget their responsibility centre and then these are combined to produce a budget for the whole firm)
• Advantages of bottom-up budgeting

  • Lower level employees are more likely to accept the targets set and be committed to meeting them
  • Lower level employees will have better knowledge of the operating environment
  • The motivation of lower level employees is likely to be increased
• Advantages of top-down budgeting

  • Quicker, and therefore cheaper, to prepare
  • Senior employees are more likely to have skills required to produce budgets
  • Senior employees will have a better view of the organisation as a whole
  • Avoids the problem of lower level employees attempting to set budgets that are easy to achieve
• Budgetary Slack/Padding

  Padding the budget means intentionally underestimating revenues or overestimating costs. The difference between the revenue or cost projection that a person provides and a realistic estimate of the revenue or cost is called budgetary slack.
• Types of Budgets

  • Fixed (based on one level of activity) - master plan for year
  • Flexible (recognises different cost behaviours) - when volume of activity changes
• Incremental Budgeting

  The current budget is taken as the starting point for next year's budget. Therefore it is only the changes in the budget that must be justified. Managers do not need to justify the total.
• Zero-Based Budgeting (ZBB)

  An alternative to the traditional incremental budgeting approach. ZBB starts budget figures from the base zero. A system of establishing financial plans beginning with an assumption of no activity and justifying each program or activity level.
• Benefits of Zero-Based Budgeting (ZBB)

  • More efficient allocation of resources - only activities that can be justified through the decision package are committed
  • Managers are made aware of the consequences of their decisions (mainly through justification process)
  • Reflects the activities needed in the future rather than those performed in the past
• After some initial success, zero-based budgeting was found to often be impractical. Massive amounts of time were required to implement and update the budget. Costs and efforts involved. Difficulties in justifying activities.
• Disadvantages of budgeting

  • Encourage rigid planning and incremental thinking that is unable to react to changes in the environment
  • Are extremely time consuming, meaning that the cost of producing them outweighs their benefits
  • Focus too much on short-term financial numbers and ignore what is really important to the creation of value
  • Provide incentives to meet, not do better than, targets
  • Encourage wasteful spending as managers try to avoid their budget being cut in the following year
  • Are disconnected from strategy
• Disadvantages of bottom-up

  • requires more time and money, not very efficient
  • each sector might create easy goals for themselves
  • can stress the employees as they may not have the required skill level
• disadvantages of top-down

  • senior managers dont know the realities of the operating environment
  • can seem dictatorial whereby lower employees may feel discouraged by not having an opinion