Managing Financial and Human Resources

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Topic Overview 7 – Budgeting, Financial Planning, Cash

budget and Decision Making

Contents:

1. Introduction

2. Budgetary process

3. Advantages and Disadvantages of Budgets

4. Budgeting, Master budget and Cash budget

By the end of this week, you will be able to:

• Understand what budgeting is

• Understand budgeting’s advantages and disadvantages

• Perform the budgeting process

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1. Introduction

Shims et al. (2011) defines budget as the formal expression of plans, goals, and

objectives of management that covers all aspects of operations for a designated time

period. The budget is a tool providing targets and direction. Budgets provide control over

the immediate environment, help to master the financial aspects of the job and

department, and solve problems before they occur. Budgets focus on the importance of

evaluating alternative actions before decisions are implemented.

As the authors discuss, Budgeting allocates funds to achieve desired outcomes. A budget

may span any period of time. It may be short term (one year or less, which is usually the

case), intermediate term (two to three years), or long term (three years or more). Short-

term budgets provide greater detail and specifics.

Effective budgeting requires the existence of:

• Predictive ability

• Clear channels of communication, authority, and responsibility

• Accounting-generated accurate, reliable, and timely information

• Compatibility and understandability of information

• Support at all levels of the organization: upper, middle, and lower

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Shims et al. present the following example of budget segments within an organization.

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2. Budgetary process

Rosanas (2016) argues that budgets have to be considered a management activity, and,

thus, have to be accepted in managerial terms. One should not expect budgets to be a

technique that does not need managerial abilities to be applied, or a technique that works

alone automatically, or is done by specialists in accounting and/or finance.

On the contrary, as it is discussed by the author, it is something that has to be applied by

line management, largely by people whose training in accounting is rather limited, as

accounting is not their job (like people in production or sales, who typically are a big

percentage of the firm’s payroll) and thus has to be as simple as possible. Otherwise, one

should not be surprised to find most of the people involved to be strongly against budgets.

They may simply misunderstand budgets or budgets may require from them an

unreasonable effort.

Shims et al. (2011) argue that the budget process used by a company should suit its

needs, be consistent with its organizational structure, and take into account human

resources. The budgetary process establishes goals and policies, formulates limits,

enumerates resource needs, examines specific requirements, provides flexibility,

incorporates assumptions, and considers constraints. The budgeting process should take

into account a careful analysis of the current status of the company. The process takes

longer as the complexity of the operations increase. A budget is based on past experience

plus a change in light of the current environment.

Budgeting process steps:

1. Setting objectives

2. Analyzing available resources

3. Negotiating to estimate budget components

4. Coordinating and reviewing components

5. Obtaining final approval

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6. Distributing the approved budget

Libby and Lindsay (2010) as it is summarized by the following figure, argue that the

criticism that budgets are not linked to strategy is unfounded for the majority of firms in

the sample. The budgeting process is used in many firms to promote strategically focused

behavior and is recognized as being an important mechanism for doing so. The results

have been produced by asking the following question to the responders (in US and

Canada) regarding how Strategy is implemented in the organizations: Strategy

implementation measure: “Please allocate a total of 100 points across the following

elements of management control to reflect their relative importance in implementing

strategy in your business unit”.

Shims et al. (2011) list several possible budgets’ weaknesses:

➢ Managerial goals are off target or unrealistic.

➢ There is management indecisiveness.

➢ The budget takes too long to prepare.

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➢ Budget preparers are unfamiliar with the operations being budgeted and do not

seek such information. Budget preparers should visit the actual operations

firsthand.

➢ Budget preparers do not keep current.

➢ The budget is prepared using different methods each year.

➢ There is a lack of raw information going into the budgeting process.

➢ There is a lack of communication between those involved in budgeting and

operating personnel.

➢ The budget is formulated without input from those affected by it. This will likely

result in budgeting errors. Further, budget preparers do not go into the operations

field.

➢ Managers do not know how their budget allowances have been assigned or what

the components of their charges are. If managers do not understand the

information, they will not perform their functions properly.

➢ The budget document is excessively long, confusing, or filled with unnecessary

information. There may be inadequate narrative data to explain the numbers.

➢ Managers are ignoring their budgets because they appear unusable and

unrealistic.

➢ Managers feel they are not getting anything out of the budget process. Changes

are made to the budget too frequently.

➢ Significant unfavorable variances are not investigated and corrected. These

variances may also not be considered in deriving budgeted figures for next period.

Further, a large variance between actual and budgeted figures, either positive or

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negative, that repeatedly occurs is an indicator of poor budgeting. Perhaps the

budgeted figures were unrealistic. Another problem is that after variances are

identified, it is too late to correct their causes. Further, variance reporting may be

too infrequent.

➢ There is a mismatching of products or services.

All the above must be taken into consideration in order to take the required corrective

action.

The budgetary and control process is summarized by the following exhibit presented by

Shims et al. (2011).

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3. Advantages and Disadvantages of Budgets

Shims et al. (2011) mention the following advantages of budget:

Links objectives and resources.

➢ Communicates to managers what is expected of them. Any problems in

communication and working relationships are identified. Resources and

requirements are identified.

➢ Establishes guidelines in the form of a road map to proceed in the right direction.

➢ Improves managerial decision making because emphasis is on future events and

associated opportunities

➢ Encourages delegation of responsibility and enables managers to focus more on

the specifics of their plans and how realistic the plans are, and how such plans

may be effectively achieved.

➢ Provides an accurate analytical technique

➢ Provides better management of subordinates. For example, a manager can use

the budget to encourage salespeople to consider their clientele in long-term

strategic terms

➢ Fosters careful study before making decisions

➢ Helps management become aware of the problems faced by lower levels within

the organization. It promotes labor relations

➢ Allows for thinking how to make operations and resources more productive,

efficient, competitive, and profitable. It leads to cost reduction

➢ Allows management to monitor, control, and direct activities within the company.

Performance standards act as incentives to perform more effectively

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➢ Points out deviations between budget and actual, resulting in warning signals for

changes or alterations

➢ Helps identify on a timely basis weaknesses in the organizational structure. There

is early notice of dangers or departures from forecasts. The formulation and

administration of budgets pinpoints communication weaknesses, assigns

responsibility, and improves working relationships

➢ Provides management with foresight into potential crisis situations so alternative

plans may be instituted

➢ Provides early signals of upcoming threats and opportunities

➢ Aids coordination between departments to attain efficiency and productivity. There

is an interlocking within the business organization. For example, the production

department will manufacture based on the sales department’s anticipated sales

volume. The purchasing department will buy raw materials based on the

production department’s expected production volume. The personnel department

will hire or lay off workers based on anticipated production levels. Executives are

forced to consider relationships among individual operations and the company as

a whole

➢ Provides a motivational device setting a standard for employees to achieve

➢ Provides measures of self-evaluation

➢ Management can make distasteful decisions and blame it on the budget.

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However, the authors mention several disadvantages for budgets as well:

➢ A budget promotes gamesmanship in that those managers who significantly inflate

requests, knowing they will be reduced, are in effect rewarded by getting what they

probably really wanted.

➢ A budget may reward managers who set modest goals and penalize those who

set ambitious goals that are missed.

➢ There is judgment and subjectivity in the budgeting process.

➢ Managers may consider that budgets redirect their flexibility to adjust to changing

conditions.

➢ A budget does not consider quality and customer service.

Further to the above, Hansen et al. (2003) present the following criticisms of budgets

and/or assumptions underlying the use of budgets:

• Budgeting consumes a lot of managerial time which makes it a costly process and

the benefits may not be worth the cost.

• Budgets inhibit firms from adapting to changes in a timely manner due to their fixed

nature.

• The budgeting process is disconnected with strategy thereby putting it out of kilter

with the competitive demands facing firms.

• The use of the budget as a fixed performance contract leads to unreliable

performance evaluation and promotes budget gaming.

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Concluding, organizations need to observe and assess the advantages and

disadvantages of budgets in order to achieve the optimal financial planning and control

by ensuring that the benefits of budgeting outweigh the drawbacks. As Libby and Lindsay

(2010) conclude for the majority of firms budgets continue to be used for control purposes

and are perceived to be value-added. While problems exist with budgets, organizations

are adapting their use to account for these problems rather than abandoning budgets

altogether.

4. Budgeting, Master budget and Cash budget

Shims et al. (2011) argue that a comprehensive—master—budget is a formal statement

of management’s expectation regarding sales, expenses, volume, and other financial

transactions for the coming period.

The budget is classified broadly into two categories:

1. Operating budget

2. Financial budget

The operating budget consists of:

➢ Sales budget

➢ Production budget

➢ Direct materials budget

➢ Direct labor budget

➢ Factory overhead budget

➢ Selling and administrative expense budget

➢ Pro forma income statement

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The financial budget consists of:

➢ Cash budget

➢ Pro forma balance sheet

The five major steps in preparing the budget, according to Shims et al. (2011), are:

1. Prepare a sales forecast.

2. Determine expected production volume.

3. Estimate manufacturing costs and operating expenses.

4. Determine cash flow and other financial effects.

5. Formulate projected financial statements.

Bužinskienė (2019) reports that budget is an important tool of profit planning and

contributes to the formulation of a comprehensive plan of action:

o to control the disbursement expenses

o to control revenues necessary to support the business

o to determine financial sources

As it is obvious, budgeting is vital in the process of making the optimal decisions for the

organization a manager is working for.

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Master budget

A master budget example used by Shims et al. (2011) follows:

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References:

Bužinskienė, R., 2019. MASTER BUDGET FORMATION IN PRIVATE

COMPANIES. Professional Studies: Theory & Practice/Profesines Studijos: Teorija ir

Praktika, (21).

Hansen, S.C., Otley, D.T. and Van der Stede, W.A., 2003. Practice developments in

budgeting: an overview and research perspective. Journal of management accounting

research, 15(1), pp.95-116.

Libby, T. and Lindsay, R.M., 2010. Beyond budgeting or budgeting reconsidered? A

survey of North-American budgeting practice. Management accounting research, 21(1),

pp.56-75.

Rosanas, J.M., 2016. Budgeting Beyond Budgeting: A Tool for Management, Surprise

Avoidance, Trust Creation and Organizational Learning. European Accounting and

Management Review, 3(1), pp.24-44.

Shim, J.K., Siegel, J.G. and Shim, A.I., 2011. Budgeting basics and beyond (Vol. 574).

John Wiley & Sons.