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A budget is defined 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 actually are implemented.

A budget is a financial plan to control future operations and results. It is expressed in numbers, such as dollars, units, pounds, and hours. It is needed to operate effectively and efficiently. Budgeting, when used effectively, is a technique resulting in systematic, productive management. Budgeting facilitates control and communication and also provides motivation to employees.

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 (two to three years), or long-term (three years or more). Short-term budgets provide greater detail and specifics. Intermediate budgets examine the projects the company currently is undertaking and start the programs necessary to achieve long-term objectives. Long-term plans are very broad and may be translated into short-term plans. The budget period varies according to its objectives, use, and the dependability of the data used to prepare it. The budget period is contingent on business risk, sales and operating stability, production methods, and length of the processing cycle.

There is a definite relationship between long-range planning and short-term business plans. The ability to meet near-term budget goals will move the business in the direction of accomplishing long-term objectives. Budgeting is done for the company as a whole, as well as for its component segments, including divisions, departments, products, projects, services, and geographic areas. Budgets aid decision making, measurement, and coordination of the efforts of the various groups within the entity. Budgets highlight the interaction of each business segment with the whole organization. For example, budgets are prepared for units within a department, such as product lines; for the department itself; for the division, which consists of a number of departments; and for the company.

Master (comprehensive) budgeting is a complete expression of the planning operations of the company for a specific period. It is involved with both manufacturing and nonmanufacturing activities. Budgets should set priorities within the organization. They may be in the form of a plan, project, or strategy. Budgets consider external factors, such as market trends and economic conditions. The budget should list assumptions, targeted objectives, and agenda before number crunching begins.

The first step in creating a budget is to determine the overall goals and strategies of the business, which are then translated into specific long-term goals, annual budgets, and operating plans. Corporate goals include earnings growth, cost minimization, sales, production volume, return on investment, and product or service quality. The budget requires the analysis and study of historical information, current trends, and industry norms. Budgets may be prepared of expected revenue, costs, profits, cash flow, production purchases, net worth, and so on. Budgets should be prepared for all major areas of the business.

The techniques and details of preparing, reviewing, and approving budgets vary among companies. The process should be tailored to each entity's individual needs. Five important areas in budgeting are planning, coordinating, directing, analyzing, and controlling. The longer the budgeting period, the less reliable the estimates.

Budgets link the nonfinancial plans and controls that constitute daily managerial operations with the corresponding plans and controls designed to obtain satisfactory earnings and financial position.

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

The budget should be reviewed by a group so that there is a broad knowledge base. Budget figures should be honest to ensure trust between the parties. At the corporate level, the budget examines sales and production to estimate corporate earnings and cash flow. At the department level, the budget examines the effect of work output on costs. A departmental budget shows resources available, when and how they will be used, and expected accomplishments.

Budgets are useful tools in allocating resources (e.g., machinery, employees), making staff changes, scheduling production, and operating the business. Budgets help keep expenditures within defined limits. Consideration should be given to alternative methods of operations.

Budgets are by departments and responsibility centers. They should reflect the goals and objectives of each department through all levels of the organization. Budgeting aids all departmental areas, including management, marketing, human resources, engineering, production, distribution, and facilities.

In budgeting, consideration should be given to the company's labor and production scheduling, labor relations, pricing, resources, new product introduction and development, raw material cycles, technological trends, inventory levels, turnover rate, product or service obsolescence, reliability of input data, stability of market or industry, seasonality, financing needs, and marketing and advertising. Consideration should also be given to the economy, politics, competition, changing consumer base and taste, and market share.

Budgets should be understandable and attainable. Flexibility and innovation are needed to allow for unexpected contingencies. Flexibility is aided by variable budgets, supplemental budgets, authorized variances, and review and revision. Budgets should be computerized to aid what-if analysis. Budgeting enhances flexibility through the planning process because alternative courses of action are considered in advance rather than forcing less-informed decisions to be made on the spot. As one factor changes, other factors within the budget also change. Internal factors are controllable by the company, whereas external factors usually cannot be controlled. Internal factors include risk and product innovation.

A master budget is an overall financial and operating plan for a forthcoming calendar or fiscal year. It is usually prepared annually or quarterly. The master budget is really a number of subbudgets tied together to summarize the planned activities of the business. The format of the master budget depends on the size and nature of the business.

The operating budget deals with the costs for merchandise or services produced. It covers income statement items comprised of revenues and expenses. In contrast, the financial budget examines the expected assets, liabilities, and stockholders' equity of the business. It encompasses balance sheet items. Both budgets are needed to see the company's financial health.

The cash budget is for cash planning and control. It presents expected cash inflow and outflow for a designated time period. The cash budget helps management keep cash balances in reasonable relationship to its needs and aids in avoiding idle cash and possible cash shortages. The cash budget typically consists of four major sections:

1. Receipts section, which is the beginning cash balance, cash collections from customers, and other receipts

2. Disbursement section, comprised of all cash payments made by purpose

3. Cash surplus or deficit section, showing the difference between cash receipts and cash payments

4. Financing section, providing a detailed account of the borrowings and repayments expected during the period

The static (fixed) budget is budgeted figures at the expected capacity level. Allowances are set forth for specific purposes with monetary limitations. It is used when a company is relatively stable. Stability usually refers to sales. The problem with a static budget is that it lacks the flexibility to adjust to unpredictable changes.

The flexible (expense) budget is most commonly used by companies. It allows for variability in the business and for unexpected changes. It is dynamic in nature rather than static. Flexible budgets adjust budget allowances to the actual activity. Flexible budgets are effective when volumes vary within a relatively narrow range. They are easy to prepare with computerized spreadsheets such as Excel.

The four basic steps in preparing a flexible (expense) budget are:

1. Determine the relevant range over which activity is expected to fluctuate during the coming period.

2. Analyze costs that will be incurred over the relevant range in terms of determining cost behavior patterns (variable, fixed, or mixed).

3. Separate costs by behavior, determining the formula for variable and mixed costs.

4. Using the formula for the variable portion of the costs, prepare a budget showing what costs will be incurred at various points throughout the relevant range.

The capital expenditure budget is a listing of important long-term projects to be undertaken and capital (fixed assets such as plant and equipment) to be acquired. The estimated cost of the project and the timing of the capital expenditures are enumerated, along with how the capital assets are to be financed. The budgeting period is typically 3 to 10 years. A capital projects committee, which is typically separate from the budget committee, may be created solely for capital budgeting purposes.

BUDGETING IN ACTION

Need for Flexible Budgets

The difficulty of accurately predicting future financial performance can be readily understood by reading the annual report of any publicly traded company. For example, Nucor Corporation, a steel manufacturer headquartered in Charlotte, North Carolina, cites numerous reasons why its actual results may differ from expectations, including: (1) the supply and cost of raw materials, electricity, and natural gas may change unexpectedly; (2) the market demand for steel products may change; (3) competitive pressures from imports and substitute materials may intensify; (4) uncertainties regarding the global economy may affect customer demand; (5) changes to U.S. and foreign trade policy may alter current importing and exporting practices; and (6) new government regulations could significantly increase environmental compliance costs. Each of these factors could cause static budget revenues and/or costs to differ from actual results.

Source: Nucor Corporation 2010 annual report.

The capital expenditures budget often classifies individual projects by objective, as for:

· Expansion and enhancement of existing product lines

· Cost reduction and replacement

· Development of new products

· Health and safety expenditures

The lack of funds may prevent attractive potential projects from being approved.

An approval of a capital project typically means approval of the project in principle. However, final approval is not automatic. To obtain final approval, a special authorization request is prepared for the project, spelling out the proposal in more detail. The authorization requests may be approved at various managerial levels, depending on their nature and dollar magnitude.

Programming is deciding which programs should be funded and by how much. A common application of program budgets is to product lines. Resources are allocated to accomplish a specific objective with a review of existing and new programs. Some suitable program activities include research and development, marketing, training, preventive maintenance, engineering, and public relations. Funds usually are allocated based on cost-effectiveness. In budget negotiations, proposed budgetary figures should be explained and justified. The program budget typically cannot be used for control purposes because the costs shown cannot ordinarily be related to the responsibilities of specific individuals.

Incremental budgeting looks at the increase in the budget in terms of dollars or percentages without considering the whole accumulated body of the budget.

There are also self-contained, self-justified increments of projects. Each one specifies resource utilization and expected benefits. A project may be segregated into one or more increments. Additional increments are required to complete the project. Labor and resources are assigned to each increment.

An add-on budget is one in which previous years' budgets are examined and adjusted for current information, such as inflation and employee raises. Money is added to the budget to satisfy the new requirements. With add-on, there is no incentive for efficiency, but competition forces one to look for new, better ways of doing things. For example, Konica Imaging U.S.A. has combined add-on with zero-based review.

Supplemental budgets provide additional funding for an area not included in the regular budget.

A bracket budget is a contingency plan with costs projected at higher and lower levels than the base amount. Sales are then forecasted for these levels. The purpose of this method is to provide management with a sense of earnings impact and a contingency expense plan if the base budget and the resulting sales forecast are not achieved. A contingency budget may be appropriate when there are downside risks that should be planned for, such as a sharp drop in revenue.

A stretch budget may be considered a contingency budget on the optimistic side. Typically, it is confined to sales and marketing projections that are higher than estimates. It is rarely applied to expenses. Stretch targets may be held informally without making operating units accountable for them. Alternatively, stretch targets may be official estimates for sales and marketing personnel. Expenses may be estimated at the standard budget sales target. Many of the best-performing companies, such as GE and Microsoft, set stretch targets. Stretch targets are challenging but achievable levels of expected performance, intended to create a little discomfort and to motivate employees to exert extra effort and attain better performance. Firms such as Goldman Sachs also use "horizontal" stretch goal initiatives. The aim is to enhance professional development of employees by asking them to take on significantly different responsibilities or roles outside their comfort zone.

Strategic budgeting integrates strategic planning and budgeting control. It is effective under conditions of uncertainty and instability.

A target budget is a plan in which categories of major expenditures are matched to company goals. The emphasis is on formulating methods of project funding to move the company forward. There must be strict justification for large dollars and special project requests.

A budget plans for future business actions. Managers prefer a participative bottom-up approach to an authoritative top-down approach. The bottom-up method begins at the bottom or operating (departmental) level based on the objectives of the segment. However, operating levels must satisfy the overall company goals. Each department prepares its own budget (such as estimates of component activities and product lines by department) before it is integrated into the master budget.

I. Budget Savings

One-Year Savings Amount:

Two- to Five-Year Savings Amount:

More Than Five-Year Savings Amount:

Savings Description:

II. Budget Impact

Reduction in Current Year Budget

· Budget Account

· Budget Amount

Budget Adjustment Not Needed

III. Budget Participants

IV. Management Incentives:

V. Employee Awards

Prepared by:

Reviewed by:

Approved by:

COMPUTER APPLICATIONS

A computer should be used to make quick and accurate calculations, keep track of projects instantly, and make proper comparisons.

MOTIVATION

Budgets can be used to affect employee attitudes and performance. Budgets should be participative, including participation by those to be affected by them. Further, lower-level employees are on the operating line every day so they are quite knowledgeable. Their input is needed. Budgets can be used to motivate because participants will internalize the budget goals as their own since they participated in their development. Information should be interchanged among budget participants. An imposed budget will have a negative effect on motivation. Further, there is a correlation between task difficulty and loss of control to negative attitudes.

A budget is a motivational and challenging tool if it is tight but attainable. It has to be realistic. If the budget is too tight, it results in frustration because managers will give up and not try to achieve the unrealistic targets. If it is too loose, complacency will arise and workers may goof off.

The best way to set budget targets is with a probability of achievement by most managers 80 to 90 percent of the time. Performance above the target level should be supplemented with incentives, including bonuses, promotion, and additional responsibility.

ADVANTAGES AND DISADVANTAGES OF BUDGETS

Preparing a budget takes time and resources. The benefits of budgeting must outweigh the drawbacks. A budget can be advantageous because it:

· 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, 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 a long-term strategic perspective.

· Fosters careful study before making decisions.

· Helps management become aware of the problems faced by lower levels within the organization, which promotes labor relations.

· Encourages employees to think about 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.

· 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 human resources 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.

· Allows management to make distasteful decisions and blame them on the budget.

A budget can be disadvantageous because:

· It 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.

· It 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 think that budgets restrict their flexibility to adjust to changing conditions.

· It does not consider quality and customer service.

· There is a risk it will be padded, thereby creating budgetary slack.

BUDGETARY SLACK: PADDING THE BUDGET

BUDGETING IN ACTION

Budgeting Tied to Compensation

1. A manager's compensation is often tied to the budget. Typically, no bonus is paid unless a minimum performance hurdle, such as 80 percent of the budget target, is attained. Once that hurdle is passed, the manager's bonus increases until a cap is reached. That cap is often set at 120 percent of the budget target. This common method of tying a manager's compensation to the budget has some serious negative side effects.

· Example 1: A marketing manager for a big beverage company intentionally grossly understated demand for the company's products for an upcoming major holiday so that the budget target for revenues would be low and easy to beat. Unfortunately, the company tied its production to this biased forecast and ran out of products to sell during the height of the holiday selling season.

· Example 2: Near the end of the year, another group of managers announced a price increase of 10 percent effective January 2 of the following year. Why would they do this? By announcing this price increase, managers hoped that customers would order before the end of the year, helping managers meet their sales targets for the current year. Sales in the following year would, of course, drop. What trick would managers pull to meet their sales targets next year in the face of this drop in demand?

Source: Michael C. Jensen, "Corporate Budgeting Is Broken—Let's Fix It," Harvard Business Review (November 2010).

2. Towers Perrin, a consulting firm, reports that the bonuses of more than two out of three corporate managers are based on meeting targets set in annual budgets. "Under this arrangement, managers at the beginning of a year all too often argue that their targets should be lowered because of tough business conditions, when in fact conditions are better than projected. If their arguments are successful, they can easily surpass the targets."

3. Source: Ronald Fink and Towers Perrin, "Riding the Bull: The 2000 Compensation Survey," CFO (June 2000): 45–60.

SUMMARY

A budget should be based on norms and standards. The budget should be coordinated, integrated, organized, systematic, clear, and comprehensive to accomplish optimal results. The budget preparation, review, and evaluation process must be facilitated. An orderly budgeting process will result in less cost, fewer man-hours, and minimization of conflict and turmoil. It will require less revision at a later date. The budget process must consider input-output relationships. The budget aids in anticipating problems before they become critical. Short-term budgets should be used for businesses subject to rapid change. A budget is a tool for planning and for what-if analysis. It aids in identifying the best course of action.

As it is in the computer world—garbage in, garbage out—so it is with budgeting. If forecasts are inaccurate, so will be the projections, resulting in bad management decisions to the detriment of the firm. A manager must be cautious when analyzing past experience. Unforeseen circumstances, such as economic downturns and future innovations, have direct inputs on current operations. A manager deviating from a budget target must explain why and, of course, is on the defensive. Without proper justification for missing targets, the manager may be dismissed.

The failure to budget may result in conflicting and contradictory plans, as well as in wasting corporate resources. Budget slack, the underestimation of revenues and the overestimation of expenses, should be avoided or minimized. Budgets should be revised as circumstances materially change. A manager who has responsibility to meet a budget should also have the authorization to use corporate resources to accomplish that budget. Priorities should be established for the allocation of scarce resources. Budgets may include supplementary information such as break-even analysis by department, by product, and for overall operations.

It is important to avoid a situation in which a manager feels he or she must spend the entire budget or else lose funding in the next period. Managers should not be motivated to spend the entire budget. Rather, cost savings should be realized, and those responsible should be recognized, such as through cash bonuses or nonmonetary awards (e.g., trophies, medals). Budget savers should be protected in the funding for future budgets.

Budgets should not be arbitrarily cut across the board. Doing so may result in disastrous consequences in certain programs. If budget reductions are necessary, determine exactly where and by how much.