The Purpose of Budgets
A budget in the most simple terms is a financial plan that plans all the resources of the business. The purpose of putting budgets together, essentially, is to plan all these resources towards an objective. But of course, there are lots of different reasons and nuances as to why we would put budgets together. To make it a bit easier to remember, we're going to use an acronym for the five different purposes of putting budgets together. That acronym is P-R-I-M-E, and each of the letters represents one of the purposes of putting a budget together.
P: planning is all about setting the objectives of the business. So, putting a budget together forces the management in an organisation to consider the objectives of the business. It also forces the business to look into the future and to anticipate any potential threats that could be coming down the road. It also gives a chance for management to look at the possible opportunities that the business could seize in the future. And a part of planning is to ensure that resources are properly organised in the future, so that the objectives of the business are achieved.
R: the next purpose of putting a budget has to do with responsibility. Responsibility is all about giving managers a clear indication of what it is that they're accountable for. A budget gives a manager a very clear idea of the results that he/she is supposed to be controlling and what it is that they'll be measured on, what they're actually responsible for. Typically a manager that's given a budget to look after is called a budget holder. So, a budget holder would have a clear idea of the different areas that they're responsible for.
I: the next purpose for putting a budget together is for integration and coordination. This refers to aligning the different divisions, business units, or separate business entities within the business towards the same objective. So, a budget acts as a tool that ensures that all the different divisions or departments in the actual business itself are working towards the same goal.
M: next up is motivation. A budget gives a manager a set of targets to work towards. If you can imagine in a production facility, a budget might list all the different costs that a production manager might be responsible for. That gives them an indication of what their target is for the year e.g. what cost they have to stay in line with, and that gives them the motivation to want to achieve that cost target. It's important when you're putting budgets together, obviously, that the goals and the targets set in the budget are difficult enough, and that they encourage the manager to work hard to stretch themselves, but it's also important that the targets are not completely unrealistic. We'll look at that in greater detail later in the article.
E: finally, we have evaluation and control. This is the most important part of putting a budget together, and has to do with evaluating the results of the business and controlling the performance of the business to ensure that it's reaching its objective. Evaluation and control is normally carried out by performing a variance analysis. This involves looking at the actual results versus the budget results for the period and looking at the differences between those two, so that highlights where possibly the performance of the business is deviating from the plan.
The Cycle of Planning and Control
Putting a budget together is only one part of the overall planning and control process in the business. The cycle of planning and control begins with the setting of the objectives of the organisation. This is essentially what the business wants to achieve over a sustained period of time. Some typical objectives might be to increase revenue by 10% for a year, or it could be to increase profitability by 3% for the year. There are lots of different objectives that an organisation could strive towards, but in the overall planning and control cycle the first step is to establish the ambition of the business and to set the overall objectives that the business wants to achieve.
The next part of the planning and control cycle is to plan and to set a budget that ensures that those objectives are reached. When we're setting a budget, we're taking into consideration the overall objectives that we've set out and we're creating a budget that ensures that we're going to achieve those objectives in the long term.
The third part of the planning and control cycle is operating in line with those objectives. This means actually carrying out day to day functions that are in line with the objectives that we've set. This is simply carrying out operationally all the different actions that will lead to the objectives being achieved.
The final step of the planning control cycle is to evaluate and to compare actual results with budgeted results. When we're doing this, we're making sure that our performance is evaluated on a periodic basis. So, generally speaking, this would normally happen on a monthly or maybe a quarterly timeframe, and what we're looking at is the difference between actual results and budgeted results. If there's any deviation between the two, we look to rectify that, so that we can ensure that in future periods the objectives are going to be achieved.
So, that's the planning and control cycle and it's a loop. As soon as our performance has been evaluated, we move on to determining objectives again for the next period.
Advantages of Budgets
The first advantage of the budgeting process is that it forces an organisation to plan and set targets. As we said when we were looking at the purposes of preparing budgets, by preparing a budget it focuses the organisation on thinking ahead, and looking at the different threats and opportunities that the business can take advantage of. It also helps to plan resources that might be required to ensure that the business achieves its objectives. If you can remember back to the planning cycle, we set our objectives at the start of the overall planning cycle. When we have those objectives set, we need to make sure that the resources of the business come together in order to ensure that the objectives are achieved. To do that, we need to think about the future and plan those resources and budgeting helps us do that.
Budgets also help a business to allocate responsibility. A budget lets a manager know what it is that hs/she is responsible for and it also gives him/her an idea of what it is in the business that he/she has control over. So a budget sends a signal to a manager or a budget holder as to what it is that they're accountable for and that they have control over.
The next point is that budgets encourage coordination and integration between different departments. A budget acts as a tool that takes the different divisions and the different departments of a business and ensures that they're all working towards the same goal. So, if you can imagine a production facility, the first budget that is usually prepared is the sales budget, and from that the production budget is drafted afterwards. When the production budget is drafted, the raw materials department or the procurement department (whichever department is responsible for buying raw materials), would usually use the production budget to make their budget. With that simple example, you can see that the production department relies on the sales department, and that the procurement department relies on the production department. So, when we're setting a budget, we're making sure that the other departments in the business are actually coordinating activities in the pursuit of the same objective. The objective could be to increase sales by 5%, and we're making sure that all the other departments in the business are going to be aligned towards that objective.
The next advantage of budgets is that they can motivate employees. It's important to emphasise the word "can" here; it can motivate, but sometimes it doesn't, and sometimes when budgets are perceived as being too difficult, they can actually demotivate managers. However, a budget that's set on a fair basis, and that has targets in it that stretch a manager’s ability so that they're difficult but not unrealistic or impossible to achieve, will encourage a manager and motivate a manager, especially if there are incentives related to the achievement of that budget.
One final advantage is that budgets provide targets against which to evaluate performance. Budgets make evaluating a manager’s performance a little bit easier, because we can look at the budget versus the actual results on a periodic basis. This gives us an idea of how to perform an evaluation over a division or it could be a manager’s individual performance. So it's a tool that we can use to ascertain how well a division or a business unit or a particular manager is doing and so it acts as a performance evaluation tool.
Disadvantages of Budgeting
One of the disadvantages of budgets is that they can encourage fixation on plans and creates a lack of flexibility. If budgets are implemented and are adhered to in a very rigid sense, then this reduces the amount of agility in the business. Consider, for example, that an opportunity comes up during the year and it requires some expenditure that hasn't been budgeted for. A business that wants to conform to its original budget in a rigid manner won’t be able to take advantage of that opportunity, and so sometimes budgets create tunnel vision in an organisation. It depends on the business attitude towards budgets. Some businesses are a little bit more loose with budgets, and some have the attitude that the business should perform within the strict constraints of the budget no matter what.
The next disadvantage is that it takes a lot of time to actually put a budget together, especially if there's lots of different departments in the business. It can take a lot of time, resources, and it can be quite expensive as well to actually put a budget together.
Another disadvantage of preparing budgets is that it can be demotivating if they're seen as being unrealistic, or too difficult. As I discussed before, if a manager receives a budget this normally gives them an idea of how they're to perform what they're going to be judged on. If the budget is too difficult, it's not going to really motivate a manager, it might put them off, and it might give them the sense that the business is not understanding of the environment that the manager is working in.
Variance reports (when we look at actual versus budgeted results), can be really useful at highlighting the different areas of the business that may need to be addressed or looked at or reviewed, but variance reports do not actually offer any solutions. So, a variance report is a really important reporting tool, but it doesn't actually provide the solution for the variance. In that respect, they're useful but they're not reports that we can rely on for generating actions that are actually going to fix the inefficiencies or variances that we identified.
One of the major disadvantages of budgets is that if budgets are achieved, that's celebrated normally, but if budgets are exceeded (so if we perform better than we had budgeted), there's very little incentive to actually do that. The goal of an organisation, for example, might be to keep their costs in line with budget. So, a manager might be incentivised by being given a bonus if their costs lie within the budget limit. However, if that manager actually achieves cost savings, generally speaking, there's very little incentive for him/her to perform better than budget because they're being evaluated on just meeting the budget. So, there's no incentive for the manager to go the extra mile and actually perform better than the budget.
Finally, budgets encourage spending in order to protect costs or budgeted figures. For example, a manager could be given a budget and if they don't spend that budget at a central level, someone reviewing the budget might think the manger didn't need to actually make that expenditure, and they don't need that budget. So, what managers will do to protect the budget that they have, is maybe spend unnecessarily amounts that they might need for that year, just to ensure that the budget is kept next year. This is a really important disadvantage of budgets, because it encourages spending that isn't necessary just so the manager can keep that budget in the next budgeting period.
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