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TECHNICAL

Budgeting:amanagement tool
Samuel Idowu MSc ACIS DMS Teachers Cert is a Senior Lecturer in Accounting and Acting ACCA Course Leader at North East Surrey College of Technology

his article will be of interest to students taking paper 8, Managerial Finance in the ACCAs syllabus. It will also serve as an introduction to the subject in paper 9, Information for Control and Decision Making. It seeks to provide readers with an understanding of budgeting which is an essential tool used by managers of organisations to plan and control their firms operations. All organisations regardless of size, profit or non-profit motive need to plan in advance what they intend to do in future. Failure on the part of an organisation to plan its activities in advance could make the achievement of its objectives difficult or even impossible. It could also result in serious consequences for both the organisation and its stakeholders. Budgeting is a means whereby organisations express in quantitative and/or monetary terms their intentions for a forthcoming period. An organisation which has no plan of what it intends to do in the future is rather like a ship without a rudder.

not necessarily be the same as those of the organisation. 3 Controlling activities. A budget acts as a standard against which actual performance can be compared. As the budget period progresses, managers are constantly comparing actual performance with the budgets. Adverse differences between the two may call for appropriate corrective actions. This will ensure that objectives contained in the plans should be achieved effectively. Planning of future activities is formalised by management. Because there is a plan prepared by senior managers, it points the way towards which those charged with carrying out the intentions of the plan must aim. It shows the way forward. Motivating people who are to execute the plans contained in the budgets. A budget, if carefully prepared and communicated, has the benefit of encouraging people to achieve the targets set by the plan provided targets are realistic. This is especially the case when rewards e.g. promotion, bonus payments etc. are linked to the target set. Performance measurement. The budget acts as a yardstick against which actual performance can be measured.

This stage of the budgetary planning process will formalise the strategic objectives of the business concern and will enable budget planners to refer to it during the preparation of the budgets. (b) Consideration of the entitys internal factors These factors are collectively referred to by the mnemonic SWOT which stands for Strengths, Weaknesses, Opportunities and Threats. For the budgetary planning process to achieve the intended objectives, an organisation must realistically look at these four areas and act appropriately for its own benefit. For example areas where the entity is strong should not be taken for granted as its competitors are probably aware of these strengths and are perhaps formulating strategies which could reverse these strong points. Areas of strength should be constantly looked at and improved on. Areas where there are weaknesses should be carefully evaluated to eliminate those factors causing the problems. Opportunities need to be identified in order to make the best use of them. Threats should equally be identified in order to remove those factors posing the threats. (c) Consideration of the entitys external factors Again these factors are collectively referred to by the mnemonic PEST which stands for Political, Economic, Social and Technical environment which impacts on the organisation. There are some factors over which the organisation has little or no control. These factors will usually in one way or another affect its operations. Factors such as new government legislation, change of government, the state of the economy, political situations in the firms overseas markets, exchange and interest rates etc. are examples of such factors. A firm which ignores these externalities during the budgeting process does so at its own peril. (d) Historic data Past results must be carefully evaluated as one of the many guides available to the firm in the preparation of the budgets. Historic data will be useful even when the

The benefits derived from preparation of budgets

Business organisations operate in a dynamic and competitive environment. If an organisation fails to plan in advance, it will find itself at a competitive disadvantage and may not survive for long. Organisations which have prepared their budgets may derive the following benefits from doing so: 1 Communicating its objectives in both quantitative and financial terms to those people within the organisation who will execute the plans. Knowing what is expected of you as an individual working for an organisation clears the way for an effective performance of your tasks. A budget which has been fully and effectively communicated to people will inform them what is expected of them. Co-ordinating the activities of the different departments within the organisation. Budgeting ensures that there is a unity of purpose. It ensures that people within the organisation will aim towards the achievement of the organisations objectives rather than an individuals objectives which may 6

The budgetary planning process

Before an organisation begins to prepare its budget for a coming period it is important that it first takes the following steps: (a) Set corporate/strategic objectives Corporate objectives need to be set in order to point the direction towards which the entity must move. These should then be incorporated into the budgets of each of the subsequent periods. For example, one of the long-term objectives of the organisation might include being the market leader in its industry by say the year 2006. In order for this objective to materialise, it might be necessary that sales revenue in each of the coming years up to the year 2006 must increase by 10% per annum.

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firm uses Zero Based Budgeting System a modern approach to budgeting.

Setting up a budget committee

It is traditional in most organisations for a Budget Committee to be set up. The committee will be made up of senior managers responsible for the different functions in the organisation, e.g. Sales, Finance, Production, Personnel, Research & Development etc. under the chairmanship of the chief executive of the organisation. The committee may also appoint a Budget Manager who is usually a senior accountant in the organisation usually with the title Financial Controller. One of the important documents to be used in the budgeting exercise, the Budget Manual will need to be prepared. The manual will describe the objectives and procedures to follow in the budgeting exercise. It is a useful reference document to which those responsible for preparing budgets of their areas of responsibility can refer. The duties of the budget manager will include assisting members of the committee in preparing the budgets for their areas of responsibility, providing them with accounting information, issuing instructions on how to prepare their budgets, establishing deadlines to be met and finally preparing the Master Budget. The master budget is made up of three statements namely the budgeted profit statement, balance sheet and cash flow forecast or cash budget. These three statements will pull together all the budgets which departmental heads have prepared for their various departments. In other words it will express the overall intentions of the organisation for the coming period as one unit.

The comparison will undoubtedly reveal differences in costs and revenues. Reasons for the differences termed as variances will be investigated to enable responsible managers to take appropriate remedial action(s) to exercise control.

Choice of budgeting systems

An organisation preparing its budgets has a choice between four available budgeting systems namely, Incremental Budgeting, Zero Based Budgeting (ZBB), Programme Planning Budgeting Systems (PPBS) and Rolling Budgets. We will now look at each of these budgeting systems in turn. Incremental budgeting system (IBS) The incremental budgeting system is an approach which looks at the current years results and adjusts these results for changes in activity levels and for increases in costs due to price inflation. In the past most budgets were prepared based on this system. In todays world, budgets are no longer prepared based on current years result because of the weaknesses of this system. One of the weaknesses of this system is that it encourages past inefficiencies to be perpetuated ad infinitum. It prevents a critical look at and a fresh approach to all the costs of running an organisation. Zero Based Budgeting Systems (ZBBS) The Zero Based Budgeting System was developed to eliminate some of the weaknesses of IBS. It operates on the premise that to automatically prepare budgets with existing levels of expenditure encourages perpetuating past inefficiencies. With ZBB each item of expenditure to be included in the budget will need to be justified in terms of what will happen if it were excluded from the plan. In other words each item of expenditure will need to pass a qualifying test for it to be included in the budget of a coming period. For any expenditure to be included in the budget it must be absolutely necessary. Budgets prepared using this approach are more likely to have unnecessary expenditure excluded. This should make it possible for the organisation to maximise profits as available resources will be allocated in the most effective and efficient manner. Programme Planning Budgeting Systems (PPBS) Governmental and non profit seeking organisations experience difficulties when they apply the conventional budgeting methods in preparing their budgets. Most of these difficulties arise because of the nature of their activities. For instance the outputs of some government departments are difficult to measure in quantitative terms. This then makes it impossible to flex actual outputs in terms of the master budget and compare the flexed budgets with actuals for control purposes.

In order to remove these problems budgets in these sort of organisations are prepared based on long range strategic plans which are expressed in terms of programmes. These programmes are planned activities which have been previously stated to be undertaken. Normally programmes will involve different departments and costs are therefore expressed for the programme rather than each department. For example programmes in the armed forces could be grouped as follows: 1 2 3 4 Anti-terrorism; Defence against external invasion land, sea and air; Peace keeping in war torn regions of the world; Fighting a war.

The above programmes will cut across different departments of the Army, Navy and Air Force. To use the conventional budgeting methods in planning for the above programmes may be difficult as results cannot be expressed in quantitative terms but in qualitative terms. In addition, conventional budgeting may not allocate the required resources efficiently. One of the benefits of PPBS is that it allows scarce resources to be put to the best use. It will therefore be a better approach. Rolling budgets A rolling budget is one that is constantly being updated by adding a further period e.g. month or quarter and deducting an earlier period. It is basically used for control purposes and to reduce the influence of uncertainty which factors such as inflation, market conditions etc. may have on the budgets. Needless to say that for a rolling budget to meet the intended objectives a lot of time and continuous effort will be required on the part of managers.

For effective control to take place

For control purposes the year will be broken down into months to enable managers to compare budgeted information with actual information at the end of each month. The master budget is usually referred to as a Fixed Budget. Fixed in the sense that it was prepared based on a given volume of activity for both production and sales. To allow effective control to take place, the actual activity will have to be flexed to reflect what the actuals would have been in terms of the master budget. In other words a Flexible Budget will have to be prepared. A flexible budget is a budget which recognises that some costs are fixed and will not alter regardless of the volume of activity. It also recognises that some costs are variable and as such will vary with the level of activity. A flexible budget recognises that some of the costs incurred will be semi-variable, that is part fixed and part variable. The actual activity will be flexed to determine what the actual activity should have cost. A comparison will be made with what the actual activity did cost.

Budgeting a necessary tool

Budgeting is a necessary tool which managers of organisations must use in order to be able to allocate resources efficiently and compete successfully in an ever changing environment where organisations have to operate. An organisation which fails to prepare its budget will decline and subsequently fail. Budgeting for the sake of it will not suffice. A careful approach to the exercise is what is required. The modern manager has at his/her disposal modern techniques to use in order to ensure that organisational objectives are achieved. After all these are what objectives are set for to achieve them! References 1 Drury C, Management & Cost Accounting, Chapman & Hall, 1992. 2 Emmanuel C, Otley D, Merchant K, Accounting for Management Control , Chapman & Hall, 1993.