Budgeting in Business Operation - Term Paper Example

 BUDGETING Introduction Budgeting has always been a key part of any economy. In today’s world, every individual needs to plan his/her activities according to his/her financial budget. Budgeting helps individuals as well as companies in carrying out day-to-day operations in an appropriate manner. If an individual or a company does not pay attention towards managing financial activities, problems can occur which may delay the planned activities (Lynch, 1991). Budgeting is such process that companies use to plan their business activities regarding time and money. This process makes the business operations undergo in an effective and efficient manner. According to Morgan (2006), a company’s financial success depends largely on the budgeting decisions that its managers take concerning all financial aspects of the business. Therefore, it is imperative for a company to develop a perfect budget plan that should help the company achieve its desired goals and objectives, as well as it should help it maintain the financial equilibrium. Objectives In this paper, we will discuss different aspects and key areas related to the process of budgeting in order to understand the role that budgeting plays in the success of a company. We will discuss in detail certain issues in order to know the importance of budgeting for a company. Topics in Detail about Budgeting and Discussion The topics which will be covered in this project include functions of budgeting, employee motivation through budgeting, responsibilities of budget holders, budgetary control, capital budgeting, and techniques of capital budgeting. Discussing these topics will help us get a good understanding of some of the core aspects of budgeting. Let us discuss all of these topics in some detail. Functions of budgeting 1. Financial Analysis Budgeting helps firms in doing financial analysis. Managers of the firms can know the exact financial position of the company through proper budgeting. They can know the actual strength of their company and can take various decisions based on that financial analysis. They can know what is happening in reality related to the use of money for various business activities. Budgeting is a process that provides managers with the information concerning current financial position of the company, capital in hand for the company, and predicted future expenditures related to current and ongoing business processes. Companies can save their capital and related business expenditures through effective budgeting. Proper financial analysis also helps companies cut off the extra costs from the business expenditures and utilize the available capital for other business activities. 2. Planning Budgeting helps companies properly plan their business activities in accordance with the financial analysis report and available budget. Planning is one of key business processes that help companies take calculated steps towards progress. A company can take measurable steps regarding its future activities, such as, loan decisions, investment decisions, employees’ salary increment, compensation and benefits, and buying or selling decisions after forecasting the financial position and planning for activities. 3. Communication Communication is another key function of budgeting. If a company makes some kind of financial contract with some other company, budgeting helps in resolving all kinds of issues regarding the use of capital between the two companies. Companies can set priorities considering their budgets in order to escape from financial issues and conflicts. An effective budget is one which assists companies communicate with each other for discussing various money related issues, such as, the way the companies should spend the money and the amount of money they should spend on different business ventures. 4. Motivation Budgeting is a process that plays a critical role in motivating the employees of a company. Upon doing the analysis of the financial position of the company, managers can develop such plans for their employees that can play an imperative role in improving the efficiency and motivation levels of the employees. We can take example of a company which develops a well-structured compensation plan for its employees in order to increase their motivation and dedication. Such move from the managers of the company can result in favor of the company because employees always prefer to work for such companies which praise their commitment and value their performances by providing them with the compensation and rewards that they deserve. Compensation plans ultimately result in increasing the productivity of employees and improving their individual performances and group performances as well. However, the fact is that development of effective compensation plans has direct connection with the available budget of a company. The compensation plans can only be designed if a company has enough capital in the account. If a company has enough money for developing and putting into practice the compensation plans, only then such plans can prove successful for the company. 5. Evaluation Evaluation of financial performance, as well as all other business processes plays a key role in every industry. Budgeting demonstrates the target performance of the company which managers measure with in accordance with the actual financial performance of the company. Evaluation is a technique that helps companies in comparing their budgeted results with those of actual results of the financial activities performed by the companies. If the policies implemented by a company produce beneficial results for the company, managers tend to keep those policies in the budget plan. However, if the outcome of the policies does not result in favor, managers change those policies in order to come up with some beneficial budget plans. 6. Control Another key benefit of budgeting is control over financial resources. Budgeting helps companies take charge of all financial resources (Lawrence, 2004). Managers of a company belonging to any industry can make correct decisions regarding investing or any other business activity with the help of an effective budget. A company can never enjoy increased productivity or high market share without doing effecting budgeting. The reason is that budgeting helps companies get control over resources which ultimately helps companies take correct decisions regarding different business activities. Budgetary control is imperative for the survival and success of a company in today’s competitive market. A company cannot perform any financial activity successfully without a proper budgetary control system in implementation because when there will be no proper check on the financial affairs of the company, capital required for completing business projects will be mismanaged and wasted in unnecessary activities. Employee Motivation through Budgeting Budgeting can play a key role in building employees’ motivation. As we have already discussed above, salary raise and compensation plans play a vital role in increasing employees’ commitment and dedication, we must also say that budgeting is the base for these two factors. Without proper budgeting, a company cannot implement compensation plans for the employees. Compensations are those rewards or payments, which a firm provides to its employees for achieving some desired set of goals and objectives. Compensation and benefits are essential to make employees productive and beneficial for the company. The reason is that employees like to work for those companies, which give attention to the needs and concerns of the employees during the process of budget development. Employees show more attentiveness and dedication towards their job when they know that their managers will appreciate their uphill struggle in the form of bonuses and rewards. Compensation and incentives help companies achieve higher levels of employee productivity. A company can appreciate the performance of employees through many ways in order to increase their job satisfaction. Some of those ways can be paid vacations, a meal for two, and increase in allowances. Such rewards play a key role in increase employee satisfaction, as well as productivity. However, the fact is that provision of all of these benefits and rewards are associated with the financial power of a company. A company provides these benefits only if the budget of the company allows it to do so. Therefore, we can say that budgeting makes a company decide on many key issues by providing a compete report of the financial situation to the mangers. One of the common rewards is basic salary plus bonus that includes fixed bonus amounts for employees who show excellent performances. Salary raise and implementation of a compensation plan motivates employees, as well as prove productive for the business of a company. The reason is that when employees of a company show improved productivity, the productivity of the company also increases consequently, which puts a very positive impact on the overall ratings of the company. The design of a reward plan depends largely on the economic conditions of a company. If a company is not stable financially, it cannot provide cash bonuses and rewards to the employees. Therefore, considering the financial status of the company is very important for designing a practical and productive compensation plan for the employees. If we research the success factors for then most successful companies of the world, we come to know that those companies achieve success, which provide bonuses, salary raise, and other incentives to the employees. However, companies should never develop such incentive plans in which bonuses and cash prize schemes go beyond the actual budget of the company. Responsibilities of the Budget Holders Once the budget-makers are done with designing the budget for the financial year of a company, the responsibility shifts from their shoulders to the budget holders. Some potential dysfunctional consequences can occur as the result of the negligence of the budget holders that they may show while using the budget for different business affairs. A little negligence shown by the budget holders can create severe financial problems both for their respective departments and for the company. According to Reames (2010), it is very important to figure out those key areas of the company’s budget where it needs to spend some extra amounts and those where it need to cut down the extra costs. If people holding the responsibility of the budget management show some kind of negligence, they can create many problems for the business processes of their companies. We can take example of a construction firm that takes a large project of constructing 10 to 20 houses. Now if the company starts developing the houses without any financial management, it may result in creating difficulties in some later stages of the project completion because planning is essential in every step. Without financial planning, a company can never achieve its objectives properly. Moreover, if people responsible for managing the budget show negligence in forecasting and calculating the figures, it can put an unpleasant impact on the overall project for the reason that unavailability of capital at any stage of the project completion is likely to affect the progress level of the project. Therefore, concluding the above discussion, we can say that it is the responsibility of the budget-makers to do a proper analysis of the financial status of the, forecasted income and expense ratio, and actual income and expense ratio of the company while doing any kind of planning regarding the use of the budget. As Biglefeld and Zoumbaris (2000) state, “it does take careful thought and planning to budget your money” (p. 85). The reason is what we have discussed already that lack of care or attention can cause problems for the company. Therefore, we can say that every budget holder holds the responsibility to pay full attention towards budget management in order to avoid any finance shortage situation. Budgetary Control Budgetary control is another very important area of budgeting. It is obvious that no company can ever achieve success without having a proper understanding of budgeting and control over the financial resources. Budgetary control is imperative for the success of a company in a competitive market. According to Baker and Powell (2005), a company cannot perform any financial activity in an appropriate manner without implementing a proper budgetary control system; rather it may result in creating financial crises for the company. The reason is that when there will be no proper control over monetary affairs, the capital will be wasted instead of being used in a right way. Budgets assist organizations in the management of financial resources. Budgetary control helps managers of companies achieve the goals successfully through controlling the use of money. As Peterson and Fabozzi (2002) state, “capital budgeting is one of the most important, and sometimes most difficult, parts of financing” (p. 245). Budgetary control helps managers compare the budgeted results of business operations with those of the actual results. It also helps companies achieve financial goals, as well as business goals by following a proper set of guidelines related to capital management. Budgetary control relates to the establishment of effective budgets and identification of the responsibilities of the people accountable for the management of the budget for various business operations. Therefore, we can say that it is a very important budgeting process and it closely linked with the achievement of company’s goals and objectives. Capital Budgeting Having discussed in detail the importance of budgetary control in carrying business activities of a company, let us now discuss capital budgeting which is another important topic related to budgeting. According to Tatum (2011), capital budgeting is a financially responsible process that managers use to select the long term business projects based on the financial resources. Managers select such projects that are usually able to generate a high return on investment for the company. Capital budgeting is a process in which managers allocate financial resources for the projects by ensuring a balance between three key factors that include the amount of resources companies need to allocate, the time scale within which an investment starts showing return, and the use of resources. According to Morgan (2006), the success of a company largely depends on the decisions of managers regarding capital budgeting. The reasons is that capital budgeting is an effective tool that helps managers evaluate, examine, compare, and choose the most suitable project from a list of investment related projects. It is such a tool that helps managers choose projects on the basis of cash flows and predicted rate of return. Managers choose such projects that are able to generate high amounts of profits. Techniques of Capital Budgeting Having discuss the concept of capital budgeting in detail, let us now discuss the techniques that managers can use for capital budgeting. There are many techniques for managers to do capital budgeting. Some of those rely on accounting rules, whereas some techniques rely on the values of incremental cash flows. Incremental cash flows based budgeting techniques have been found somewhat more useful as compared to accounting based budgeting techniques. That is the reasons why most of the managers use incremental cash flow technique to do capital budgeting. According to Morgan (2006), some of the main capital budgeting techniques commonly used by the managers include discounted cash flow (DCF), net present value (NPV), modified internal rate of return (MIRR), internal rate of return (IRR), and payback period. All of these methods provide a great help to the managers in the process of capital budgeting. Let us get an overview of these budgeting techniques in order to get an understanding of how these techniques help managers. 1. Profitability Index This is one of the main techniques used by most of the managers for capital budgeting. It is also known as value investment ratio or profit investment ratio/ this technique is usually based on the relationship between the proposed project’s pay off and that of the actual investment done by a company in a project. Managers find out the actual profit investment ratio by dividing the present value of the future cash flows by the present value of initial investment in a project. The figure helps managers take decision regarding investment. 2. Internal Rate of Return Finding the internal rate of return is also a common method used by managers for capital budgeting. This method helps managers know the feasibility of any specific investment. It is the discount rate that compares the initial values of the cash flows of a project with the present value of the future net cash flows generated by the investment. The result or calculation that managers get help them decide whether they should invest in a project or not. 3. Modified Internal Rate of Return The third way for managers to do capital budgeting is to find the modified internal rate of return. It is also a very useful technique which helps managers know the future standing of the investment. 4. Net Present Value Finding the net present value is a method in which managers find the difference between the amount of initial investment in a project and the present value of the future cash flows. The figure that managers get also helps them know the credibility of a project. Managers choose such project that generate positive net present values and reject the ones having negative values. The reason is that projects with positive net present value are likely to give a better return in future, whereas the projects having negative net present value are likely to be less profitable or unprofitable for the company. 5. Equivalent Annuity Equivalent annuity is the last of the common methods used by managers for capital budgeting. It is an incremental cash flows-based technique for capital budgeting that is used mainly for comparing the projects based on their life. Although it is also a useful way that generates good results for the managers, but we cannot say that this method has any edge over the other capital budgeting methods discussed earlier. From the discussion, we come to know that the most commonly used methods are net present value, internal rate of return, and profitability index. Conclusion Summing it up, budgeting plays a key role the success of any company or organization. Budgeting not only keeps financial activities of a company on track but also increases the motivation level of the employees. Budgeting is such a process that helps companies plan their business activities in accordance with the available money. Budgeting helps companies get long-term benefits from the investments, as well as increase the revenues. Companies need to take correct decisions concerning the allocation of the budget for different business processes in order to escape from any kind of hazardous situation that may involve shortage of financial resources. References Baker, H., & Powell, G. (2005). Understanding Financial Management: A Practical Guide. Malden: Blackwell Publishing. Bijlefeld, M., & Zoumbaris, S. (2000). Teen Guide to Personal Financial Management. Westport: Greenwood Publishing Group. Lawrence, J. (2004). The Budget Kit: Common Cents Money Management Workbook (4th ed.). Chicago: Dearborn Trade Publishing. Lynch, D. (1991). Federal Budget and Financial Management Reform. Westport: Greenwood Publishing Group. Morgan, E. (2006). Capital Budgeting. Retrieved from http://ezinearticles.com/?Capital-Budgeting&id=195855 Peterson, P., & Fabozzi, F. (2002). Capital Budgeting: Theory and Practice. Hoboken: John Wiley & Sons. Reames, P. (2010). How to Develop a Budget and Stick to It. Retrieved from http://ezinearticles.com/?How-to-Develop-a-Budget-and-Stick-to-It&id=3817001 Tatum, M. (2011). What is Capital Budgeting?. Retrieved from http://www.wisegeek.com/what-is-capital-budgeting.htm Read More