Budgeting System for Planned Allocation of Sources - Essay Example

Budgeting System Introduction Budgeting is part of long-term planning process of an organization. It prescribes limits of spending and limits of expected revenue for a given period. It allocates available funds to each department within a company by which process it controls overspending on less productive areas and puts more on the income generating areas. Budgeting is a means to an end.. In the hands of the management, well being of organization is at heart and budgeting can accomplish much.(Doh Joon Chien). Success of this depends upon the effectiveness of the budget system. Budgeting is generally handled by accountants, financial experts and representatives from each department of the company. Broad view of budgetary process By Budgetary process, an organization makes short term tactical planning or budgetary planning by preparing detailed , short term(usually 1 year) plans for the functions, activities and departments of the organization thus putting into action of the long term corporate plan. Budgets are created by adding monetary values to plans for departments, functions such as production, inspection, marketing, or financial and resource items such as capital expenditure, cash, materials etc. Annual process of budgeting should be seen as stages in the progressive fulfillment of the long-term plans of the organization. Thus the budgetary process steers the organization towards the long-term objectives defined in the corporate plans. (Lucey p.133) Budgetary process is a long-drawn but an essential one... First a Budgetary committee is entrusted with the task of developing and co-coordinating budgets. Committee members are usually from various functions of the organization. The committee will have budgeting officer who will be the accountant of the company. His duty will be to administer the budget and provide technical assistance and data during budget preparation. The budget planning precedes the budget period and it is a continuous and regular activity in case of budgets prepared on a rolling basis. Having seen the overview of budgetary process, let us make an empirical study of how it is implemented in a chemical manufacturing company. The chemical company's current year's annual turnover will touch $1.5 billion. They cater to the market in different segments namely Food Industries, Pharmaceutical industries, and Exports. In addition to the usual 10% increase every year, each year will witness some more variances peculiar to the period. Again the amount of increase in sales forecast helps work out purchase budgets for different inputs according to categories. Most importantly, the sales figure forecast is the deciding or limiting factor for the budget process in this case assuming that the sales forecast is an achievable one in terms of production capacity. After deciding on the deciding or limiting factor for the budgetary process to start, the expenditure budgets are prepared for funds required to deploy additional labor, increased inputs for manufacture and consumables and all other recurring expenditures such as advertising, electricity, traveling and local conveyance, wages and salaries, professional charges, interest charges, and quality control charges and a master budget is prepared pooling all the information collected, known also as Projected Profit and loss and Balance Sheet. Since I happen to be working at the Chief Executive's Secretariat, I am proximate to preparation of the Master Budget. This enables me to have an overall view of the organization and insight into the preparation of the individual budgets from the functional departments. Master Budget also known as summary budget is a summary of all supporting budgets. Another summary budget is the Cash Budget which also comes under our division's purview because of its controlling effect. Cash budget is vital for the organization since it involves liquidity and cash flow management. A typical cash budget which is of rolling nature is prepared for periods such as week, month or quarter. It is a primary tool in short-term financial planning. It allows finance manager to identify short-term financial needs and opportunities. (Firer Ross Westerfield Jordan p 610) An Example of a typical cash budget of the Chemical Company is illustrated in the four tables below. Sales Projections Q1 Q2 Q3 Q4 Sales (in millions $) 300 350 450 550 The sales shown above are predicted ones subject to forecasting risks and the actuals can be more or less. The chemical company started the year with receivables out standings at $ 300 millions. The average collection period is 45 days. Projected cash collections for the year Figures In millions Q1 Q2 Q3 Q4 ------------------------------------------------------------------------------------------------------------------ Opening receivables $ 300 150 175 225 Sales for the quarter 300 350 450 550 Cash collections - 450 - 325 -400 -500 ------------------------------------------------------------------------ Closing receivables 150 175 225 275 The above table shows cash collections based on sales. Other sources of cash can be sale of assets, income on investments and cash inflows from long term financing. Next we have to consider cash disbursements. They come in four basis categories as follows. 1 Payments of Accounts payables which are for payments of raw materials etc purchased and services received which are paid after some time of purchase. 2 Wages, Taxes and other expenses which include recurring manufacturing and administrative expenses but not depreciation which is only notional. 3 Capital expenditures which include payments for fixed assets purchased if any. 4 Long-term financing expenses such as interest on long-term term loans, debentures and dividend payments. Projected cash disbursements Figures In millions Q1 Q2 Q3 Q4 Payments for purchases (60% of sales) $ 180 210 270 330 Wages, taxes and other expenses(20% 60 70 90 110 Of sales) Capital expenditures 0 0 0 0 Long term financing expenses 30 30 30 30 (interest,dividends) ----------------------------------------------------------- Total Cash disbursements 270 310 390 470 Next step is to prepare the projected net cash inflow which will be the difference between cash collections and disbursements. Assuming that the year opens with $20 millions, the net cash inflow will be as follows. Figures in millions Q1 Q2 Q3 Q4 Total Cash collections 450 325 400 500 Total cash disbursements 270 310 390 470 ------------------------------------------------------------------ Net cash inflow 180 15 10 30 --------------------------------------------------------------------------------------------------- In the above table, there are sufficient cash balances in all the four quarters. But if in any quarter or quarters there is/are negative balance(s) due to net cash disbursements being higher than cash collections, then the company will have to meet the deficit by way of bank overdraft or any other short term measures. We prepare here a quarterly cash budget though we can also prepare for shorter periods for month, week or even daily basis. The Chemical Company's cash flow come from the sale of chemicals produced. Therefore the cash budget has to start with sales forecast for the next year on quarterly basis Method of setting annual budget in the organization shall now be briefly examined. Month wise data collection is made by the departments or units concerned such as Sales, Procurement, shipping, advertising in respect of not only the main functions but also expenditures such as communications, traveling, rent for godowns, electricity, postage, stationery, wages, salaries, commissions and entertainment etc associated with such functions. The expenditures while being estimated apart from the proportionate percentage of increase due to increase in activity, a certain allowance is also given for inflationary trend. Practical example may be seen below:- The Chemical Company's transport cost for the last year amounted to $ 120,000. Planned expansion is expected to increase transport cost by $10,000 thus total estimates at current prices are $ 130,000. The inflation for the year is expected to be 3%. Hence adding the inflation percentage in terms of value i e $ 3,900 the total budget estimate of transport cost will be $139,900. These data furnished by the departments are pooled together expenditure wise and consolidated figures for 12 months of the year are complied to prepare the annual budget almost akin to the projected profit and loss account. Certain common unallocable expenditure such as office rent, accounts and administration expenditures, legal expenses are finally incorporated by the Chief Accountant in the annual budget. The annual budget thus prepared is presented to management as draft budget proposals in a clear and appropriate format and on scheduled time after verifying that proposals are consistent with organizational objectives, and including all relevant data and assumptions. The budget is then communicated to the budget holders (departments concerned) in a manner which maintains goodwill and ensures budget proposals are agreed to by them. This type of incremental budgeting method assumes activities and working in the same manner without any chance for introducing new ideas. There is no incentive to reduce costs. On the other hand, spending the budgeted amount is encouraged so that the next year's budget is maintained at the same level. Priority for resources might have changed from the originally set principles and there may be hidden budgetary slack which is never revealed because of the fact that budget holders might have overestimated their estimates in the past, in order to get a budget which is easier to work and which will allow them to achieve favorable results. "Because of these problems, which can occur in a similar way throughout an organization, the incremental approach may not lead to the best use of its resources. A department which has had a large share of the total funds available over a number of years may no longer be as important to the organization, whereas newer departments which are gradually increasing in importance will need a greater share." (aat_managing_performance_t.pdf) As an alternative to this, there are other types of budgeting such as Zero-base Budgeting and Program Planning and Budgeting being adopted by organizations lately. It is learnt when Jimmy Carter became the President of America, he introduced Zero-based budgeting for Government budgeting as early as in eighties. The Zero-based budgeting starts from zero data every year or as the case may be and builds the budget. The idea is to take a fresh look at every expenditure without preconceived notions.(www.olemiss.edu) An obvious advantage in this method is that decision can be taken by comparing actual performance to the budget. It helps make better estimate of revenue projections by eliminating continuation of non essential expenditures incurred in the previous year. As Zero based budgeting is ideal for service organization, for the organization of our nature i.e manufacturing and selling, we can have a mix of incremental budgeting and Zero-based budgeting. While incremental budgeting can be applied for sales forecast and purchases, Zero-based budgeting can be applied for expenditures It must be noted that unless budgets are carefully monitored over 12 months, it will become difficult to make available funds for operations of the subsequent years. Hence progress of the operations can be jeopardized. Budget will be difficult to control unless effectively integrated with ERP ( enterprise resource planning) of the company. Spread sheets traditionally being used for budgets have now become outdated and time consuming. Hence a separate budgeting software 'Pharos' was installed for the company which takes care of the figures and variance analysis and suggests remedial measures. The newly introduced mix of incremental and zero based budgeting with the Pharos software, will result in the following improvements.. 1) Active participation and support of the top management. 2) Clear-cut definition of long-term, corporate objectives, 3) Practical and conducive organizational structure in the company, 4) Line managers are genuinely involved in all aspects of the budgeting process, 5) A sound accounting system with 100 % accuracy is in place to show actuals against the budgeted figures as and when required instantaneously., 6) Revision of the budgeted figure can be done if necessary. and 7) Budgets are administered without rigid adherence which may not be always appropriate if the conditions have changed. Further communication flows in all directions.. Liaison and contact between departments at all levels of management are ensured, Formal means of communication facilitates preparation of Master Budgets with the supporting budgets and communication of the approval of the same to the departments concerned. To ensure co-ordination of activities, vertical communication between levels and lateral communication between functions are maintained. Besides communication, a genuine participation of operating management brings about high motivation levels amongst the executives concerned resulting in goal congruence. Success of the budgeting system is judged by the extent of goal congruence by the budget holders. Conclusion It has been seen above that budgeting system has to be in place in a company for planned allocation of sources every year in tune with the long term planning and mission of the company. While the top-down budgeting method is characterized by arbitrary allocation of funds, the method of bottom-up budgeting sets up promotional objectives, plans the activities to achieve the objectives, defines the cost of activities and makes top management to approve the total budget. 1) Company's strategic plans which should be defined and operational tactics for achieving strategies shall be laid and most importantly allocating funds to achieve those strategies. 2) The business unit managers' must be involved in budgeting as they give honest inputs to senior managers and officers who develop a budget which should be viable and in alignment with the company's strategy. 3) Instead of compensating the managers for meeting the budget by raise in salaries or bonuses which can be a misused motivator, measurement of budgetary success should be in terms of customer relationships, customer satisfaction or increase in market share etc 4) Budget should be founded on real cost data and the departmental managers should be educated to know cost of doing business without just adding a percentage to a particular budget item every time, 5) Budget can be a gospel as long as it allows changes according to current trends in economic conditions, and 6) The spread sheet method should be replaced by best software tools which should be faster and more accurate While we have seen the importance of budgeting, we can not be blind to the fact that some concepts against budgeting have been emerging. Jeremy Hope and Robin Fraser (www.bbrt.org) in Harvard Business Review state "modern companies reject centralization, inflexible planning, and command and control. So why do they cling to a process that reinforces those things" It says that failed companies like World Com, Enron, Barings Bank did have tight budgetary control. It is not that the current trend is rejecting budgets as such but rather they have gone beyond budgeting by judging every part of the company's performance by comparing with those class benchmarks rather than budgeted figures thereby saving 95% of the time spent on budgeting.. It has been reported that Ford Motor Company spends $ 1.2 billion on budgets alone per year on the budgetary process. A 1998 study says that global companies spend more than 25000 man days in budgeting process. Many companies who have abandoned budgeting have adopted decentralized operations by unleashing the power of modern information systems and tools. "Corporate planning ceases to be a series of breathless sprints and instead becomes an endless conversation. Knowledge flows from frontline people to the headquarters and back again, permitting the full potential of a radically decentralized organization to be realized" (Harvard business review) It can be however safely concluded that budgeting has not met with its death. The need for the providing for resources through budget like system can never be done away with. If not through budget, it will be done through some other system but the concept will stay for ever. "Words can be negative, backward oriented, reactive, and depressing. Alternatively, they can be positive, forward oriented, proactive, and uplifting. "Budgeting" in many organizations, has become the former. A new term-I would suggest "value-creating plan"-could be the latter " (Howell.) The above discussion outlining the budgetary process with an empirical study seeks to create an impression that the process and method alone can not make a good budgeting system without actually involving budget holders as participants in the process from beginning to end as a cyclical process. The budget should be a living document throughout the year subjected to revisions as and when necessary rather than remaining a Statute or Gospel. (Rick Whiting). And the improvement to the budgeting systems absorbs the theoretical aspects of Forward planning, Co-ordination, Motivation , Control and Authorization Bibliography Firer Ross Westerfield Jordan Fundematals of Corporate Finance 2004 Third South African Edition The McGraw - Hill Companies Lucey (2003) Management Accounting 5th Edition Continuum London New York Doh Joon Chien, Asian Journal of Public Administration, http://sunzi1.lib.hku.hk/hkjo/view/50/5000251.pdf.accessed on March 30,2006 References Herald Scheruga http://www.microsoft.com/windowsserversystem, accessed on April 15, 2006 Howell, Robert A Turn Your Budgeting Process Upside Down , Harvard Business Review, 00178012, Jul/Aug2004, Vol. 82, Issue 7/8 EBSCO HOST Data base: Business source primer, www.britishcouncil.org accessed on April 17, 2006 http://www.bbrt.org accessed on March 30,2006 http://www.csuchico.edu/mgmt/strategy/module1, accessed on April 15, 2006 http://www.olemiss.edu/depts/nfsmi/Information/fmis/section_5.pdf., accessed on April 15,2006 http://www.osbornebooks.co.uk/pdf/aat_managing_performance_t.pdf accessed on April15, 2006 http://sunzi1.lib.hku.hk/hkjo/view/50/5000251.pdf.accessed on March 30,2006 Rick Whiting Sept 25, 2000 Budget Planning: The Next Generation, http://www.informationweek.com, accessed on April 15, 2006 Read More