Manging Finance: The Concept of Budget and Budgeting - Research Paper Example

Table of Contents Table of Contents 1 Introduction 2 Corporation budget 3 Budgeting techniques 4 Budgeting process 6 How reliable are budgets in the present world 8 Suitability of budgeting in the 21st century 11 Conclusion 12 Reference 13 Bibliography 19 Introduction Budget has different meaning for different people; some believe that a budget is required when resources are scanty, whereas other think budget is needed when things have to be done in proper chronological manner. But the fact is one makes budget to plan the future activities, to plan the way in which money will be allotted for doing different activities. As per NACUBO’s definition “Budget is an itemised, authorised and systematic plan of operation which is expressed in monitory terms, for a given time period” (Purkey, 2009). Budget preparation is an annual phenomenon in the companies where they set long term as well as short term plan and allocate appropriate budget for fulfilling these plans. While setting the budget, companies believe that budget will act as an indicator of expanse and revenue related to individual activities; it will provide information that will assist in managerial decision making; it will act as a controlling tool by analysing the deviation of actual performance against the budget and taking appropriate action (Institute of Chartered Accountants, n.d.). Management undertake budget to boost their business performance and for that they try to understand and monitor the major business drivers. The three main drivers for any business are: sale, cost and working capital. So the management try to control these drivers with help of budget. But with fast changing market conditions, budgets are losing their importance, many companies believe that it’s a time consuming process which hardly have any major utility (Investopedia, 2009) To understand the fact that how effective budgets are in 21 century, one have to understand what does the term “budget” actually means, its advantages and disadvantages and finally the conclusion should be derived. Corporation budget Budgets are being made for different purposes by different entities like the corporation make its business budget, government makes its own fiscal budget and budgets are also being made at individual levels. For corporation, the common budgets are sale budget, production budget, purchase budget, marketing budget, revenue budget and expanse budget. Management know the fact that budget preparation is time consuming, but it greatly influence a business. It helps in identifying problems and opportunities at an early stage, thus it assists in improving business. If described in nutshell budgets are future forecasts on basis of which money inflow and outflow can be monitored (Economy Watch, n.d.). From centuries, management has considered a well planned budget as an excellent financial tool for monitoring their performance and developing discipline (Co, 2006). Budgeting techniques A budget not only gives information regarding allocation of money, it also provide information toward needs of different department, priority given by business to these needs, future revenue which the top management is planning to achieve, the level of expenditure that will be allowed in different departments and the different activities which will be undertaken by different organisation. (Purkey, 2009). There are various approaches for formulating budget in a company, some are traditional form of budgeting like Line item which is the most common form of budgeting, it focuses more on whet need to be the purchased, it is easy to understand as well as easy to prepare but it fails in providing in-depth information and it is less flexible (National Centre For Educational Statistics, 2009). With passage of time, different kinds of modern budgeting technique came in existence like program budgeting, performance budgeting and zero-base budgeting. Program budgeting emphasises on outcome (program) rather than input, it focuses on accomplishment of goals and it is quite easy to understand (Kirch, 2005). Performance budgeting ties up budget with performance of different departments and business units, it focuses more on unit cost and activities and hence it is quite quantitative. It follows the axiom “what gets measured, gets done” (Arnold, 2008, p.27). But as per many experts it is a troublesome process because the information regarding performance cannot be properly utilized and leads to state of confusion (Gilmour & Lewis, 2006 p. 743). Zero budgeting is also known as floating budget, it focuses on better utilization of resources, it is designed in such a way that resources can be reallocated to meet the changing needs (Lin, 1979). But the main problem with this technique is its complex nature and intensive labour requirement (National Food Service Management Institute, n.d.). Another common type of budget which is commonly used in corporation is cash budgeting process. Cash is being considered as blood in the organisation, hence management take care that circulation of cash (inflow and outflow) should be under control. So they use different techniques of cash budgeting. Cash budget is a statement which estimates future cash inflow and cash outflow for a given period of time. Taking the cash flows into consideration, the future problem can be analysed (NetTOM, n.d.). Though cash flow budget helps the management to plan the future cash flow, but it too have certain disadvantages such as its time consuming nature because it needs great deal of planning and constant monitoring. If the accounting techniques are not well planed, it can lead to wrong information that creates greater problems in coming future (Elizondo, n.d.). Budgeting process Budgeting process has to be well planned to make the whole process successful. It can be said that budgeting process is cyclic in nature and its main two phases are planning phase and control phase. These stages can be further subdivided into four phases that take place in a cycle. 1. Planning & Development refers that before the actual budget is made, all the historic data and future financial projection of the company has to be taken into consideration. Some organisation follows top-down method of budget development where the top management makes the budgets and it rolls down to the bottom level management, the other way is bottom-up method where the ground level managers along with the assistance of their employees make the budget and then the budget goes to the top management for approval. But the best way of budget formation is when both the management and the employees come together and set the future budget. The employees and the ground level management are well aware of market scenario where as the top management have the information regarding financial potential of the company. So when they take the decision together, a better budget is formed. 2. Implementation comes after budget is developed. The budget is introduced at beginning of the financial year and it has to be followed throughout the whole year. Successful implementation of the budget is a responsibility of both management and employees, so to make the budget successful they should work hand in hand. 3. Monitoring is necessary to keep a check whether things are moving as per the budget or not. Different organisational results and reports are gathered and then compared with the budget to verify deviation from the budget. Such constant monitoring is necessary throughout the year. 4. Control helps the management to keep the things under control. If management finds variation between actual and planned action, they should immediately take certain appropriate action to minimise the gap. The actual cause behind such deviation has to be identified and should be removed. Again in the next year a new budget has to make on the basis of previous years’ data. Hence it is a cyclic process (Colorado, n.d.). Success of the budget depends on how well these four steps are executed with the organisation. If any of the steps is overlooked, it will distort the whole budgeting process; hence management should take care of these steps. How reliable are budgets in the present world One has to accept the fact that budgeting process consume a lot of executive’s time. They often have to get engaged in endless rounds of meeting and tense negotiation. Many a time it has been found that budgeting encourages managers to lie and cheat. Often colleagues go against each other; they play games to fulfil their motto. Such situation creates a negative environment and people get de-motivated. Their focus shifts from company’s welfare toward fulfilling their own desires and earning higher incentive (Jensen, 2001). As incentive of the employees are related to fulfilment or accomplishment of their targets, so to achieve the targets, sometime the employees adopt unfair means which leads to high cost for the company, but employees are less bothered for such long term impacts. Many a time the managers under predict the future demand, so that they will have less burden on them, as the production budget and purchase budgets are based on sales budget, hence the company underperforms and the real potential remain unexplored. But the sad thing is after knowing all these facts, companies still continues the process of budgeting for setting their future strategies. The main target for the corporation is its profit so while setting the budget, management pay more attention toward profit maximisation in short run, and underestimates the long term future outcome of such misbalanced budgets (Journal of Accountancy, 2001). The process of budgeting is so deeply imbedded in the corporate sector that all the disastrous effect of budgeting are overlooked by management and still it is continuing. As long as the incentives and bonuses will remain associated with fulfilment of targets, budgets cannot be removed from the organisations. In the traditional way of budgeting, managers are paid on the basis of “pay for performance”. As per this process, the employees are paid a fixed amount of salary as soon they reach a certain percentage of the target (like 80 to 85 percent); if they manage to cross the budgeted target they receives bonus for their performance and the more they move above the target, the more they receive incentive. So it can be clearly concluded that employees’ incentive are directly related to budgets and targets. The lower the target, the more they will be benefited (Lagace, 2003). For example if the manager finds that their incentive is related to the profit earned by the company, then they will try to boost the revenue by realising future sales at present and postponing expenses to future, without paying attention to what will be the impact of such action in company. In big companies, management set budget at the beginning of their financial year with an aim to create a harmonious coordination between other business units, a healthy flow of information, lower expanses and highly satisfied customers. But as soon as the budget comes into action, the business unit’s managers start hiding vital information. Such distorted information often leads to wrong decision making (Jensen, 2001). Many a time the top level management gets involve in such fraud cases and they disperse wrong information to the customers and shareholders. One such example of fraud case in past was seen in Lernout & Hauspie, a software firm in the year 2001 (The New York Time, 2007). The misguiding information not only hampers the company, but the damage spreads and affects the national economy. For example at the time of economic boom, misguiding information revealed by company leads to wrong prediction of the financial analysts regarding future growth of the company. They gives an over statement of company’s earning and profitability, and the top management ends up taking wrong decisions. But as soon as the economic slowdown starts, sales falls below expected levels, inventories gets accumulated, and as a result the management’s incentive and bonus moves down. All these create an environment of de-motivation and depression that negatively affects company’s image (Jensen, 2001). Though budgets are common in almost all the organisations, but it has to be accepted that almost all the employees hate the term “budget”. Employees believe that budgets are designed in such a manner that the employees can never reach them and thus management can make them work more (Media Willy, 2003). Suitability of budgeting in the 21st century There are many factors which lead to faulty budgeting process like “Faulty Arithmetic in the Budget Figures, Errors in the Arithmetic of the Actual Results, Reality is Wrong and Differences between Budget Assumptions and Actual Outcome” (Financial Management Development, n.d.). As per the report published by Centre for Sustainability Management, many organisations (like network organisations) have accepted the fact that budgets no longer serve the purpose in their organisations (Centre for Sustainability Management, 2001). In a survey conducted by KPMG in UK, it was found that 37 percent of the companies provided a monthly update of their 12 months’ forecast, 50 percent of the companies are planning to start updating their annual budget on a monthly basis and around two-third of the companies have adopted rolling budget for forecasting. But as per KPMG, a good forecasting can be only achieved if the company has a good performance management and reporting system (KPMG, 2009). It has been found that company puts a lot of time and effort to set their annual budget, but as soon as they are bought into action, the market condition changes and the budgets lose their importance. So keep the budget updated it has to be revised on monthly basis. Again such regular updating needs further managerial time which makes it more costly. Many experts suggest that budget can be only successful its results are achievable and measureable. Management should undertake stress testing and scenario analysis to find out economic risk and prevailing opportunities. Conclusion The concept of budget and budgeting has evidence regarding its origin in bible. Budget was first introduced in industrial organisations in 1920’s. With passage of time it developed as an integrated financial tool (Akintoye, 2008). The budget and budgeting technique has undergone constant change to fit the changing market condition. But in the present competitive world where market situations and the corporate strategies are changing at fast rate, budgets are losing their importance. Many a time the top management find themselves helpless (Diamond, 2006, p. 94-95). The underling truth behind budget is whatever precaution does the management adopt, there will always be a gap between the actual and perception. While setting the budget for the future, management have to undertake historical data into consideration, but in the fast changing globalised world, no one can predict what will happen in near future. So the management have to decide where they should go for budget preparation or not. Before taking any vital decision, the company have to rethink what role does budget play in proper functioning of their organisation and then only they should decide that where they should quit the budget or they should stick to it. They should plan what changes be introduced in the budgeting technique that to make the process more reliable. So the question remains open that where budgets are suitable in 21 century or not. Reference Akintoye, R. I. 2008. Literature Review and Theoretical Framework. Budget and Budgetary Control for Improved Performance: A Consideration for Selected Food and Beverages Companies in Nigeria. [pdf]. Available at: http://www.eurojournals.com/ejefas_12_01.pdf [Accessed on November 03, 2009]. Center for Sustainability Management. 2001. Abstract. Suitability Of Budgeting In The 21st Century. [pdf]. Available at: http://www.leuphana.de/csm/content/nama/downloads/download_publikationen/05-4downloadversion.pdf [Accessed on November 03, 2009]. Colorado. No date. 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