Introduction: Why Budget?
While a budget planning is a laborious process it is crucial for the success of any company. The budgeting process forces managers to be proactive in planning for the future while fostering communication and coordination within a company. Different departments must work together in order to develop a proper budget. A properly formulated budget will aid to define a company’s objectives and provides guidelines to avoid wasted actions. Also, risk can be mitigated when objectives and action plans are clarified through the budgeting process.
This article will identify the key components of a budget as well as the methodologies involved in the budgeting process. The influences of management behavior will be discussed followed by a brief example of bad budgeting practices and its consequences.
The master budget is a summary of a company’s plans that sets concrete targets for sales, production, distribution and financing activities. Companies prepare cash budget not only for operating activities but also for investing and financial activities. This is because management should be aware in advance of any borrowing needs and when loans can be repaid. Budgets are interdependent because the figures of one budget are conventionally utilized in the preparation of another. Budget estimates are dependent on the nature of the business, its products and services, processes, organization, and management needs. It is a detailed model of the firm’s operating cycle that includes all internal processes which is developed into a cash budget, a budgeted income statement, and a budgeted balance sheet.
The Master Budget defines the organizations objectives and strategies. As well as allowing the company to realistically project future cash flows, it also smoothens the functioning of organizations operating cycle.
Disadvantages of developing a master budget is that it is both time consuming and highly complex. However, it should be noted that the advantages of a proper Master Budget far outweighs the disadvantages.
Components of the Master Budget
The Sales Budget includes the forecast of sales revenue, sale units and sales collection in the future market conditions.
The Purchase budget would include purchase of merchandise for sale and raw material for manufacturing. It is expressed in terms of sales dollars.
The Selling Expense Budget presents expenses the organization plans to incur in connection with sales and distribution.
The General and Administrative Expense Budget presents the expenses the organization plans to incur in connection with general administration such as the accounts department, the IT department, law etc.
The Cash Budget summarizes all cash receipts and disbursements expected to occur during the budgeting period. After a company makes sales predictions, an organization uses information regarding credit terms, collection policy, and prior collection experience to develop a cash collection budget. Other items included are an allowance for bad debt, cash sales, sales discount, allowance for volume discounts, and seasonal changes of sales prices and collections. The cash budget shows cash operations deficiencies and surplus expected to occur at the end of each month, which is used to plan for borrowing and loan payments.
Budgeted Financial Statements are pro forma statements that reflect the “as if” effects of the budgeted activities on the actual financial position of the organization. It reflects the results of operations assuming the budget predictions.
Budget Development in a Manufacturing Organization
Manufacturing organization converts the raw materials into finished goods and sells it to the customer for consumption. It prepares the master budget before production to make the organization successful and survive in a competitive environment. For example, a Bicycle manufacturer will plan a Master Budget in the following fashion:
A Sales Budget will be based on the anticipation of sales of the Bicycle and pricing policy, expected number of units to be sold and the revenue generated.
Once the sales budget is completed the Production Budget will derive the total volume of Bicycle units to be manufactured based on the targeted sales and inventory required to maintain sales. For example, if the expected number of sales of Bicylces for the month of January is 500 units, the production budget will plan for 650 units (Sales projected (500) + inventory as per company s strategy (30%)).
The Purchase budget will be obtained based on volume of Bi Cycles to be manufactured, material required to manufacture a single unit and the cost of materials. As per the above example, the material required for 650 units will be budgeted for the month of January.
The Manufacturing Cost Budget will be derived from the cost of making 650 units of bicycles using the design of product and process used to manufacture while considering the raw material cost, direct labor cost and manufacturing over headed cost.
Finalizing the Budget
For efficient and effective budgeting two questions must be addressed: Is the proposed budget feasible?
Is the proposed budget acceptable?
To be feasible the organization must be able to implement the proposed budget. Possible actions include obtaining equity financing, issue long-term debt, reducing the amount of inventory on hand, or obtaining a line of credit. Constraints for infeasibility are availability of merchandise and production capacity for a manufacturer. When evaluating the budget, management must consider various financial ratios such as return on assets, profit margins, etc. The company must compare the return provided by the proposed budget, the past budget and industry average as well as the organization’s goals.
Companies using the Input/Output approach calculate the required input or resources through estimating the potential output or performance. For example, if a microchip manufacturing plant requires 5 grams of metal to create one microchip and each gram costs $2, then each microchip costs $10 of material. Thus, a projected output of 1000 microchips would cost $10,000 and 5 kilograms of material. This approach is mainly used for industries with a measurable relationship between effort and return, such as manufacturing, service, and merchandising but is not compatible with industries that are inelastic to unit level changes.
The Activity-based Approach is subset of the Input/Output which reduces the potential for error by determining cost through evaluating the cost of each activity in the manufacturing process rather than focusing on inputs such as machine or labor hours. Thus, the approach provides a more accurate picture of costs involved by providing costs at each level of production. It results in a more efficient budget by allowing the identification of the optimal set of activities. However, it is far more time consuming to produce.
A budget prepared using the previous year budget as a base with some percentage increase or decrease is called incremental budget. Budget justification is to be given only for the percentage change not for the base amount (previous year’s budget). This type of budget is best suited for non-profit organizations, government organizations or in organizations in which the amount of output is weakly correlated to the money spent. For example, the Boston Public School budget for FY12 increased by 1.2% from the FY 11 and for FY11 it increased by 0.4% of the FY 10 budgets (OBM 2011, 2012). The increase in both budgets was justified as improving opportunities for English Language learners, arts and physical education, but not for their existing programs. The advantages of this budget are that it is easy to practice, quick preparation, stability and conflict avoidance between departments due to different budget approval. Some of the main disadvantages are there is no incentive to reduce expense as peopmsle are tempted to spend the allotted expense so that their future budget is not affected. Also, no room for innovative changes to the budget is given.
Minimum Level Approach
In this type of approach a minimum budget level is fixed for carrying out ongoing projects and activities and anything above the budget should be justified. For example, the R&D budget in a pharmaceutical company is fixed for ongoing projects and new projects must be approved by the management. Main advantages are ongoing projects will not be disturbed due to budget changes and last year budget will not be approved without revision as in the case of Incremental approach.
The Minimum level approach is considered as Zero Level Budgeting in some organizations in which for every amount spent, justification must be (TWF n.d.). For example if an R&D department of an Electronics manufacturer puts forth many project proposals to the management , based on the market trend and project feasibility, the management will approve the most profitable project. Advantages of this method are that allocation of resources is very efficient and detects inflated budgets. However, this method consumes a significant amount of time and resources.
Top-down vs. Bottom-up
In addition to macro methods of budgeting (Input/output, activity based, incremental, and minimum level) there is also a distinction between top-down/imposed and bottom-up/participative budgets. These two methods represent opposite extremes of a spectrum of which a company’s budgeting procedure may fall on any point.
As the name suggests, a Top-down Budget is formulated by a small number of high ranking managers who make all decisions regarding a company’s objectives which are then received by the lower managers who implement the plan. Because only a few people are involved in the decision making, it is quick and saves time. It also avoids the cushion that is lower management tend to build into their budgets. However, because only a few people are involved in the decision-making process, those not involved may lack the motivation and commitment to properly implement the plan.
On the opposite end of the spectrum is the Bottom-up process of budgeting. It begins at the lowest possible management level, whose budget plan is then integrated with the proposals at the next level. The process is continued until a comprehensive holistic budget is developed for the company. The Bottom-up process ensures that managers at each level clearly understand their roles in meeting company objectives. Therefore, budgets are usually far more accurate and employees are more committed to their self-made budget. However, inefficiencies tend to occur with a bottom-up process. Managers tend to provide a budgetary slack (understating revenues or overstating expenses) in order to provide a cushion against underperformance or unfavorable reviews. While this may cause inefficient spending, it can provide funds to reduce risky activities of which there is insufficient information.
There are three types of budgeting periods used by companies: Fixed-length, Life Cycle and Continuous/Rolling Budgets. The type of period used is determined by the context of the budget. Most companies use fixed-length budgets determined at the beginning of a specified period. However, for single projects, a Life Cycle budget is more attractive, where a company determines the budget for the entire project; especially if the project occurs within a period or over multiple periods. A continuous budget may be more useful than a fixed-budget as it forces managers to be continually updating their budget. Where a one-year budget plan is only available at the beginning of the year, a 4 quarter rolling budget requires managers to continually have a budget plan for a whole year at the beginning of each quarter, thus, sustaining the budgets relevancy.
Forecasts, Ethics, and Open Book Management
In addition to deciding methodologies of budgeting, a manager must also consider company forecasts, ethics and employee support. A manager must allow for the development of various forecasts and consider them during the budgeting process. Industry forecasts, such as economic conditions, as well as internal forecasts, such as collection periods, should be factored into the budget.
Because ethical issues regarding budgeting are rarely illegal, there is a strong incentive to either pad the budgetary slack or overstate performance. Organizations should be firm in their rules against unethical behavior as it is easy to fall into a moral gray area.
Finally, in order to properly motivate employees by gaining support for the budget, many companies have adopted an Open Book Management approach. The approach involves interacting with employees by sharing information and teaching employees to understand the relevant financial information.
A well formulated budget is crucial in order to facilitate a company’s operations. However, when a company’s budget is poorly formulated, it can have disastrous consequences. An example is OGX Petróleo e Gás Participações S.A. owned by Eike Batista. At the company’s peak in 2009, it achieved an IPO of $3 billion (Spinetto et al. 2013). However, the company filed for bankruptcy on Oct. 30, 2013 with debts of $5.11 billion with Batista being sued for violations of disclosure ruels (Fontevecchia 2013). While its failure was due to a variety of factors, we will argue that poor budgeting is a crucial factor.
Within the petroleum industry, the exploration and production process is both a high risk and high expense venture where predicted outputs require complex calculations (Suslick et al. 2009). Even after production has begun, the projected output may change depending on a variety of variables (Katusa 2012). OGX had calculated potential output at 4.8 billion barrels and therefore invested heavily into the required infrastructure based on this estimate (Spinetto 2013). However, these decisions were made before the wells were operational which resulted in final outputs at roughly 50% of the initial amount (Katusa 2012).
Management decisions at OGX were made by Bastista and a small group of managers and its inputs were based on an estimation of outputs (Katusa 2012, Spinetto 2013). In addition, performance was highly overstated due to “[Batista’s] tendency to shoot the messenger” (Spinetto 2013).
Therefore, OGX should have adopted a bottom-up minimum level approach of budgeting as well as adopting a policy of reporting performance after confirmation. A bottom-up approach would have generated a much more precise picture of performance and costs while a minimum-level approach would have required confirmation of projected outputs before beginning operations at the cost of time. In addition, reporting performance after confirmation would have avoided any overstatements of performance.
To be successful in a competitive environment a company must develop proper Master Budget in order to promote proactive thought, communication and coordination within a company. It is also an important aide to planning and risk management. In order for a company to run smoothly, the Master Budget must balance all the variable constituents of a company’s operational activities. In addition, methodologies used, while utilized at the management’s discretion, should reflect the context of the company’s operations. As illustrated in the OGX example, failure to properly develop a budget can have catastrophic consequences to a company.
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Fontevecchia, A. 2013. Death of the Brazilian Dream: Ex-billionaire Eike Batista’s OGX Files for Bankruptcy. Forbes, Oct. 30. Available at: http://www.forbes.com/sites/afontevecchia/2013/10/30/death-of-the-brazilian-dream-ex-billionaire-eike-batistas-ogx-files-for-bankruptcy/
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