Accounting: The Language of Business - Vol. 1 (Part 128)

“Accounting does not make corporate earnings or balance sheets more volatile. Accounting just increases the transparency of volatility in earnings.”

—Diane Garnick

Budgeting (Part A)

by

Charles Lamson

You may have financial goals for your life. To achieve these goals, it is necessary to plan for future expenses. For example, you may consider taking a part-time job to save money for school expenses for the coming school year. How much money would you need to earn and save in order to pay these expenses? One way to answer this question would be to prepare a budget. For example, a budget would show an estimate of your expenses associated with school, such as tuition, fees, and books. In addition, you would have expenses for day-to-day living, such as rent, food, and clothing. You might also have expenses for travel and entertainment. Once the school year begins, you can use the budget as a tool for guiding your spending priorities during the year.

The budget is used in business in much the same way as it can be used in personal life. The budget provides the company "game plan" for the year. In the next several posts, you will see how budgets can be used for financial planning and control.

Nature and Objectives of Budgeting

If you were driving across the country, you might plan your trip with the aid of a road map. The road map would lay out your route across the country, identify stopovers, and reduce your chances of getting lost. In the same way, a budget charts a course for a business by outlining the plans of the business in financial terms. Like the road map, the budget can help a company navigate through the year and reduce negative outcomes.

Although budgets are normally associated with profit-making businesses, they also play an important role in operating most units of government. For example, budgets are important in managing rural school districts and small villages as well as agencies of the federal government. Budgets are also important for managing the operations of churches, hospitals, and other non-profit institutions. Individuals and families also use budgeting techniques in managing their financial affairs. In the next several posts, we emphasize the principles of budgeting in the context of a business organized for profit.

Objectives of Budgeting

Budgeting involves (1) establishing specific goals, (2) executing plans to achieve the goals, and (3) periodically comparing actual results with the goals. These goals include both the overall business goals as well as the specific goals for the individual units within the business. Establishing specific goals for future operations is part of the planning function of management, while executing actions to meet the goals is the directing function of management. Periodically comparing actual results with these goals and taking appropriate action is the controlling function of management. The relationships of these functions are illustrated in Exhibit 1.

Planning

A set of goals is often necessary to guide and focus individual and group actions. For example, students set academic goals, athletes set athletic goals, employees set career goals, and businesses set financial goals. In the same way, budgeting supports the planning process by requiring all organizational units to establish their goals for the upcoming period. These goals, in turn, motivate individuals and groups to perform at high levels.

Planning not only motivates employees to attain goals but also improves overall decision-making. During the planning phase of the budget process, all viewpoints are considered, options identified, and cost reduction opportunities assessed. This effort leads to better decision making for the organization. As a result, the budget process may reveal opportunities or threats that were not known prior to the budget planning process.

Directing

Once the budget plans are in place, they can be used to direct and coordinate operations in order to achieve the stated goals. For example, your goal to receive an "A" in a course would result in certain activities, such as reading the book, completing assignments, participating in class, and studying for exams. Such actions are fairly easy to direct and coordinate. A business, however, is much more complex and requires more formal direction and coordination. The budget is one way to direct and coordinate business activities and units to achieve stated goals. The budgetary units of an organization are called responsibility centers. Each responsibility center is led by a manager who has the authority over and responsibility for the unit's performance.

If there is a change in the external environment, the budget process can also be used by unit managers to readjust the operations.

Controlling

As time passes, the actual performance of an operation can be compared against the planned goals. This provides prompt feedback to employees about their performance. If necessary employees can use such feedback to adjust their activities in the future. For example, a salesperson may be given a quota to achieve $100,000 in sales for the period. If the actual sales are only $75,000, the salesperson can use this feedback about underperformance to change sales tactics and improve future sales. Feedback is not only helpful to individuals, but it can also redirect a complete organization.

Comparing actual results to the plan also helps prevent unplanned expenditures. The budget encourages employees to establish their spending priorities. For example, departments in universities have budgets to support faculty travel to conferences and meetings. The travel budget communicates to the faculty the upper limit on travel. Often, desired travel exceeds the budget. Thus, the budget requires the faculty to prioritize travel-related opportunities. In a future post, we will discuss comparing actual costs with budgeted costs in greater detail. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 871-873*

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