22107 Lecture Notes - Lecture 10: Budget, Participatory Budgeting, Cash Flow Statement
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LECTURE 10 – BUDGETING
Budgets are the financial quantification of plans dealing with the acquisition and use of
resources over a specific time period.
Planning is the cornerstone of good management – involves developing objectives and goals
for the organisation, as well as the actual preparation of budgets.
Operating involves day-to-day decision making by managers, which is often facilitated by
budgeting.
Control involves ensuring that the objectives and goals developed by the organisation are
being attained – often involves a comparison of budgets to actual performance and the use
of budgets for performance-evaluation purposes.
LEARNING OBJECTIVES
Describe the budget development process, behavioural implications of budgeting,
advantages of budgeting and the master budget.
THE BUDGET DEVELOPMENT PROCESS
Some companies start their budget process based on last year’s numbers, whereas others
employ zero-based budgeting.
Zero-based budgeting requires managers to build budgets from the ground up each year
rather than just add a percentage increase to last year’s numbers.
Consequently, managers must justify all items in the budget, not just changes from last
year’s budget.
Although zero-based budgeting is a good idea in theory, it can be very time consuming when
done on an annual basis.
In some cases, companies may require zero-based budgets only every few years or rotate
among departments the requirement that budgets be justified in full.
o Although we typically think of budgets as being prepared annually, companies frequently
use monthly budgets and rolling 12-month budgets to provide a mechanism for adjusting
items in response to unforeseen circumstances.
o Many state governments prepare budgets every two years – this can cause major problems
if unexpected costs are incurred due to natural disasters or if tax revenue falls unexpectedly.
PARTICIPATION IN THE BUDGET DEVELOPMENT PROCESS
Traditionally, budgeting is a bottom-up process dependent on departmental managers
providing a detailed plan for the upcoming month, quarter or year.
Participatory budgeting is a budgeting process that starts with departmental managers and
flows up through middle management and then to top management. Each new level of
management has responsibility for reviewing and negotiating any changes in the proposed
budget.
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Regardless of the specific process used, budget development must be guided by a strategic
plan that focuses attention on the company as a whole and integrates individual budgets.
A budgeting process that is clearly guided and focused by a strategic plan makes managers
more focused on important aspects of the budget and less worried about irrelevant details.
Also, to motivate managers and other employees to meet the objectives and goals provided
in budgets, companies should structure bonuses, merit pay, and other tangible or intangible
rewards in ways that link these rewards to measurable goals outlined in the budgets.
BEHAVIOURIAL IMPLICATIONS OF BUDGETING
When budgets are used for both planning and control purposes, conflicts invariably arise.
If managers are evaluated and compensated according to whether they ‘meet the budget’,
they may have incentives to pad the budget, thus making the targets easier to reach.
This style of behaviour is often described as budget ‘gaming’.
For example, if a manager knows that she will receive a bonus if sales in her department
exceed the budget, she may attempt to set the sales budget at an unrealistically low level.
While this form of gaming refers to managers attempting to manipulate the budget
numbers, gaming can have more ‘real’ effects.
For example, if a manager is $1000 behind their sales target on the last day of this period,
and they expect a sale at the start of the next period (tomorrow), they might record this sale
into their accounts today in order to show that they reached their budgetary sales target this
period. This action directly affects income statement (revenue recorded in wrong period).
This has the effect of overstating this period’s profit and understating next year’s profit.
Therefore, budget-related gaming can have negative effects on the quality of financial
reporting – this type of behaviour is unethical.
o Tying compensation to meeting targeted budgets can also cause managers to manipulate
expenses, and not only revenues – managers are incentivised to inequitably shift expenses
from one period to another in order to make certain that the budget is met.
o Companies can reduce incentives for this type of behaviour by holding managers
accountable and punishing unethical behaviour with strong sanctions.
o However, they can also reduce its likelihood by taking more positive steps, such as assuring
managers that performance evaluation will be done in a fair and equitable manner and will
include other factors such as customer satisfaction, quality of products and similar metrics.
ADVANTAGES OF BUDGETING
1. The budgeting process compels communication to occur throughout the organisation.
2. It forces management to focus on the future and not be distracted by daily crises.
3. It can help management identify and deal with potential bottlenecks and constraints.
4. It can increase the coordination of organisational activities and help facilitate goal
congruence. Implementing goal congruence means making sure that the personal goals of
the managers are closely aligned with the goals of the organisation.
5. It can define specific goals and objectives that become benchmark, or standards of
performance, for evaluating future performance.
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THE MASTER BUDGET
The master budget consists of an interrelated set of budgets prepared by a business.
- The starting point in both the master budget for a manufacturing company and a
merchandising company is FORECASTING SALES and PREPARING A SALES BUDGET.
Explain how managers develop a sales forecast and demonstrate the preparation of a
sales budget.
Sales forecast combines with the sales budget to form the starting points in the preparation
of production budgets for manufacturing companies, purchases budgets for merchandising
companies and labour budgets for service companies.
Sales budget is used in planning the cash needs for manufacturing, merchandising and
service companies.
The sales budget is a key component used in the overall strategic planning process and is
also used in planning the cash needs of businesses.
o There are many different ways to forecast sales – most forecasting will combine information
from many different sources either informally or through the use of computer programs.
o Regardless of the size of the company or the sophistication of the forecasting methods used,
the usual starting point in sales forecasting is last year’s level of sales.
o Other factors and information sources typically used in sales forecasting are:
1. Historical data, such as sales trends for the company, competitors and the industry.
2. General economic trends/factors, like inflation rates, interest rates and personal spending.
3. Regional and local factors expected to affect sales.
4. Anticipated price changes in both purchasing costs and sales prices.
5. Anticipated marketing or advertising plans.
6. The impact of new products or changes in product mix on the entire product line.
7. Technology or process changes in an industry (e.g. change from DVDs to Blue-Ray DVDs).
8. Other factors such as political and legal events.
Every organisation will have unique factors that it needs to consider and each organisation
will also attach a different level of importance to each factor.
E.g. forecasting sales revenue for a ski resort requires not only the consideration of general
economic conditions, the impact of new resorts and the potential impact of advertising, but
also a consideration of the weather.
The size and complexity of the organisation will often determine the complexity of the sales
forecasting system.
In large companies, preparation of the sales forecast is usually accomplished by the
marketing department while in smaller companies, the sales forecasts may be made by an
individual or a small group of managers.
Some companies will use regression analysis while others may use managerial intuition.
Operating budgets are used to plan for the short term – typically one year or less.
Document Summary
Budgets are the financial quantification of plans dealing with the acquisition and use of resources over a specific time period. Planning is the cornerstone of good management involves developing objectives and goals for the organisation, as well as the actual preparation of budgets. Operating involves day-to-day decision making by managers, which is often facilitated by budgeting. Control involves ensuring that the objectives and goals developed by the organisation are being attained often involves a comparison of budgets to actual performance and the use of budgets for performance-evaluation purposes. Describe the budget development process, behavioural implications of budgeting, advantages of budgeting and the master budget. Some companies start their budget process based on last year"s numbers, whereas others employ zero-based budgeting. Zero-based budgeting requires managers to build budgets from the ground up each year rather than just add a percentage increase to last year"s numbers. Consequently, managers must justify all items in the budget, not just changes from last year"s budget.
