The concept of budgeting is most likely familiar to you. Financial decisions, large and small, require some type of planning. For example, as you decide whether to rent an apartment or buy a house, repair your older vehicle or buy a new one, cook at home or eat out, you are considering your financial situation. Perhaps you decide to cook at home in order to save for a down payment on a house, which indicates you have a financial plan to meet your goals. For many people, however, budgeting is not a formal process where plans are written and carefully followed. This failure to formalize the plans often results in a failure to achieve financial goals.
Companies use budgets for the same reasons as you do in your personal life—to plan, direct, and control actions and the related revenues and expenses. Companies also use budgets to meet their goals. As part of long-term planning, companies develop a corpo- rate strategy and set goals to meet their objectives. These goals will be integrated into the budgeting process to ensure that the company achieves its long-term strategy.
Budgeting Objectives
A budget is a financial plan that managers use to coordinate a business’s activities with its goals and strategies. Managers use budgets in fulfilling their major responsibilities. First, they develop strategies—overall business goals, such as a goal to expand international operations or a goal to be a value leader in one market while diversifying into other markets.
Companies then plan and budget for specific actions to achieve those goals. The next step is to direct the company on how to act, or, in other words, how to carry out the plans.
After acting, managers compare actual results with the budget and use the information to make control decisions. The feedback allows them to determine what, if any, corrective action to take. If, for example, the company spent more than expected in one area of opera- tions, managers must cut other costs or increase revenues. These decisions then affect the company’s future strategies and plans.
Exhibit 22-1 illustrates the process of developing strategies, planning, directing, and controlling. Notice that the process is a loop—the company begins by developing strategy to help identify the company’s goals. Using those goals, the company plans the actions needed to be taken to meet its goals. The results of the actions are then compared to the plan to aid in control and provide feedback. The control step is not an end, but an input into the develop strategies step. Successful companies use current period results to help make decisions regarding the company’s future.
Learning Objective 1 Describe budgeting objectives,
benefits, and procedures and how human behavior influences budgeting
Budget A financial plan that managers use to coordinate a business’s activities with its goals and strategies.
1 Describe budgeting objectives, benefits, and procedures and how human behavior influences budgeting
2 Define budget types and the components of the master budget
3 Prepare an operating budget for a manufacturing company
4 Prepare a financial budget for a manufacturing company
5 Prepare an operating budget for a merchandising company
6 Prepare a financial budget for a merchandising company
7 Describe how information technology can be used in the budgeting process
Chapter 22 Learning Objectives
Budgeting Benefits
Budgeting requires managers to plan, promotes coordination and communication, and provides a benchmark for evaluating actual performance. The budget really represents the plan the company has in place to achieve its goals.
Planning
Budgeting requires managers to plan for the company’s future. Decisions are then based on this formalized plan, which helps prevent haphazard decision making. For example, if the company plans to expand into a new market, the budget will include expected funding sources and expenditures for the expansion. Keep in mind, however, that bud- gets are plans for future activities and may need to be modified. If a company learns of a revenue shortfall, where actual revenues earned are less than budgeted revenues, the company has to modify its plan and devise strategies to increase revenues or cut expenses so the company can achieve its planned goals. The better the plan and the more time the company has to act on the plan, the more likely it will be to find a way to meet the target.
Coordination and Communication
The budget coordinates a company’s activities. Creating a budget facilitates coordination and communication by requiring managers at different levels and in different functions
Exhibit22-1 | Budgeting Objectives
Control Plan
Direct Japanese division
U.S. division
Develop strategies Feedback to identify
corrective action
Benchmarking
Budgets provide a benchmark that motivates employees and helps managers evaluate performance. Benchmarking is the practice of comparing a company with its prior perfor- mance or with best practices from other companies. Companies might compare budgeted numbers with previous year’s performance or the company might compare their budgets to other leading companies through the use of industry averages. Benchmarking helps compa- nies determine where a company can improve and helps companies plan how to meet performance goals. Through the benchmarking process, companies are able to develop budgets that present a detailed road map of how performance goals will be achieved.
Budgets should always be compared to actual results. The areas where actual results differed from the budget should be evaluated in order to explain why the amounts differed.
This function helps to highlight any problems and provides opportunities for management to implement new strategies to meet its goals. In this chapter, we will focus on the develop- ment of the budget and in the next chapter, we will discuss how companies evaluate the differences between budgeted and actual numbers.
Budgeting Procedures
The budgeting process varies from company to company. For a small company, the process may be relatively simple and somewhat informal. In larger companies, however, the process can be very complex, with a budget committee coordinating the process. To achieve the benefit of motivating employees, the budget should include input from all levels. Many com- panies choose to develop the budget from the bottom-up (often referred to as a participative budget ). A participative budget is a budgeting process where those individuals who are directly impacted by a budget are involved in the development of the budget. This requires significant coordination among the company’s various business segments. Therefore, the budgeting process usually begins several months before the beginning of the budget period.
When a company uses participative budgeting, budgets tend to be more achievable because those directly impacted by the budget help to create the plan. Preliminary budgets are developed at the departmental level and then flow up to the higher levels of the com- pany for review by managers, vice presidents, and presidents. This bottom-up approach is better for employee morale and tends to result in more buy-in from employees as opposed to budgets that are imposed on employees by senior management.
Budgeting and Human Behavior
What is the most important part of a budgeting system? It is getting managers and employ- ees to accept the budget so the company can benefit from the control and feedback illus- trated in Exhibit 22-1.
Few people enjoy having their work monitored and evaluated. If managers use the budget as a benchmark to evaluate employees’ performance, managers must first motivate employees to accept the budget’s goals. Here is how they can do it:
• Managers must support the budget themselves, or no one else will.
• Managers must show employees how budgets can help them achieve better results.
• Managers must have employees participate in developing the budget so that employees feel the goals are realistic and achievable.
Managers’ performance is also evaluated by comparing actual results to the budget. When they develop the company’s budget, they may be tempted to participate in budgetary “gaming”
and build in budgetary slack. Budgetary slack occurs when managers intentionally understate expected revenues or overstate expected expenses. For example, managers might want to bud- get fewer sales and higher expenses than they expect. This increases the chance that their actual performance will be better than the budget and then they will receive a good evaluation. But adding slack into the budget makes it less accurate—and less useful for planning and control.
Benchmarking The practice of comparing a company with its prior performance or with best practices from other companies.
Participative Budget A budgeting process where those individuals who are directly impacted by a budget are involved in the development of the budget.
Budgetary Slack Occurs when managers intentionally
understate expected revenues or overstate expected expenses to increase the chances of receiving favorable performance evaluations.
Another budgetary game is referred to as spend it or lose it. In many companies, if a business segment has a budgeted expense item and does not spend as much as expected for the item, there is a fear the budgeted item will have a lower amount in future budget periods. For example, if the Accounts Payable Department budget allows for $5,000 in Supplies Expense and the department only spends $3,000, then there is a fear the amount will be reduced to $3,000 in the next budget. The employees are then motivated to purchase unneeded supplies, which reduces the operating income for the company.
Try It!
Match the following statements to the appropriate budgeting objective or benefit: developing strategies, planning, directing, controlling, coordinating and communicating, and benchmarking.
1. Managers are required to think about future business activities.
2. Managers use feedback to identify corrective action.
3. Managers use results to evaluate employees’ performance.
4. Managers work with managers in other divisions.
Check your answers online in MyAccountingLab or at http://www.pearsonhighered.com/Horngren.
For more practice, see Short Exercise S22-1. MyAccountingLab