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The Business Forum Journal

 

Budgeting:  An Introduction

 

By Henry H. Goldman

 

 

“. . . we know of no better definition of budgeting than to say that a budget is a planning and control system . . .”

 

WHAT BUDGETING IS

 Many companies refer to their annual budgeting activity as profit planning: these two terms are synonymous and are used interchangeably in the following:

Definition of Budgeting

Budgeting (or profit planning) is a process or technique with broad applications in the management of a business, school or government agency.  The rules apply to not-for-profits, as well.  The process involves the formation of definite and specific plans or budgets for a limited future period, usually the ensuing fiscal or calendar year.  These plans, which take into account all phases of the budgeted operations, are given expression in financial terms.  They also become standards against which to measure and evaluate actual performance as the period progresses.  Budgeting is, therefore, not only a short term planning and coordinating process, but is also a means of exerting management control over budgeted operations.  Budgeting becomes a management process rather than a financial one. 

Budgeting, as Distinguished from Forecasting

Forecasting and budgeting, despite their similarities, should be clearly distinguished from each other.  A forecast is a prediction of likely future events.  But, unlike a budget, a forecast is not a plan for achieving those forecasted (desired?) results.  And a forecast is too general to serve as a control standard against which actual progress across the period can be measured.  Forecasts are the starting point in the budget planning process.  Most firms and public agencies precede the preparation of their operating budgets with revenue forecasts and expectations of economic conditions within their markets or constituencies, and in the world's economy as a whole.  We've just witnessed how economic conditions in Greece and Italy have affected the United States, as well as the poor financial climate since 2008. 

Essentially, the forecasting process analyzes the market and other conditions that the company or the agency is likely to face during the forthcoming period and attempts to predict what sales level the company can expect to achieve under those economic and market conditions.  Budgeting, on the other hand, is an attempt by management to respond to those predicted conditions; to allocate the organization's resources in such a way so as to take the best advantage of the anticipated situation and fulfill the sales or revenue forecast.

The distinction between budgeting and forecasting is not simply a matter of degree: forecasting requires its own techniques and is a management skill in of itself.  In addition, a firm or agency that does not keep the distinction in mind, might undertake a program of budgeting that includes little more than forecasts; such a program would lack the depth, the detail and the involvement, at all levels of management, that are considered necessary inputs to a successful budgeting system.

Long-Range Planning, as Distinguished from Budgeting

Budgeting is also distinguished from long-range planning.  Unlike a long-range plan, a budget is specific and detailed, and  it is usually prepared for no longer than one year ahead.  Retail organizations very often budget on a six months' basis.  These characteristics are practical requirements for an effective operating plan, which a budget is intended to be.  By contrast, the kind of planning that looks more than one year into the future is necessarily more general and less detailed than the budget.  The budget, in every sense of the word, ought to be Year One of the  long-range plan.  These differences are also addressed in the section, below, comparing strategic planning to tactical planning.      

BUDGETING'S ROLE IN THE MANAGEMENT PROCESS

The purpose of budgeting is to assist management in accomplishing the basic tasks of planning, coordinating and controlling the activities of the entity.  It is not the only tool that management can use in this regard, but it can be the one that is the most effective.  Moreover, it serves to correlate these tasks: in fact, some executives emphasize that a budgeting system will lack effectiveness unless the system encompasses them.

Planning

Planning an essential element in the management process; and a budget is a plan, or has the qualification of a plan.  A properly prepared budget is a complete plan, in that it is detailed and includes every aspect of the budgeted activities.The planning that goes into the budget's preparation yields several advantages to the company or agency and its management.  For example, the budgeting process:

  • Sets goals (people perform better when they have definite objectives to work toward).
     

  • Establishes limits within which managers understand that they are expected to operate.
     

  • Establishes what the firm's or the agency's needs will be during the budget period for manpower, raw materials, plant and equipment, programs and for the funds needed to pay for them.
     

  • Foresees potential problems and gives management the time to prepare for them.
     

  • Increases management flexibility. 

Coordination

Management is charged with making the most productive use of the company's or agency's resources, including its people.  This requires coordination of effort and the use of facilities and materials.  Budgeting is one means by which these elements can be pulled together and dovetailed.  It helps to prevent the waste that results when firm or agency units work at cross-purposes or duplicate each other's work.  It is the forum through which the nature, the direction, the size and the timing of the organization's efforts can be coordinated.  Management relies on the budgeting function to find gaps or overlapping areas in proposed operating budgets submitted by operating managers, and to suggest how these might be tightened or corrected.  If the budget program is to serve this purpose effectively, it must encompass all significant areas of activity, since coordination on a practical scale, can have only limited value.

Control

Many executives regard the budget as primarily an instrument of management control.  This coincides with the growing attention to the concept of control, in general, and the refinement in control techniques like: standard costs, responsibility reporting and Activity Based Management.[i] 

Budgetary control consists of verifying that performance is going according to plan and, if it is not, locating and correcting the cause of the unfavorable variances.  Of the several techniques that management can use to achieve control over the organization's activities, the budgeting system has the greatest potential.  The budget provides a standard for use in measuring performance over the budget's horizon; at the same time it establishes the organizational channels that facilitate the comparison of performance against these budgeted standards.  And, unlike some other control techniques, budgeting can be applied to every part of the firm or the agency.

Budgetary control is also an effective method of ensuring that the coordination built into approved budget plans is not subverted during actual operations.

The effectiveness of budgeting as a control device depends, to a large extent, on how sound and realistic was the planning that produced the budgeted targets.  Budgetary control also requires, in addition to adequate plans, an effective system for reporting performance results on a regular and timely basis.  Executives emphasize that sound planning and effective reporting are not enough for control.  Management must see that any corrective action indicated by the reports is carried out.  Only then does control through budgeting become a reality.

CONDITIONS NECESSARY FOR EFFECTIVE BUDGETING

Certain conditions are indispensable if an organization's budget system is to provide satisfactory results.  These conditions are, in part:

  • A suitable organizational structure

  • An adequate accounting system

  • Interest and support of senior management

  • Acceptance by middle management

  • A budget system that meets and serves the organization's needs

DEALING WITH MANAGEMENT RESENTMENT

One danger in budgeting is that managers may come to view the budget as a constructive device that will tie their hands and deprive them of a flexible response to changing conditions during the budget's time horizon.  Most surprisingly, managers who equate budgeting with repression rarely give the program the cooperation necessary to make it work.  These managers never seem to have the time to prepare their budgets' inputs or to analyze their monthly variance reports.

We hope that these reflections will be useful to organizations just now becoming aware of the need for careful and thoughtful operational planning.  The economics of the second decade of the twenty-first century demand such attention and care.

 

 [i] "Activity Based Budgeting, Costing and Planning," are outgrowths of Zero Base Budgeting and Planning.


Henry H. Goldman is a Fellow of The Business Forum Institute and is the Managing Director of the Goldman Nelson Group.  Henry got his Masters Degree at the University of Iowa and did his Doctoral Studies at the University of Southern California.  He is a Certified Professional Consultant to Management (CPCM); and has published numerous articles in trade journals and was Associate Editor of Taking Stock: A Survey on the Practice and Future of Change Management (Berlin, Germany).  He is a member of the American Society for Training and Development (ASTD); Association of Professional Consultants (APC) and the Institute of Management Consultants (IMC). Henry has consulted and/or offered training in South Africa, Tanzania, China, Hong Kong, Indonesia, Macau, Malaysia, Philippines, Singapore, Barbados, Georgia, Kosovo, Tajikistan, Turkey, Saudi Arabia, the United Arab Emirates and of course North America.  He has also taught at Baker University: Lee’s Summit, MO, 2008, Adjunct Professor of International Business; National Graduate School: Falmouth, MA, 2004-2008, Adjunct Professor of Quality Management; California State University: Fullerton, 2005-2006, Lecturer on Taxation; University of California: Berkeley, 2002, Adjunct Professor of Management; University of Macau (China), Adjunct Professor of Management, 2001-2003.


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