Understanding Business Accounting For Dummies, 2nd Edition (75 page)

Budgeting also has other planning-related benefits:

Budgeting encourages a business to articulate its vision, strategy, and goals.
A business needs a clearly-stated strategy guided by an over-arching vision, and should have definite and explicit goals. It is not enough for business managers to have strategy and goals in their heads - and nowhere else. Developing budgeted financial statements forces managers to be explicit and definite about the objectives of the business, and to formulate realistic plans for achieving the business objectives.

Budgeting imposes discipline and deadlines on the planning process.
Many busy managers have trouble finding enough time for lunch, let alone planning for the upcoming financial period. Budgeting pushes managers to set aside time to prepare a detailed plan that serves as a road map for the business. Good planning results in a concrete course of action that details how a company plans to achieve its financial objectives.

Management control reasons for budgeting

Budgets can be and usually are used as a means of
management control
, which involves comparing budgets against actual performance and holding individual managers responsible for keeping the business on schedule in reaching its financial objectives. The board of directors of a corporation focus their attention on the master budget for the whole business: the budgeted management profit and loss account, the budgeted balance sheet, and the budgeted cash flow statement for the coming year.

The chief executive officer and the chairman of the business focus on the master budget. They also look at how each manager in the organisation is doing on his or her part of the master budget. As you move down the organisation chart of a business, managers have narrower responsibilities - say, for the business's north-eastern territory or for one major product line - therefore, the master budget is broken down into parts that follow the business's organisational structure. In other words, the master budget is put together from many pieces, one for each separate organisational unit of the business. So, for example, the manager of one of the company's far-flung warehouses has a separate budget for expenses and stock levels for his or her bailiwick.

By using budget targets as benchmarks against which actual performance is compared, managers can closely monitor progress toward (or deviations from) the budget goals and timetable. You use a budget plan like a navigation chart to keep your business on course. Significant variations from budget raise red flags, in which case you can determine that performance is off course or that the budget needs to be revised because of unexpected developments.

For management control, the annual budgeted management profit and loss account is divided into months or quarters. The budgeted balance sheet and budgeted cash flow statement are also put on a monthly or quarterly basis. The business should not wait too long to compare budgeted sales revenue and expenses against actual performance (or to compare actual cash flows and asset levels against the budget timetable). You need to take prompt action when problems arise, such as a divergence between budgeted expenses and actual expenses. Profit is the main thing to pay attention to, but debtors and stock can get out of control (become too high relative to actual sales revenue and cost of goods sold expense), causing cash flow problems. (Chapter 7 explains how increases in debtors and stock are negative factors on cash flow from profit.) A business cannot afford to ignore its balance sheet and cash flow numbers until the end of the year.

Other benefits of budgeting

Budgeting has advantages and ramifications that go beyond the financial dimension and have more to do with business management in general. These points are briefly discussed as follows:

Budgeting forces managers to do better forecasting.
Managers should constantly scan the business environment to identify sea changes that can impact the business. Vague generalisations about what the future might hold for the business are not quite good enough for assembling a budget. Managers are forced to put their predictions into definite and concrete forecasts.

Budgeting motivates managers and employees by providing useful yardsticks for evaluating performance and for setting managers' compensation when goals are achieved.
The budgeting process can have a good motivational impact on employees and managers by involving managers in the budgeting process (especially in setting goals and objectives) and by providing incentives to managers to strive for and achieve the business's goals and objectives. Budgets can be used to reward good results. Budgets provide useful information for superiors to evaluate the performance of managers. Budgets supply baseline financial information for incentive compensation plans. The profit plan (budget) for the year can be used to award year-end bonuses according to whether designated goals are achieved.

Budgeting is essential in writing a business plan.
New and emerging businesses must present a convincing
business plan
when raising capital. Because these businesses may have little or no history, the managers and owners of a small business must demonstrate convincingly that the company has a clear strategy and a realistic plan to make money. A coherent, realistic budget forecast is an essential component of a business plan. Venture capital sources definitely want to see the budgeted financial statements of the business.

In larger businesses, budgets are typically used to hold managers accountable for their areas of responsibility in the organisation; actual results are compared against budgeted goals and timetables, and variances are highlighted. Managers don't mind taking credit for
favourable
variances, or when actual comes in better than budget. Beating the budget for the period, after all, calls attention to outstanding performance. But
unfavourable
variances are a different matter. If the manager's budgeted goals and targets are fair and reasonable, the manager should carefully analyse what went wrong and what needs to be improved. But if the manager perceives the budgeted goals and targets to be arbitrarily imposed by superiors and not realistic, serious motivational problems can arise.

In reviewing the performance of their subordinates, managers should handle unfavourable variances very carefully. Stern action may be called for, but managers should recognise that the budget benchmarks may not be entirely fair, and should make allowances for unexpected developments that occur after the budget goals and targets are established.