What are the advantages of budgeting?

The advantages of budgeting include:

Planning orientation. The process of creating a budget takes management away from its short-term,
day-to-day management of the business and forces it to think longer-term. This is the chief goal of
budgeting, even if management does not succeed in meeting its goals as outlined in the budget - at
least it is thinking about the company's competitive and financial position and how to improve it.
Profitability review. It is easy to lose sight of where a company is making most of its money, during
the scramble of day-to-day management. A properly structured budget points out what aspects of the
business produce money and which ones use it, which forces management to consider whether it
should drop some parts of the business, or expand in others.
Assumptions review. The budgeting process forces management to think about why the company is in
business, as well as its key assumptions about its business environment. A periodic re-evaluation of
these issues may result in altered assumptions, which may in turn alter the way in which managements
decides to operate the business.
Performance evaluations. You can work with employees to set up their goals for a budgeting period,
and possibly also tie bonuses or other incentives to how they perform. You can then create budget
versus actual reports to give employees feedback regarding how they are progressing toward their
goals. This approach is most common with financial goals, though operational goals (such as reducing
the product rework rate) can also be added to the budget for performance appraisal purposes. This
system of evaluation is called responsibility accounting.
Funding planning. A properly structured budget should derive the amount of cash that will be spun off
or which will be needed to support operations. This information is used by the treasurer to plan for the
company's funding needs.
Cash allocation. There is only a limited amount of cash available to invest in fixed assets and working
capital, and the budgeting process forces management to decide which assets are most worth investing
in.
Bottleneck analysis. Nearly every company has a bottleneck somewhere, and the budgeting process
can be used to concentrate on what can be done to either expand the capacity of that bottleneck or to
shift work around it.

The Advantages of Budgeting in a Business

Creating a budget that does nothing more than set spending limits can damage a small business by
preventing it from reacting to market conditions. A flexible budget helps you to adjust spending,
increase marketing to expand sales, react to an unexpected drop in revenues and otherwise operate
your company using real-time data to keep it on track.

Forecasting

A business budget not only helps you project annual expenses but lets you see costs as they will
occur. For example, averaging your insurance premiums per month helps you set average monthly
revenue goals. Budgeting the exact amount of money to pay premiums in the months they come due
helps you manage your cash flow to ensure you have money on hand to pay your bills each month.
Budgets also let you forecast your annual bottom line using more than one revenue scenario.
Price Setting
Market conditions such as your competitors prices arent the only parameters you need to set your
fees, rates and prices. You must know your manufacturing and overhead costs before you set your
prices. A budget lets you project your utility, health care, marketing, rent, wages, debt service and
other costs so you can learn the true cost per unit of making your products or delivering your service.
Once you know this, you can set your prices to make the profit you want. If this price is too high for
you to be competitive in your marketplace, you can use your budget to identify areas where you can
reduce your costs.
Capital and Credit Procurement
Few venture capitalists, banks, suppliers or other lenders will give you money or credit unless you
have financial data to demonstrate you are a going concern. Unless you have assets you can use as
collateral, youll need to show financial statements that prove you are stable. If you are a new
business, or are expanding, a budget will show potential partners how their participation will affect
your sales and profits.
Flexibility
A budget lets you track your business performance throughout the year, allowing you to make
necessary changes to rein in costs or increase spending to take advantage of growth opportunities. If
your marketing is effective, a budget will let you know if you have funds available to increase your
advertising to grow your sales. If your sales are slow, a budget identifies areas where you can cut
discretionary costs to make you more competitive or tide you through slow periods
The biggest benefit of a budgeting system is that it allows managers the freedom of decision making
as long as they do not exceed the budgets. It also enables a company to lay standards of performance
and levels of activities of different functions and departments within the company. This ensures that
various departments and functions operate within the framework of a common overall plan. Budget
also serves as a means of evaluating the performance of different functions and managers within an
organization.

Managerial Accounting
Class Notes and Lecture Outline
Operations Budgeting
What is Budgeting?

budgeting defines the planning and forecasting of future business operations in quantitative
terms
establishes objectives for revenue inflows and cost outflows
provides guidelines for future operations
serves as a basis for performance appraisal

The 3 Goals of Budgeting

1. provide organizational estimates of revenues, expenses, human resource needs, and
equipment requirements
2. provides the basis to develop coordinated management procedures and policies for both the
short term and the long term
3. provides methods of control for comparison and evaluation of actual operating results
Types of Budgets
1. Capital Budget
o this budget considers balance sheet items and long-range expenditures projected to
improve operating capacity and efficiency
2. Operating Budget
o projects sales revenues and operating costs over a specified operating period
o note: this results in a projected income statement also called pro forma income
statement
3. Departmental Budget
o forecasts revenues and operating expenses for a specific profit center
4. Master Budget
o comprehensive budget that includes all of the operating departments or division of the
organization
5. Fixed Budget
o forecasts 1 level of activity and shows a static projection of estimates forecasted
o main disadvantage of a fixed budget -- there is no plan in place if actual revenues and
costs differ from the forecast
6. Flexible Budget
o forecasts several levels of operating activity for the coming period
7. Short Term Budget
o 1 year or less
8. Long Term Budget
o greater than 1 year
o considers the major future plans of the organization

Advantages and Disadvantages of Budgeting

advantages
1. encourages participation and enhances communication among management,
employees, and customers
2. encourages the development of potential courses of action for evaluation and
consideration
3. allows comparison between the standards developed and actual results
4. may provide a variety of different operating scenarios
5. forces the organization to look into the future
6. requires those involved to be aware of the internal and external factors affecting the
organization
disadvantages
1. the time and resulting costs in preparing the budget may be considerable
2. based largely on "unknown" information -- our best "guesstimates"
3. may require the use of confidential information
4. there could be a tendency to "spend to the budget"

The Budgeting Cycle

1.
2.
3.
4.
5.
6.

establish attainable and reasonable goals and objectives

create a plan to reach those goals and objectives
compare the actual results to the budgeted results
identify problems areas and analyze the variances
take action to correct unfavorable variances
always seek new techniques and procedures that will improve the effectiveness of the
budgeting process (this creates a dynamic process)

Limitations to Budget Forecasting Techniques

1.
2.
3.
4.
5.

the results are only as good as the forecasted data used

mathematical approaches cannot substitute for individual judgment and experience
mathematical approaches may not consider certain variables controllable by management
the longer the time horizon budgeted the greater is the chance for forecasting error
historical data may not be a good predictor of future activity levels

Developing The Pro Forma Income Statement

estimate revenue levels by department

o past revenue figures; anticipated trends; competitive factors
o economic factors; limiting factors
deduct direct operating expenses for each department
o usually based on historical %
o with labor, develop staffing schedules
combine departmental operating incomes and deduct undistributable expenses to arrive at net
income
o many of these fixed costs are called discretionary expenses
o distribute unallocated expenses as a ratio of revenues

Zero Based Budgeting (ZBB)

technique used to control undistributed expenses

ZBB requires that each budgeted amount be justified
key element is the decision unit process:
o establish decision unit
o determine units objectives
o justification of the units continuation
o list alternative ways to achieve goals
o recommend one alternative
o develop budget for different levels
o rank the different decision units
advantages of ZBB
o concentrates on the $ cost and not broad %
o can reallocate funds to areas providing the greatest benefit
o provides quality information to the operation
o obliges management to identify inefficient functions
o reduce areas of duplication or overlap
disadvantages of ZBB
o implies that the traditional budgeting process is not adequate
o time, effort, paperwork, and cost
o may be unfair to some department heads who are not as capable as others in
defending their budgets

Variance Analysis

process of analyzing variances in order to give management more information about

the causes of the variance
a variance is the difference between budgeted and actual results
we can classify this difference as:
o favorable
o unfavorable
the variance usually made up of 2 components
o price (or cost) variance
o quantity variance
can be used for revenues and expenses
variance analysis provides additional information that is of help identifying causes of
these differences
3 major types
1. revenue variance analysis

2. cost of goods sold variance analysis

3. variable labor variance analysis

Forecasting

Moving Averages
o attempt to remove random variations
o gives equal weight to each of the periods
o a large number of periods (n) results in a forecast that reacts slowly
o current forecast is based on past information
Regression Analysis
o assumes a linear relationship between 2 variables
o Y = mX + b
o Y is called the dependent variable
o X is called the independent variable
o we use this relationship to forecast the value of the Y variable

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last updated January 15, 2011

The biggest limitation of traditional budgeting system is that it focuses primarily on

expenses, paying little attention to the results obtained as a result of the expenses
incurred. Thus in the above example, the marketing manager may fail to cash on an
opportunity to sell more by increasing the travelling of his sales-persons because that
will lead to the travel expenditure exceeding the budget.
The emphasis on input cost to the inclusion of the consideration of results obtained
makes budgeting quite meaningless when the level of operations are very much
fluctuating. For example, production cost in any company are closely linked to the level
of production. Therefore, a rigid budget, that fails to take into consideration the level of
production can become quite inappropriate as planing or controlling tool.
Another common problem of budgeting system is related to the way budgets are
finalised. In many organizations the budgets are often prepared on the basis of past
performance rather than the future requirements. This tends to create a false feeling of
planned working, when in reality the organization is only drifting along with the flow of
past trends.