Importance Of Budgets

Many associate the word “budget” with “dread” or “drudgery.” Perhaps the word “budget” should be avoided altogether. Words like “financial map” or “operational guide” might be suitable alternatives. No doubt, some employees will question the need for a budget. The process of budget preparation is sometimes seen as painful, and it is not always clear how the effort that is required leads to any productive output. Furthermore, budgets can be seen as imposing constraints that are hard to live with and establishing goals that are hard to meet!

Despite these dismal remarks, it is imperative that organizations carefully plan their financial affairs to achieve financial success. These plans are generally expressed as “budgets.” A budget is a detailed financial plan that quantifies future expectations and actions relative to acquiring and using resources.

Forms And Functions

Budgets can take many forms and serve many functions, providing the basis for detailed sales targets, staffing plans, inventory production, cashinvestment/borrowing, capital expenditures (for plant assets, etc.), and so on. Budgets provide benchmarks against which to compare actual results and develop corrective measures; give managers “preapproval” for execution of spendingplans; and allow managers to provide forward-looking guidance to investors and creditors. Budgets are necessary to persuade banks and other lenders to extend credit. This chapter will illustrate the master budget, which is a comprehensive set of documents specifying sales targets, production activities, and financing actions. These documents lead to forward-looking financial statements (e.g., projected balance sheet). Other types of budgets (e.g., flexible budgets) are covered in subsequent chapters.

Avoiding Business Chaos

In small organizations, formal budgets are a rarity. The individual owner/manager likely manages only by reference to a general mental budget. The person has a good sense of expected sales, costs, financing, and asset needs. Each transaction is under direct oversight of this person and hopefully he or she has the ability to keep things on a logical course. When things don’t go well, the owner/manager can usually take up the slack by not taking a paycheck or engaging in some other form of financial hardship. Of course, many small businesses ultimately fail anyway. Explanations for failure are many and varied, but are often pinned on “undercapitalization” or “insufficient resources to sustain operations.” Many of these postmortem assessments reflect a failure to adequately plan! Even in a small business, an authentic business plan/budget can often result in anticipating and avoiding disastrous outcomes.

Medium and larger organizations invariably rely on budgets. This is equally true in business, government, and not-for-profit organizations. The budget provides a formal quantitative expression of expectations. It is an essential facet of the planning and control process. Without a budget, an organization will be highly inefficient and ineffective.

Imagine that one has just been appointed as general manager of a newly constructed power plant. Compensation and ultimately the manager’s job will depend on the financial success of the venture. The manager would try to quickly get a handle on the business. How many customers will be served? What are the peak electricity loads? What rate can be charged and will it be enough to cover expenses? How much fuel will be necessary to produce the electricity? Will the cash supply always be sufficient to meet needs? Furthermore, how will actions be executed and controlled?

Perhaps the above is too much to deal with. Instead the manager could spend time only on marketing and personnel management. These efforts might sell a lot of electricity. Unfortunately, sales growth could be such that the natural gas pipeline cannot deliver enough fuel to meet the plant’s demand. More expensive fuel oils might need to be trucked in to produce the electricity. Suppliers might become concerned, as they sense that revenues might be inadequate to cover the added fuel cost. As a result, vendors might begin to insist on shortened payment terms, thereby pressuring the company’s cash supply. To solve this problem, it could become necessary to reduce the workforce. A downward spiral might ensue.

Rewind this unfortunate scenario, this time utilizing a plan. Careful studies are performed to determine the most efficient levels of production for the plant, in conjunction with an assessment of customer demand. The expected sales are translated into a schedule of expected daily electricity production. Based on this information, long-term supply contracts are negotiated for natural gas supplies. Staffing plans are developed that optimize the number of employees and their work times. Contingency plans are developed for a variety of scenarios. Periods during which cash might be tight are noted and a line of credit is set up with a local bank to cover those periods. All of these activities lead to a projected outcome.

Once the plan is in place, individuals will be authorized to act consistent with the plan. The entire team will steer toward an expected outcome. The manager will monitor operations and take corrective actions for deviations from the plan. The remainder of his time can be spent on public relations marketing, employee interaction, and so forth.