What is budgeting?
A
budget is a financial plan. It is a projection (forecast) of what will happen
financially if certain strategies and decisions are implemented. This is
something we all do from time to time.
For
example, if you plan to buy a new car with a bank loan, you will want to know
how much the loan repayment installments will be. This helps you to construct a
financial plan which includes determining the extent of the loan that you can
afford. This type of planning is very much a budgeting activity.
The picture below shows a
person's income and expenditure on a monthly basis.
Budgets
are more than just a few calculations that we throw away when our questions are
answered. In a business context, a budget, once constructed, becomes an
essential tool for the financial management of the business. In fact operating
a business without a budget is very bad management.
By
developing budgets, business managers set income and expenditure targets to be
achieved. The business manager can constantly compare actual financial outcomes
with targets in the budget and take corrective action if the targets in the
budget are not being met.
Business
managers need to continually review the budget and use it as a guide when
making financial decisions. If a proposed course of action has been anticipated
in the budget, then managers will feel confident in making a decision to go
ahead. But if a proposed course of action has not been costed in the budget,
then managers will appreciate that going ahead will entail financial risk.
Purpose
of Budgeting
In the
context of business management, the purpose of budgeting includes the following
three aspects:
- A
forecast of income and expenditure (and thereby profitability)
- A
tool for decision making
- A
means to monitor business performance
Forecast
of income and expenditure
Budgeting is a
critically important part of the business planning process. Business owners and
managers need to be able to predict whether a business will make a profit or not. The purpose of budgeting is basically to
provide a model of how the business might perform, financially speaking, if
certain strategies, events, plans are carried out.
In
constructing a Business Plan, the manager attempts to forecast Income and
Expenditure, and thereby profitability.
Tool for
decision making
The purpose of
budgeting is to provide a financial framework for the decision making process
i.e. is the proposed course action something we have planned for or not.
In
managing a business responsibly, expenditure must be tightly controlled. When
the budget for advertising has been fully expended, the decision on "can
we spend money on advertising" is likely to be "no".
Monitoring
business performance
The purpose of
budgeting is to enable the actual business performance to
be measured against the forecast business performance i.e. is the business
living up to our expectations.
In the
figure opposite, "variance"
is the difference between budgeted expenditure and actual expenditure.
Budgeting
Principles
For
those who have the task to develop budgets or to be involved in the process of
developing budgets, it is important to have a good knowledge of budgeting
principles that can make the difference in the financial health of the
organisation. Failure to engage in sound budgeting processes would rank as one
of the main reasons why companies and organisations fail.
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Be conservative not optimistic
The
first principle of budgeting is to avoid budgeting on the basis that
everything will turn out as expected. Be very cautious about optimistic
forecasts. Try to build in a safety factor by tending to underestimate your income and overestimate your expenses.
There will always be unexpected events and therefore a common strategy in
developing a budget is to insert an additional expense called
"contingencies". This item in the expense budget is an insurance
policy against the unforeseen.
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Team
work and consultation
One
of the most important principles of budgeting is that it requires teamwork
and consultation. Although one person may be responsible for the overall
compilation of the budget, one person should not be responsible for all the
work involved. The task of budgeting should be split and allocated among
those individuals who have the best chance of knowing what expenditure is
likely to be needed and what income is reasonable to expect. Involvement by
many people in budgeting might slow the process down, but the answer is far
more likely to be accurate and dependable.
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Allow plenty of time
Budgeting
is not an activity that is completed in a few hours. A good budget may be
worked on for several weeks, if not months, adding and changing figures as
new information comes to light. For this reason, budgeting is often referred
to as an iterative process. The budgeting process is lengthy because much
research and consultation has to be carried out before people involved in the
process can be confident of the figures they supply.
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Excellence in documentation
It is
very important that the author(s) of the budget strive to produce documents
that can be read and understood by anyone. If budget workings are unclear and
figures are not clearly labeled even the author will, as time passes, have
trouble understanding where the figures come from and how the calculations
were made. It should be assumed that budgeting workings will be:
- Circulated
to many different people who may have lower levels of financial literacy
- Useful
again in a year's time when the budgeting process begins again. Unless
workings are well labeled it may be difficult to remember.
Example
of labeling:
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Provide Training
Ensure
people who have a significant role in the budgeting process have a reasonable
understanding of the principles of budgeting, how it relates to the strategic
and operational plans, and how everyone must live with the consequences of
the finalised budget in the year ahead. Training need only be a single
meeting in which those who have experience of budgeting provide knowledge to
others involved who are less experienced.
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Get Sign Off
Another
one of the important principles of budgeting is to ensure that all persons
formally involved in the budgeting process agree to the final iteration of
the budget. This agreement by those involved is often referred to as the
"Sign Off". In other words, those involved add their signature to
the final iteration of the budget. This ensures that there will be no
argument later about who agreed to what.
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