3.9. Budgets (HL only)

The importance of budgets for organizations

In the most basic sense, a budget tries to predict the inflow and outflows that a company will incur. This can be drilled down by division and within each department and put all back together to make a master budget. These budgets are typically created on a monthly, quarterly or annual basis but with the use of technology some companies are going to real time budgets (especially for sales).

Why make a budget?

Budgeting is much more about strategy rather than only looking costs and revenues. If a firm aims to achieve certain objectives, it is necessary to know whether or not it has the necessary capital to achieve them. If not, then the strategy may need to be scaled back, pricing policies may need to change, additional sources of finance may be needed or investment decisions may be altered. Only with a proper budget can a firm turns its strategy into practice.

Organisations produce budgets for a variety of reasons including:

● To motivate managers by giving them goals

● To co-ordinate business activities

● To help foresee potential problems

● To formalise business plans and objectives

● To have a basis on which to make comparisons with actual results

By breaking down budgets by division, firms can see whether each division is meeting its benchmarks and also how each division contributes to the firm. This can then be broken down regionally to see how division differ over different regions.

Some of the most common budgets made include:

● Sales revenue budget

● Marketing budget

● Capital expenditure budget

● Cash flow budget

By comparing the above, a firm will be able to see whether they are allocating their resources correctly and if the allocation reflects the strategy of the company. To make a budget one must look at past final accounts in order to predict the future and also external forces which may affect the future. Let's look at the following as an example.

Prediction

Once a prediction of sales is made, are they in line with the firm’s goals and objectives? Does the marketing budget need to be increased? Can we now predict our costs? Do we need to invest in more capital? Now think if we used the same sales information and then broke it down country or even city. Would that information help us in our budgeting and planning process?

By comparing the results across divisions one can see a variety of characteristics such as:

● Is the firm’s strategy actually working?

● Which division/department are using capital most effectively?

● Are divisions/departments meeting the targets and benchmarks initially set?

● How effectively are divisions at controlling costs? Is it a corporate problem or can it be drilled down to certain divisions?

● Are the staff within specific divisions motivated and productive?

● How can staff receive incentives based on the financial performance of themselves and their department?

● If meeting targets, can departments be given more autonomy to control their own budget.

● How do divisions and managers handle exceptions, especially negative variance.

● Are departments having a silo effect where there is a lack of communication and common goal between departments.

Going through the process of making a budget is a good exercise for any department. By looking back at the final accounts, the firm is forced to reflect on the past and find way they can improve and be more in line with the firms objectives. These departmental budgets can then be consolidated into a master budget in order to see the big picture of the firm. The master budget gives the Chief Financial Officer the necessary snapshot of the firm in order to see what capital expenditures the firm may undertake. Firms can also compare themselves with other public firms to see where they stand with their competition.

Source - http://www.dpbusinessmanagement.com/34-budgeting.html

Difference between cost and profit centres

Types of responsibility centres

1. Cost centres: a cost (expense) centre is one in which the manager’s responsibility is limited to control of costs. The performance report will show the controllable costs of operating the unit for a specified time period. The costs for which the manager has direct responsibility will appear in the performance report of that unit. The manager of a cost centre is evaluated on the basis of his or her ability to accomplish assigned tasks at an acceptable cost. The amount of costs considered acceptable is often determined by reference to the costs of previous periods. The acceptable level of costs may also be established by an evaluation of what the costs should be to accomplish the task. This approach is considered more desirable.

2. Revenue centres: Organisational sub-units whose activities are primarily related to making sales may be viewed as revenue centres. In this case, performance is evaluated in terms of revenues achieved and direct costs incurred, usually compared with either predetermined or historical revenues and cost amounts.

3. Profit centres: if a segment of the organisation has profit responsibility it can be treated as a profit centre. The focus of control in this situation shifts from a detailed analysis of revenues and expenses to the evaluation of profits. If the organisation is highly decentralised, profit centre managers are considered to be responsible for the total operation of their units. However, there is not always a direct relationship between the use of the term profit centre and the extent of decentralisation of decision-making. Horngren and Foster (1991) point out that it is possible that a highly centralised organisation may describe some of its sub-units as profit centres but because of the high levels of centralisation, profit centre managers actually have little or no authority.

These profit centres are often referred to as strategic business units (SBUs)

Horngren, T and Foster, G. (1991) Cost Accounting: A Managerial Emphasis, Prentice Hall, Englewood Cliffs

Spillinglaw, G. (1982) Management Cost Accounting, 5^th edition, Richard Irwin, Homewood

Files to download