Budgeting

Module number 9. Hello everyone. I would like to welcome you to this HSTalks lecture series on managerial accounting. My name is Alexander Himme, and I'm an assistant professor for managerial accounting at the Kuhne Logistics University in Hamburg Germany. In this module, we will talk about budgeting. Budgeting is a concept that is widely used in many companies. So why are budgets needed, and how do we set up budgets? What kind of budgets do exist? We will answer these questions in this module.

First of all, what is a budget and why do we need budgeting? A budget is a financial plan for implementing the decisions that management has made. So the management develops strategies which are overall business goals. For example, becoming the market leader or to diversify certain product segments. Budgeting is then concerned with the implementation of the strategic plans for the year ahead. Budgets are a clear indication of what is expected to be achieved during the budget period, whereas strategies represent the broad directions of a company. If companies have decided on their broad directions, then companies need to plan and budget for specific actions to achieve the goals of the company. This is already the first benefit of budgeting. It requires managers to plan their actions. Decisions are then based on this formalized plan, which helps prevent ad hoc decision making. Without the annual budgeting process, the pressures of day-to-day operating problems may tempt managers not to plan for future operations. So the budgeting process and ensures that managers do plan for future operations and that they consider how conditions in the next year might change and what steps they should take now to respond to these changing conditions. In short, budgeting encourages managers to anticipate problems before they arise. Another benefit is that the budget coordinates a company's activities. In order to determine budgets, managers are forced to coordinate the activities among each other. For example, if the production managers run a certain amount of production units, they must coordinate the activities with the purchasing managers in order to make sure that the right amount and quality of materials is ordered. So actions of the different parts of an organization can be brought together and reconciled into a common plan. Budgeting needs managers to examine the relationship between their own operations and those of other departments, and, in the process, to identify and resolve any potential conflicts. Since managers now have to coordinate the activities, they need to communicate among each other regarding the future plans. Everyone in the organization should have a clear understanding of the part they are expected to play in achieving the annual budget. Through the budget, top management communicates its expectations to lower level management. As a result, all members of the organization may understand these expectations and can coordinate their activities to attain them. So, in summation, it is not just the budget itself that facilitates communication, there's also relevant information communicated in the actual act of preparing it. The budget is a useful device for influencing managerial behavior and motivating managers to perform in line with the organizational objectives. A budget provides a standard that, under certain circumstances, a manager may be motivated to strive to achieve. For instance, if company members have actively participated in preparing the budget, it serves as a strong motivational tool to fulfill the budget. Finally, any plan is useless without control. After the budget is set, managers start to act; that is, they carry out the plans. After acting, managers compare actual results with a budget and use information to make control decisions. Budgeting allows management to operate a system of management by exception, which means that the managers' attention can be concentrated on significant deviations from the expected results. By investigating the reasons for the deviations, managers may be able to identify inefficiencies. When the reasons for the inefficiencies have been found, appropriate control action should improve the situation. An element of this controlling benefit is that budgeting ensures that the appropriate individuals are made accountable for implementing the budget. That is why a manager's performance is often evaluated by measuring his or her success in meeting the budgets. For example, in some companies, bonuses are awarded on the basis of an employee's ability to achieve the target specified in the periodic budgets. Notice that the budgeting process is a loop. The results from comparing planned and actual results serve as an input into the development of the budget for the next period. However, although budgets may have many benefits as you have just seen, budgets can also encourage inefficiency and conflict between managers. Since a single budget system is used to serve these diverse purposes, the risk for conflicts is relatively large. As an example, the planning and motivation functions of budgets are often in conflict. For the motivation, demanding budgets should be developed, but such a budget may not be suitable for the planning purpose, which typically ask for budgets that are based on easier targets which can be realistically achieved.