I have discussed this in my previous article “Introduction to Management Accounting” that there are three primary functions of management
1.Planning
2.Control and
3.Decision making.
Budgeting is one of the most important tools used for planning and control purposes. However, these are not the only reasons budgeting is used in an organisation. This article will discuss various uses of budgeting process which are also called functions or benefits of budgeting. It will also shed light on the problems with using budgeting in an organisation.
The first thing which we should look at is the definition of budget or budgeting process. A budget is a plan written down usually in monthly structure, for operational budgets, laying down quantitative actions and figures, usually costs and revenues, for an organisation. However, tactical level budgets, which look at the multi-year planning for an organisation, are laid out yearly. Still, tactical budgets are broken down in monthly budgets eventually as yearly targets are always broken down in monthly target to be accomplished.
Another way of defining budget is the amount which a manager is allowed to spend to run his/her department. Usually, this budget is tied with targets. For example, production department is allowed to spend £100,000 in January 2021 to produce £1 million units.
The most important aspect of the first definition is the budgets being “quantitative” meaning budgets would always place a numerical value to a plan e.g. how many units to be produced and sold, how many staff to be hired, how many hours are required to achieve a certain level of production, how much do we need to pay our staff for that etc.
The following are some of the main functions and benefits of budgets or budgeting process.
1.Planning
2.Controlling costs
3.Performance evaluations
4.Authorisation of expenditures
5.Motivations
6.Communications of targets
7.Co-ordinating activities
The original purpose of budgeting was planning which is setting out organisational targets and actions to achieve those targets. For example, an organisation may have a target to increase its sales by 20% during 2022. Such targets are usually set well in advance so the budget should be prepared in 2021. Planning process will require to establish what 20% sales growth would mean i.e. how many units? Once this has been established, planning will be required for production, raw material procurement (buying), staff requirement and most importantly cash requirements for growth. A good planning will consider all relevant aspects, put those down in writing and in quantitative terms. For managers, it is extremely important to be on top of the planning process as there are many other aspects of management job which are closely linked with it for example departmental budget amount. An important tool to help planning is High-Low Methods which I have explained in a video which you can watch on the link https://youtu.be/R5QR5y4agJE
Another important benefit of budgeting is controlling costs. Every manager is given a target to achieve, and an amount is allowed to spend to achieve those targets. This means that cost has been fixed now and there is no danger to organisational overspend (at least in theory). Usually managers’ bonuses and pay rise is dependent on meeting targets within the allowed budget.
This brings us to the next advantage of using budgeting process which is authorisation of expenditures. When a manager is informed of the amount s/he is allowed to meet their departmental targets, higher management is authorising the manager to spend that money. This saves a lot of management time to get authorisation for every item of expenditures from the higher management.
However, as a manager, it is your job to ensure that you have been authorised enough budget to achieve your targets. This brings us to the point of importance of manager’s involvement in the planning process. Usually, budget amounts are given on the basis of previous year’ budget. However, if the cost of the raw material has increased significantly (prices of Natural Gas is an example in these days), managers need to ensure an extra allowance is given for that which is usually not an easy task. Therefore, managers need to be fully aware of how much they require to run their department and achieve their targets, which is only possible with good planning.
A big problem with authorising departmental budgets in this way is sandbagging and waste of resources especially money. This has been observed that managers will spend all the budget allowance without making an effort to save costs which discourages efficient use of resources and innovative thinking. I have given a personal example in my video on this topic which can be viewed using the link Introduction to Budgets – https://youtu.be/Wp9UHgZl-1I
Budgets are an excellent tool to help communication of targets and co-ordination of activities between different department. For example, if sales department estimates to sell 10,000 unit in a period, they can convey this message clearly to the production department which will set production department budget who will then communicate their requirements to human resource department, procurement (purchasing) department and finance department. This information will help all these department to set their budgets and plan their activities. I have given an excellent example of this happening in a video https://youtu.be/uQMIR1YVKEY
The above functions of the budgets are somewhat non-controversial. However, this is not the case with using budgets as a tool to motivate managers and to evaluate their performance.
Theoretically budgets should motivate managers to perform better in their jobs. The idea is that if managers are given clear targets, resources, and incentives to achieve those targets, they will be motivated to do so. However, in real life, most of the time this is not case. This is mainly due to setting up of the wrong targets, resources, and incentives. If targets are too easy, managers will be too relaxed and not put much effort, and if the targets are too difficult, managers will do the same thinking it is too difficult to achieve so why bother?
The area of performance evaluation is also very controversial. Performance evaluation entails looking at the past performance of a manager to appreciate the work done, reward for the targets achieved and highlight the areas for improvement. This process becomes unfair for managers in an organisation which uses budgeted data for this purpose.
As mentioned above, budgets are very good at controlling costs and managers’ rewards are based on those targets. However, if a manager is given a budget on the basis of historical information and if the cost to run the department has increased significantly (as the issue is with distribution departments in the UK due to shortage of lorry drivers), the managers performance will look bad. This will increase dissatisfaction among the staff which may cause high staff turnover.
I have discussed these issues in a bit more details in a video Introduction to Budgets – https://youtu.be/Wp9UHgZl-1I
This article is written by Raja Mizan ACCA, director of RMR Accountants & Business Advisors and also a senior lecturer in a UK university.