Budgetary Planning

The process of budgeting focuses on the short term, normally one year, and provides an expression of the steps which management must take in the current period if it is to fulfil organizational objectives.It is useful to distinguish between the two functions-planning and control. Applying a similar distinction to budgeting, we may examine in turn the functions of budgetary planning and budgetary control. In this webpage, we deal with the technical aspects of budgeting.

The nature of budgetary planning

We have found that long-range planning involved the determination of corporate objectives and the determination of a suitable plan for attaining these objectives. The budget represents the expression of this plan in financial terms in the light of current conditions. Therefore, the long-range plan is the guide for preparing the annual budgets and defines actions that need to be taken now in order to move towards long-term objectives. Indeed, the budget represents the first one-year span of the long-range budget.

The reader will recall that one important feature of planning is the co-ordination of the various activities of an enterprise, and of its departments, so that they are harmonized in the overall task of realizing corporate objectives. For example if the marketing function were to increase sales massively over a short period of time, the manufacturing function would have to increase output substantially-probably through the use of costly overtime labour, or by buying goods from an outside supplier at high prices. Conversely, excessive production may force the marketing function to sell at unrealistically low prices in order to avoid excessive investment in stock. The function of budgetary planning is to co-ordinate the various activities of an organization in order to achieve company rather than divisional or departmental objectives. Therefore it is necessary to establish objectives for each section of the organization which are in harmony with the organization as a whole.

The need for flexibility

Because business conditions are always changing, it is necessary to view the budgeting process as a guide to future action, rather than a rigid plan which must be followed irrespective of changing circumstances. The latter approach may place the manager in a strait-jacket in which he is forced to take decisions which are not in accordance with company objectives. For example, a departmental manager may find, due to changing conditions, that he has not spent all of his budget on a particular item. In order to spend all his budget allowance, so as to prevent the possibility of a cut in his allowance next year, he may squander funds which could have been put to better use in other sections of the organization.

More importantly, management must plan for changing business conditions, in order that appropriate action may be taken to deal with changes that may occur should any of the assumptions underlying plans be affected by such changes. This implies that contingency plans should be available to deal with changes which were unforeseen at the time when the budget was originally prepared.

Some firms relate their planning budgets to changing conditions by means of a rolling budget which is prepared every quarter, but for one year ahead. At the end of each quarter the plans for the next three-quarters are revised, if this is necessary, and a fourth-quarter is added. By this process the budgets are kept continually up to date.

Flexibility is also required if budgetary control is to be effective. Indeed the type of budget which may be suitable for planning may be inappropriate for control purposes. Therefore, budgets should be established for control purposes which reflect operating conditions which may be different from those envisaged in the planning stages. This is essential if individual managers are to be held responsible only for those deviations over which they have control. Such a requirement is called for by the use of a responsibility accounting system.

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Read on: Investment Appraisal and Inflation

As the cash flows associated with a particular project may span a considerable period of time, it is evident that the level of inflation during that time will affect considerably the profitability of the project. We have pointed out that estimates of future events should take inflation into account, and in Part 3, the distinction between general price level and specific price changes was discussed. We indicated the need to adjust cash-flow forecasts for specific price changes which would affect the enterprise, so as to maintain its operating capability. Accordingly, it is the inflating cost of specific... see: Investment Appraisal and Inflation