Monday, April 20, 2009

How to Prepare a Budget

A Budget is a plan quantified in monetary terms, prepared and approved prior to a defined period of time, usually showing planned income to be generated and/or expenditure to be incurred during that period and the capital to be employed to attain a given objective.

It expresses in quantitative terms a plan of action prepared in advance of the period to which it relates. Budgets may be prepared for the business as a whole, for departments, for functions such as sales and production, or for financial and resource items such as cash, capital expenditure, manpower, purchases, etc. The process of preparing and agreeing budgets is a means of translating the overall objectives of the organisation into detailed feasible plan of action.

Budgets can be categorised into:
Operating Budget
Capital Budget

Operating Budget: This is the type of a budget prepared in relation to the operation of the enterprise. Example includes budgeted income and expenditure, cash budget (for short term), budgeted balance sheet as at the end of the budget period, budgeted profit and loss statement etc. It is usually prepared for a one year period.

Capital budget: This is the type of budget prepared in relation to the capital structure and liquidity of the enterprise. It includes budgeted working capital, budgeted fixed asset, budgeted equity and loan capital, cash budget (for long term).

To force managers to analyze the organization’s activities critically.
To direct management’s attention from the present to the future.
To enable management to anticipate problems or opportunities in time and to deal with them effectively.
To give managers a continuous reminder of the actions they have decided upon.
To coordinate the activities of the various sub-units of the organisation.

1. It provides clear guidance for managers and supervisors and is the major way in which organizational objectives are translated into specific tasks and objectives related to individual managers.
2. The budgetary process is an important method of communication and coordination both vertically and horizontally.
3. Because of the “exception principle”, which is the heart of budgetary control, management time can be saved and attention directed to areas of most concern.
4. The integration of budgets makes possible better cash and working capital management.
5. The control of current activities is facilitated by the regular, systematic monitoring and reporting of activities.
6. Variance analysis identified areas of weakness in the business operations.

1. Badly handled budgetary systems with undue pressure or lack of regard to behavioural factors may cause antagonism and may lower grade.
2. The existence of well documented plans may cause lack of flexibility in adapting to change.
3. Variances are just as frequently due to changing circumstances and poor forecasting as due to managerial performance.
4. Budgets are developed round existing organization structures which may be inappropriate for current conditions.

This is otherwise referred to as Key Factor or the Principal Budget Factor. The limiting factor is that factor which, at any given time, effectively limits the activities of an organization. This is the factor, the extent of whose influence must first be assessed in order to ensure that functional budgets are reasonably capable of fulfilment. The limiting factor must be identified and its effect on each of the budgets carefully considered during the budget preparation process. In the budgeting for production or sales, for example, the following are key limiting factors: Materials (availability of supply, restriction imposed by licencing quotas etc), Labour (general shortage, shortage of certain grades), Plants (insufficient capacity due to shortage in supply, insufficient capacity due to lack of capital), Management (insufficient capital, policy decisions, shortage of efficient executives), Sales (consumer demand, inefficient and insufficient advertising, shortage of good sales men).

Cost Centre
– It is an identifiable function or part of the organization for which costs can be identified.

Profit Centre – A profit centre is a segment of the business entity by which both revenues are received and expenditures are caused or controlled, such revenues and expenditures being used to evaluate segmental performance.

Budget Centre – It is a section of the organization for which separate budgets can be prepared and control exercised. Thus, it is possible that a budget centre may be a cost centre, or group of cost centres or it may coincide with a profit centre.

Responsibility Accounting – It is a system of accounting that measures the plans (by budgets) and actions (by actual results) of each responsibility centre. Each manager, regardless of level, is in charge of a responsibility centre. It is a part, segment or sub-unit f an organization whose manager is accountable for a specified set of activities. Major types of responsibility centre includes: cost centre, revenue centre, profit centre and investment centre.

Planning and Coordination – Planning is the key to success in business and budgeting forces planning to take place. The budgetary process provides for the coordination of the activities an departments of the organization so that each facet of the operation contributes towards the overall plan. This is expressed in the form of a master budget which summarizes al the supporting budgets. The budget process forces managers to think of the relationship of their function or department with others and how they contribute to the achievement of organisational objectives.

Communication – The budgetary process involves all levels of management. Accordingly, it is an important avenue of communication between top and middle management regarding the firm’s objectives and the practical problems of implementing these objectives and, when the budget is finalized, it communicates the agreed plans to all the staff involved. As well as vertical communication, the budgetary process requires communication between functions to ensure that communication is achieved, for example, there must be full communication between the sales and production functions to ensure that coordinated budgets are developed.

Control – This aspect of budgeting is the most well known and is the aspect most frequently encountered by the ordinary staff member. The process of comparing actual results with planned results and reporting on the variations, which is the principle of budgetary control, sets a control framework which helps expenditure to be kept within agreed limits. Deviations are noted so that corrective action can be taken.

Motivation – The involvement of lower and middle management with the preparation of budgets and the establishment of clear targets against which performance can be judged have been found to be motivating factors. However, there are many factors to be considered in relation to the human aspects of budgeting.

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