Benefits of Budgeting
When properly developed and administered, budgets:
- Promote coordination and communication among organization units and activities.
- Provide a framework for measuring performance.
- Provide motivation for managers and employees to achieve the company’s plans.
- Promote the efficient allocation of organizational resources.
- Provide a means for controlling operations.
- Provide a means to check on progress toward the organization’s goals.
Coordination and Communication
Coordination ⇒ means balancing the activities of all the individual units of the company in the best way so that the company will meet its goals and the individual units of the company will meet their goals.
Communication ⇒ means imparting knowledge of those goals to all employees.
For example, when the sales manager shares sales projections with the production manager, the production
manager can plan and budget to produce the inventory that is to be sold. And the sales manager can make better forecasts of future sales by coordinating and communicating with branch managers, who may be closer to the customers and know what the customers want.
Measuring Performance
Budgets make it possible for managers to measure actual performance against planned performance. The current year’s budget is a better benchmark than last year’s results for measuring current performance.
For example, last year’s results may have been negatively impacted by poor performance and the causes may have now been corrected, so comparing current results with the previous year’s results would set the bar too low. Furthermore, the past is never a good predictor of the future, and the profit plan should reflect the conditions anticipated for the coming period, not the conditions that existed during the past period or periods.
However, performance should not be compared against the current budget only, because that can
result in lower-level managers setting budgets that are too easy to achieve. It is also important to measure
performance relative to the performance of the industry and even relative to performance in prior years.
Motivating Managers and Employees
A challenging budget improves employee performance because no one wants to fail and falling short of achieving the budgeted numbers is perceived as failure. The goals quantified in the budget should be demanding but achievable. If goals are so high that they are impossible to achieve, however, they are demotivating.
Efficient Allocation of Resources
The process of developing the operating budgets for the individual units in an organization includes identifying the resources each unit will need to carry out the planned activities. For example, the process of developing the production budget requires projections for direct materials and direct labor that will be required to produce the planned output. The process of budgeting for administrative salaries requires forecasts of administrative employees that will be needed by each department. If funds will be available for only a certain number of administrative employees in the organization, some units’ projections may need to be adjusted. This process leads to efficient allocation of organizational resources.
Efficient allocation of organizational resources during the budgeting process may also include making decisions about the most profitable way to utilize the resources available. A decision about what product or products to produce may need to be made under a situation of constraint. A constraint exists when one or more of the factors of production are limited in some way. Decisions about what product or products to produce would be required if a plant were operating at full capacity and management wanted to maximize net income without increasing capacity.
Decisions made under situations of constraint are usually short-run decisions. In the short run, managers must do the best they can with the resources they have. When a company is operating at capacity, it maximizes its operating income by maximizing the contribution margin per unit of the resource that is limiting either the production or the sale of products.
In the long run, however, capacity can be expanded to reduce or eliminate constraints.
Contribution margin is sales revenue minus variable costs. A company or division’s contribution margin is the amount from sales that the company can put toward covering its fixed costs or profit after the variable costs have been covered. Contribution margin per unit is the selling price of one unit minus the variable cost of one unit
Controlling Operations and Checking on Progress Toward Goals
Control refers generally to the set of procedures, tools and systems that a company uses to ensure that progress is being made toward accomplishing its goals and objectives. Financial control is achieved by comparing actual results to budgeted financial amounts. Thus, budgets provide the standard against which actual financial results are compared. Differences between the actual and the budget are called variances, and variance analysis is performed to determine whether the variances are favorable or unfavorable.