Setting budgets and agreeing financial targets for each section of a business will have many benefits. The primary benefit is of course the ability to measure the performance of each part of the business organization that has been allocated budgets.
A small business can be run informally. The owner is the manager, who will know everyone, be aware of what is going on and will make all decisions. As businesses expand the need for control grows and becomes more difficult.
In larger firms work and responsibility are delegated which makes informal control impractical. To improve control, budgeting has been developed. This forces managers to be more accountable for their decisions.
Main purposes of setting business budgets by companies
Establishing financial plans for a business and setting budgets for the future have six major purposes:
1. Planning
Budgeting assists the planning process.
Business managers need to consider future plans in the budgetary process. So, realistic targets can be planned and set. They need to both plan for the future and predict any financial problems that may happen. Hence, budgeting helps with guidance. Budgeting will help to provide some guidance for managers and budget holders to be better prepared to overcome any future financial problems should they arise.
Planning budgets requires communicating the budgeting process. It will increase interactions between Finance Managers and different departments of the business. The planning process may help to develop a greater awareness of the needs of different business functions.
The planning stage of budgeting will require asking how much sales revenue the business can generate next year, how much money should the firm spend on marketing, how many workers are needed and how much it is going to cost to produce all of the products.
By answering these questions, managers will be able to allocate budgets to different business departments and divisions in the organization.
2. Setting targets
Budgeting helps to set targets.
Budgets are often based on historical data – what has happened in the past, last year’s budgeted figures, previous experiences and knowledge of previous sales trends.
If economic forecasts are positive, then budgets maybe set at a certain percentage above the last year’s figures. If economic forecasts are neutral, then budgets maybe set at the same level as the last year’s figures. If economic forecasts are negative, then budgets maybe set at a certain percentage below the last year’s figures.
It is important to set targets for employees as most people work better when they have clear, specific and measurable targets to achieve. In addition to that, when workforce is given delegated accountability for setting and reaching budget levels, their motivation will be even greater. Delegating budgets to individual employees turning them into budgets holders who are responsible for the initial setting and achievement of a budget can boost their level of morale. They will feel valued and trusted.
Involving employees in the budgeting process also helps to promote team working. This form of non-financial motivation can further lead to increase productivity and decreased absenteeism.
3. Coordinating
Budgeting helps to coordinate activities to ensure harmony between different parts of an organization.
Discussion will take place over the allocation of scarce resources among different departments and divisions. Priorities will be discussed between these departments to agree on. Allocation of resources is important because the business cannot use more resources than it has available and has access to.
Therefore, effective budgeting requires budget holders or budget managers to match budget allocations with the business aim and business objectives. Without proper coordination, budget holders may make decisions that are in conflict with decisions made in other departments. Hence, coordinated budgeting leads to consistent and coordinated decision-making within a firm. It is because decisions will not be taken without first ensuring that they fit in with other plans.
Once budgets have been planned, set and coordinated, all people involved will have to work effectively together to achieve the targets. A clear budget will help the entire workforce to focus on the common goals.
4. Monitoring and controlling
Budgets are generally used to keep better financial control.
Budgeting aids monitoring of what happens with the firm’s resources. Especially, strictly controlling costs and linking them with revenues.
Once the targets have been set and coordinated, budgeting plans cannot be ignored. Having a budget enables business managers to control the firm’s business expenditure rather than allowing the money to control the business.
The stages in budgetary control process include:
- Preparation of plans.
- Comparison of plans with actual results.
- Analysis of variances.
As internal business environment and external business environment may change frequently, the budget holders or budget managers must check regularly that all the financial objectives are still within reach.
Because budget holders are limited by what they can do and are constantly held accountable for their expenditure, monitoring and controlling budgets will help them to identify areas where a department or division is underearning or overspending.
As the next step, budgetary control involves taking corrective measures when necessary to ensure that actual performance equals the budgeted performance.
Without proper cost control, many businesses end up overspending. And their managers are not held accountable for their actions. Therefore, having tight financial control can ultimately prevent a firm from all sorts of Cash Flow problems.
5. Modifying
Budgets may need to be modified at some point due to changes in business environment.
First, the budget set may be unrealistic. It will make reaching the targets impossible to achieve. So, in this case, either the whole budget will need to be adjusted or new ways of reaching those unrealistic targets must be invented.
Secondly, during times of change, business budgets may need to be adjusted in order for the firm to be able to respond appropriately to those changes in the external business environment.
Therefore, variances between actual results and budgeted results have to always be examined in context of what has been happening within the business organization to better understand the need to modifying the budget.
It is always a good idea to allow for some flexibility when modifying budgets, so they can reflect the true nature of changing markets and environments.
6. Measuring to assess performance
Budgeting helps with assessing performance of the management.
While budgetary controls can help with allocating and clarifying responsibilities, they can also be linked with performance management.
After the budgeted period is over, Variance Analysis will be conducted to compare actual performance with the original budgeted figures. And, if there are any discrepancies, reasons for such differences will be analyzed.
Using Variance Analysis as a part of annual appraisal is an important way of assessing managers’ performance. It is also a great opportunity for budget holders to discuss their budgets with the appraiser. Those managers who achieve their budget performance targets will be recognized and rewarded. While those who do not achieve their budget performance targets will not be. This provides an opportunity for the budget holder to express any areas of concern.
To sum up, budgets are produced for the following reasons: planning, setting targets, coordinating, monitoring and controlling, modifying and measuring to assess performance.
Budgets provide benefits that lead to the improved operational efficiency of a business organization. Having to work within a realistically set budget encourages managers to seek efficiency gains. Thereby, possibly giving the business a competitive advantage over its rivals.
