Budgetary control

David Frederick examines the importance of a budgetary framework in all organisations

Over the past two decades the one word that has become the common currency in all managers’ vocabulary is ‘budgets’. The budget is perhaps the most frequently cited explanation for some chosen course of action or inaction by management and staff across all sectors. Management at all levels within the public, private and the third sector have used the budget as their shield or excuse when confronted or challenged about any decision. It is not uncommon to hear variations of the phrases ‘the budget docs not permit us to’, or ‘it is not in our budget’. Furthermore, management in some sectors may be forgiven for believing their sole raison d’etre has become budget preparation, budget compliance and budget monitoring.

Despite the overnight prominence and success of the budget throughout all sectors it is interesting to discover the number of managers and staff who are unable to offer an explanation to the meaning of the word budget. This lack of explanation is only matched by one other question: ‘What is the role of the budget?’ Notwithstanding the inability or difficulty in providing any explanation to these questions, all parties readily use or refer to the budget in their daily life within their respective organisations.

Understanding the term ‘budget’ and its usefulness is one of the expected learning outcomes of the Institute’s accounting syllabus. It is these two themes that will be the central focus throughout the rest of this article.

A budget may be summarised by a phrase that includes its three key components: ‘A plan that is measurable and timely.’ The Chartered Institute of Management Accountants provides a fuller definition.

First, it is important to recognise that a budget is a plan of action. The plan may be regarded as a statement of intent or the goal of the organisation. For example the credit control department may be required to improve its debtor collection. Unfortunately, this cannot be achieved because it is not measurable and has no time parameters. Will an improvement by 1 per cent or 100 per cent suffice? The second component of a budget is its measurability. The plan must have some measurable yardstick to be useful to any of the stakeholders within me budgetary process. The credit control department may be required to improve its debtor collection by five clays or 10 per cent.

Although the refinement of the goal for the credit control department is now measurable, it is still deficient in terms of the time dimension. This is a common oversight when setting or issuing targets. A common source of such malpractice is central government. For example, all governments talk about improving education or health or whatever else is the flavour of the month. However, very few provide measurable parameters and time parameters.

The final feature of the budget is the time dimension. It is necessary to know over what period the plan will apply to enable us to know whether it is achieved. Thus the management of the credit control department may require that debtor collection is improved by 10 per cent in the next financial year ended 30 June.

The timescale applied in budget setting is important because it enables us to establish either a revenue or capital budget. A revenue or operational budget is prepared for all of the operational activities of the organisation within a period of twelve months. A capital budget is used for long term activities that by definition span beyond twelve months. For example building a new hospital or a new road, or the development of a new software programme. It is possible to regard a capital budget as the summation of the revenue budgets for the long term project.

The use of the term budget may imply the existence of a single budget within an organisation. However, this is rarely the case. Budgets may be prepared on the basis of the following:

  • Product/service
  • Location
  • Department/division
  • Function/speciality
  • Project
  • Cost
  • Activity

The nature of the organisation and the needs of the management will drive the chosen basis. A law firm may prepare its budgets per department whereas a publishing company may prepare budgets per publication. Irrespective of the organisation or the sector, a master budget is common to most organisations. A sample budgetary framework is shown in figure 1.

Figure 1

Sample budgetary framework

The master budget is at the heart of the organisation. It is the budget that captures all the internal management budgets irrespective of their basis or preparation. It is also the source for all the externally reporting financial accounting budgets.

To address the purpose or usefulness of the budget or budgets we need to consider the role of management. In broad terms management are responsible for making decisions and the budget is one of its tools in the decision making toolbox.

Management often use budgets to assist the decision-making process in the following areas:

  • Planning
  • Co-ordinating
  • Control and monitoring
  • Communicating
  • (De)motivating

Budgets are invariably used to provide all parties and stakeholders with an awareness of where the organisation is heading. Consequently it provides a means to enable the organisation to focus on its key activities to help it to achieve its goal. The main reason why budgets are seen as a tool to enable an organisation to attain its goal stems from the budgetary process itself. The budget is often the financial expression of an organisation’s corporate objective. For example a medium size company may set its goal for next year to increase its cashflow position. This may become translated into a requirement for the credit control department to reduce its debtor collection days by 10 per cent in the next financial year.

Budgets are also used to co-ordinate the resources required to achieve the corporate goal. Alternatively, it may be regarded as building the team to achieve the objectives, since it is combining the appropriate resources in their desired quantities to achieve the plan for the defined period. An examination of a budget provides an indication of how an organisation will be using its resources to achieve its corporate objectives.

When a budget has been set it can be used to monitor and control the activities within the organisation. The mechanics of the process will be examined and explored next month. Suffice to state that budget monitoring and control is based upon the examination of where the organisation is now compared with where it is planned to be, with the use of variance analysis.

A budget may he used intentionally or unintentionally to communicate with all stakeholders. It may be a positive means of communication through the use of devolved budgeting to allow a greater level of staff involvement within d1e process. Or it may be used negatively as a means to communicate to some members of the organisation that next year or in subsequent years their resources will no longer be required. It is therefore important that management fully appreciates and understands that budgets have these features. It may also communicate messages to other stake-holders such as investors and the money markets.

In some organisations the budget is used as a means of motivating staff by the targets that are set within it. It is also necessary to recognise that these targets may serve to demotivate staff if they are revised or addressed periodically and if they have been set without staff co-operation and participation. A modern restatement of Jung may read ‘a budget that motivates one person may demotivate another.’

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