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Budgeting

The budget system is one of the two major


control tools for a business. The other is the cash ■ Benefits of budgeting
flow plan. ■ The budgeting process
A budget is simply a tool, a financial guide, ■ The budget book
which a manager uses to plan profitable
operations by anticipating and allotting the ■ Customize the budget
revenues and expenditure of funds. Thus, the ■ Management by percentages
budget is the basic source of information fed ■ Composite budgets
into the cash flow plan. Once the various
budgets have been developed, the cash flow
plan naturally follows. Make no mistake about it, it takes great
By adopting various budgetary procedures, discipline and mental toughness to abide by a
management hopes to guide the operations to a budget, particularly in new enterprises, in
predetermined end—a certain amount of profit which expenditures are often chaotic and
from a certain volume of sales. Without a unpredictable.
budget, management could never be certain The new enterprise’s irregularities cannot be
whether operations were going successfully. used as an excuse for not diligently developing
a good budget system. Entrepreneurs resort to
Benefits of budgeting all sorts of excuses for not budgeting. “We can’t
Budgeting plays a major role in business budget. Our revenues are too uncertain. We
planning. Five major benefits are realized by haven’t time to budget. That’s something big
using a good budget system: business does.” Such excuses are not only
■ It controls expense-revenue ratios. nonsense, but are dangerous to the firm’s
■ It coordinates activities in the organization. solvency.
■ It establishes a standard of performance.
Coordinating activities
■ It serves as an evaluation tool. The budget helps top management coordinate
■ It triggers remedial managerial action. the activities of all departments. If $500,000 in
sales is to be shipped, then the shipping
Control of expense-revenue ratios department must be allowed enough money to
Maintaining the desired relationship between do the job.
expenditures and revenues is the key to profits. Production must be coordinated with sales.
Losses result when expenses exceed revenues. The firm cannot ship $500,000 worth of
The objective of business is to buy revenues in products if they have not been produced. The
the market at a reasonable cost, and the budget production budget tells the factory what is to be
establishes what that cost should be. Thus, the made.
budget helps keep expenses in line with If $500,000 sales of product are to be made,
revenue. In theory, a firm can make money at the finance department must be prepared to
almost any level of sales if it keeps its costs finance the operation.
proportional to its revenues.

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Establishing performance standard By quickly and forcefully coming down on
Once the budget is established, it becomes the offenders, several messages are delivered to
standard of performance for all departments, staff members. First, they learn that
that is, what is expected of them. Marketing is management is watching what is spent and that
expected to sell $500,000 and spend $25,000 it is on top of operations. Second, they learn that
doing it. The budget becomes the goal. The management means business about staying
name of the game in business is meet the within budget. Third, they learn what happens
budget. Those people who fail to do so seldom to people who misuse company money. Once
last long in most organizations. the proper tone is set within the company,
controls become much easier to administer. The
Evaluation tool staff learns that the very survival of the
Naturally, if a group fails to meet its budget, it is enterprise depends on staying within and
not looked upon with favor by top meeting the budgets.
management. Thus, the budget becomes a
means for evaluating each unit’s performance. The budgeting process
Obviously, this aspect of budgeting causes The process of budgeting is simple; doing it is a
some problems. Knowing that the budgets they lot more involved. The budget begins with the
submit may be the rope that hangs them, the sales forecast, since all activities must be tied to
department heads can become cautious by the anticipated level of sales. Once the sales
asking for far too much money and promising forecast has been set, then that figure is given to
far too little output. Budget meetings can be each head of a budgetary unit—the marketing
interesting as the final budget figures are manager, the production manager, for example.
pounded out between departments and the In many smaller new ventures, the entrepreneur
management. works up the entire budget with the help of the
accountant.
Triggering remedial action Obviously, the more reliable the sales
The month’s budgetary performance is on the forecast, the easier it is to budget operations. As
entrepreneur’s desk. The telephone budget was the sales forecast becomes increasingly suspect,
$2,800; the actual was $4,700. That’s too much the budget-making process becomes more
variance. What happened? The entrepreneur tentative. It is difficult to budget a large sum of
calls for the bill and either scans it himself or money for advertising in advance of sales if
hands it to someone else to do it. It is important sales are uncertain. It is difficult to budget for
to know who spent the $1,900 and why. Was it hiring new employees in the shipping room if
necessary? If so, OK, those things happen. The the volume of shipments is in doubt.
money will have to be made up elsewhere. But When developing budgets, the following
if the calls were not necessary, they must be key factors need to be considered:
stopped. ■ The role of assumptions
It is critical for effective cost control that ■ Forecasting sales under uncertain conditions
quick action be taken to remedy unnecessary
cost overruns. Allowed to go unchecked, they ■ Expense lead time
not only accumulate a large sum of money, but ■ Budget periods
they tend to accelerate in amount as employees ■ Line-item budgeting
learn that cost overruns don’t seem to be ■ Program budgeting
important and the staff does not focus on the
bottom line. ■ Budget accounts
■ Start-up costs

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The role of assumptions The second approach involves developing a
A word needs to be said about the need for must-do budget. Sometimes the founder, in the
making assumptions in developing the budget. absence of good, hard data on which to base the
For example, the sales forecast is developed forecasts and the budgets, sets the budget on
based on several assumptions about economic the basis of what must happen if the company is
activity, new products coming on line, levels of to make it. It’s pointless to set budgets that
competitive activity, prices, and so forth. These result in failure. Set budgets that result in
assumptions should be clearly stated in the success. No founder wants to budget his or her
budget document. The figures can be no better venture into failure.
than the validity of the assumptions upon
which they are based. Expense lead time
Various assumptions underlie many of the The flexibility in a budget depends greatly on
figures in the budget. These should be how much time is involved between the
footnoted in the budget so readers will know expenditure of funds and the receipt of sales
how each figure was derived. The validity of dollars from those expenditures. At one extreme
these assumptions affects all planning because a is a project in which all funds must be spent
plan can be no better than the assumptions long before any sales revenues can be realized.
upon which it is based. The cash flow If a venture is building oil rigs, management
projections are similarly based on many must spend a lot of money before it ever knows
assumptions; a company must assume many whether the venture will earn a dollar of
things in projecting its sales and costs. revenue from a well. For this reason, oil
Management must make certain those adventurers prefer to use other people’s money
assumptions are clearly recognized and stated. to drill wildcat wells. Let people who want to
Underlying all planning are some implicit take such gambles put up the money.
assumptions that often go unrecognized, such At the other extreme, there are businesses in
as the state of the economy, the state of world which revenues are received before much
peace, no adverse political or regulatory money is spent. Perhaps a customer pays up
developments, the continued good health of the front, such as in the cases of insurance,
entrepreneur, no adverse technological magazines, many direct-mail promotions, and
developments, and so on. In general, most custom manufacturing. Such instances are
planning assumes a static environment. Any fortuitous, for the venture’s management knows
significant changes in the environment often its sales volume on which to plan its budget
make plans go astray. system, and all it must do is stay within budget
for fulfilling the contract.
Forecasting sales If sales volume follows expenses by a short
When management cannot forecast sales with time, a month or so, then the budgeter can
any degree of confidence, two approaches can quickly reduce or expand budgets to reflect
be used. The minimum-budget approach can be sales experience. Risks are minimized. The
used when forecasting sales is difficult, such as longer the lead time of expenses over sales, the
when the venture is introducing a new product larger the risk of losses due to spending too
to the marketplace. For example, the owner can much money because of over-budgeting by the
draw up a minimum budget that would various expense centers.
indicate the least money for which each
function can be performed. He or she would Budget periods
start out with the minimum amount of money Most often the budget is prepared for the
needed for each expense center, and then coming year by months. Sometimes, in strongly
allocate more funds to the budgets as sales seasonal businesses such as the apparel
warrant. Budgets can be flexible, thus allowing industry, each budget will be for a season.
for changes in a firm’s fortunes. Sometimes, in project-management types of
businesses such as defense manufacturing and
contracting, a budget is prepared for each
contract.

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Line-item budgeting However, after the program has been
Most budget systems start out by identifying awarded its budget, its manager must then
expense centers for those areas over which apportion the total among the traditional line-
management wants controls established. Thus, item expense categories.
department budgets are set up for such
departments or activities as production, Budget accounts
marketing, and general and administrative The number of budget accounts and the kinds
Then the individual budget accounts under of costs lumped into each account are solely
each of those departments are determined, such matters for managerial discretion. However,
as those for marketing. there are some general guidelines.
Or budget accounts may be built along the Do not use so few accounts that all sorts of
lines of more traditional accounting systems of costs are lumped together. If advertising-media
accounts. costs are lumped together with direct-mail
Such budgets are often called line-item costs, then it becomes more difficult to tell
budgets because each expense category is a which expense is out of control. Enough detail
separate line in the total budget. Obviously, should be budgeted in that when the manager
line-item budgets go into great detail, so much looks at the performance of a budget, he or she
so that it is their weakness. Seldom can anyone knows he/she is judging one activity that needs
plan expenses in that much detail. Thus, in control. For example, if both postage and
operations, such budgets are conducive to all telephone costs are included together in a
sorts of budget games, as managers rob one communication budget, the manager would not
budget to pay for costs incurred elsewhere. It is know whether someone was stealing stamps or
marvelous what can be considered advertising making unauthorized telephone calls. A large
or field-selling expenses. If a business runs out budget variance should focus attention to one
of postage, the manager can have the sales area of expenditures.
representative buy some and put it on his For the sake of accounting convenience, the
expense account for approval. Such budget budget accounts should parallel the ledger
games have given the budgetary process a bad accounts so that posting results is easy. With the
reputation. They can be avoided if flexibility is advent of computerized accounting, the
built into the system. The manager needs a monthly output for the budget book is a simple
slush fund to meet emergencies. matter.

Program budgeting
In a system of program budgeting, larger sums Department budget accounts:
of money are dedicated to programs, with their ■ Sales-reps compensation
expenditure and distribution left to the ■ Field-selling expenses
discretion of the program manager. The ■ Sales-office expenses
marketing program would be budgeted for ■ Advertising
$500,000 in total; how that amount is spent is up ■ Printing
to the marketing manager. Obviously, ■ Communications
management must have great faith in its ■ Sales-management salaries
marketing manager, although the breakdown of ■ Trade show expenses
marketing expenses is usually reviewed by top
management. The theory is that management Traditional accounts:
should not tie the marketing manager’s hands ■ Travel
by dictating how marketing funds will be spent, ■ Auto
while holding the manager responsible for the ■ Entertainment
final sales results. ■ Supplies
■ Telephone
■ Salaries
■ Printing

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Start-up costs For example, one entrepreneur wanted to
One method of determining how much money a launch a venture that involved manufacturing
venture will need at start-up is to do a mental submarines and selling them to operators of
“walk-through” of what the business will look underwater ocean tours at island resorts. The
like. The following questions should be asked to idea seemed feasible.
determine start-up costs: After estimating his start-up budget, he
■ Where will the business be? discovered that he needed about $1.2 million for
■ What size will it be initially? operating capital to launch the venture. He
could raise only about $10,000. After estimating
■ What will the office or retail space look like? start-up costs, he determined there was no way
■ What types of walls and fixtures will it have? he could start this business himself.
■ What type of equipment will be needed, There is no lack of ideas for launching new
such as computers, furniture, carpet, copy companies, but venture ideas must match the
machine, shelving? entrepreneur’s personal and business criteria as
■ What types of signs will be required? well as his or her pocketbook. Problems, such as
running out of money or realizing enough
■ How much of an opening inventory will the money cannot be raised to launch a venture
business need? idea, can be avoided by accurately estimating
■ How will it be paid for? start-up costs and preparing an initial start-up
■ What kinds of deposits will be required? For budget.
instance, how much will deposits cost for
telephone, utilities, and rent—first and last The budget book
month? When some entrepreneurs managed the
budgetary system of their company, they
■ What city codes must be complied with, and
developed an effective yet simple way of
are there any costs involved?
monitoring the chain’s monthly budget
■ What types of government (local, state, performance.
federal) business licenses will be required? First, the entrepreneurs developed a
■ What types of supplies will be needed for “budget book,” a loose-leaf ledger or computer
cleaning, office correspondence, shipping, program containing information for each
boxes? budget account. Each sheet showed the budget
■ What kinds of marketing costs will be and actual figures for that account for the
incurred before opening for brochures, previous 12 months, the projected budget for
advertising, stationery, and business cards? the year by months, the current actual
performance, and the variance of the actual
■ What are potential costs for recruiting and
figures from the budgeted figures.
hiring initial staff?
The bookkeeper prepared the data for the
■ What type of staff training is necessary entrepreneurs by the 5th of each month. Each
before opening? account that was over or under budget was
When estimating these expenses, circled in red. The entrepreneurs would glance
entrepreneurs should be as realistic and at the red circles and decide if the difference
accurate as possible. They always discover was significant. If so, was it explainable? Did
hidden costs that are incurred but not planned they know why it happened? If they did not
for. Other owners in a similar business can be know the reason for the significant variance, the
queried about what their start-up costs were entrepreneurs would call for the checks or other
and how much money they suggest be reserved documents that supported the out-of-line
before opening doors for business. expenditures. If problems were identified, plans
Most lenders recommend that entrepreneurs were made to take immediate action. Many
have a minimum of three-months’ operating entrepreneurs claim this system is the only way
capital on hand. to manage a budget for their businesses. It takes
Avoid forcing the budget process or trying only 15 minutes a month to survey the
to underestimate start-up costs. Let the organization’s budgetary performance.
budgeting process indicate how much money
the business concept needs.

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Customize the budget If a venture is just starting out, it is much
No two budget systems should be alike. Each better off making up the budget in dollar
venture should develop one that meets its amounts based on actual field determination of
needs, not the needs of the accountant. what the expenses will be. This is the reason
The accountant is hired to accommodate the that good budget building requires considerable
venture, not to dictate his or her wants. time and effort. Of course, the entrepreneur’s
A venture needs an accounting and budgeting experience bears greatly upon the amount of
system that its personnel can understand and work that must be done. An experienced
that provides the needed information in a operator knows the costs and percentages and
usable form. can develop a meaningful budget rather
Timeliness is essential. Budget information quickly. The inexperienced person must work at
two months old is of little use. A venture should it or find some experienced operator to do the
have its accounting information within at least budget.
two weeks after the end of the month. One big Composite budgets
advantage of having an in-house bookkeeper in
Some managers prefer to develop several
addition to an outside accounting firm is that
budgets, one for each separate significant
access to needed information is much faster.
segment of the business, and then combine
Management by percentages them into a composite overall budget. For
At the heart of most budget systems is a basic example, a menswear merchant developed three
philosophy called management by percentages. budgets: sales, capital, and expenses. The sales
For most businesses, experience has established budget was developed in great detail by lines
that a firm can afford to pay only a certain and months. It was used not only for
percentage of its sales for each expense. developing the cash flow statements and
For example, in the menswear manufacturing financial budgets but was also used by the
business one owner found it difficult to make a merchant as the basis for his buying.
profit if he paid more than 8 percent for rent, or If separate budgets are developed in detail,
10 percent for sales compensation, or 5 percent then the overall budget is a simple one,
for management salaries. Naturally, these consisting of a few lines.
expenses depended upon the particular Some companies will develop a best-case/
philosophies and plans of management. Where worse-case projected budget. The best-case
one manufacturer may rely heavily on scenario represents the budget with which the
advertising, budgeting perhaps 10 percent of management team thinks it can run the
sales for it, another may rely on trade shows to company. The worst case is usually the budget
bring in the business, thus budgeting only that reflects the break-even projection. Bankers
4 percent for advertising. like to see a company use this approach, so they
The budget that the owner eventually know what the company has to do to stay in
arrived at left him 9.8 percent of sales for profit. business.
Most percentage budgets are built on operating Conclusion
experience. The owner copied the operations of
The need for entrepreneurs to master the
another business.
development and use of budgets cannot be
stressed too strongly. Entrepreneurs will find
that following budgets is really the only way
they can run businesses of any substance with
any degree of confidence. Without budgets,
ventures will sooner or later meet with trouble
when some expenses run out of control and the
managers know nothing about it until it is too
late.

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