The Budgeting Process

The development of the budget Opens in new window for the coming year generally starts several months before the end of the current year.

The budget is developed within the framework of a sales forecast.

This forecast shows potential sales for the industry and the company’s expected share of such sales. Sales forecasting involves a consideration of various factors:

1. General economic conditions,
2. Industry trends
3. Market research studies,
4. Anticipated advertising and promotion,
5. Previous market share,
6. Changes in prices, and
7. Technological developments.

The input of sales personnel and top management is essential to the sales forecast. In small companies the budgeting process is often informal. In larger companies, a budget committee has responsibility for coordinating the preparation of the budget. The committee ordinarily includes:

• the president,
• treasurer,
• chief accountant (controller), and
• management personnel from each of the major areas of the company, such as sales, production, and research.

The budget committee serves as a review board where managers can defend their budget goals and requests. Differences are reviewed, modified if necessary, and reconciled. The budget is then put in its final form by the budget committee, approved, and distributed.

Budgeting and Human Behavior

A budget Opens in new window can have a significant impact on human behavior. It may inspire a manager to higher levels of performance. Or, it may discourage additional effort and pull down the morale of a manager.

Why do these diverse effects occur?

The answer is found in how the budget is developed and administered.

In developing the budget, each level of management should be invited to participate. This bottom-to-top approach is referred to as participative budgeting. The advantages of participative budgeting are:

• First, that lower-level managers have more detailed knowledge of their specific area and thus are able to provide more accurate budgetary estimates.
• Second, when lower-level managers participate in the budgeting process, they are more likely to perceive the resulting budget as fair.

The overall goal is to reach agreement on a budget that the managers consider fair and achievable, but which also meets the corporate goals set by top management.

When this goal is met, the budget will provide positive motivation for the managers. In contrast, if the managers view the budget as being unfair and unrealistic, they may feel discouraged and uncommitted to budget goals.

The risk of having unrealistic budget is generally greater when the budget is developed from top management down to lower management than vice versa.

Participative budgeting does, however, have potential disadvantages.

First, it is more time-consuming (and thus more costly) than a top-down approach, in which the budget is simply dictated to lower-level managers.

A second disadvantage is that participative budgeting can foster budgetary gaming through budgetary slack.

Budgetary slack occurs when managers intentionally underestimate budgeted revenues or overestimate budgeted expenses in order to make it easier to achieve budgetary goals.

To minimize budgetary slack, higher-level managers must carefully review and thoroughly question the budget projections provided to them by employees whom they supervise. For the budget to be effective, top management must completely support the budget. The budget is an important basis for evaluating performance. It also can be used as a positive aid in achieving projected goals.

The effect of an evaluation is positive when top management tempers criticism with advice and assistance. In contrast, a manager is likely to respond negatively if top management uses the budget exclusively to assess blame. A budget should not be used as a pressure device to force improved performance. In sum, a budget can be a manager’s friend or a foe.

Budgeting and Long-Range Planning

Budgeting and long-range planning are not the same. One important differences is the time period involved.

• The maximum length of a budget is usually one year, and budgets are often prepared for shorter periods of time, such as a month or a quarter.
• In contrast, long-range planning usually encompasses a period of at least five years.

A second significant difference is in emphasis.

• Budgeting focuses on achieving specific short-term goals, such as meeting annual profit objectives.
• Long-range planning, on the other hand, identifies long-term goals, select strategies to achieve those goals, and develops policies and plans to implement the strategies.

In long-range planning, management also considers anticipated trends in the economic and political environment and how the company should cope with them.

The final difference between budgeting and long-range planning relates to the amount of detail presented.

• Budgets can be very detailed.
• Long-range plans contain considerably less detail.

The data in long-range plans are intended more for a review of progress toward long-term goals than as a basis of control for achieving specific results. The primary objective of long-range planning is to develop the best strategy to maximize the company’s performance over an extended future period.