Last updated: March 18, 2019
Topic: BusinessManufacturing
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Companies first look at their resources on hand and the resources required in building their business.  Resources are defined by Merriam and Webster as “a source of supply or support: an available means; a natural source of wealth or revenue; a natural feature or phenomenon that enhances the quality of human life; computable wealth; a source of information or expertise.”  In business, resources may be classified as financial or non-financial.  Financial resources consist of capital resources such as subscribed capital, reserves and surplus as well as borrowed funds.  Some companies may have access to special funds such as contributions, grants and the like.  While businesses cannot run without financial resources however, successful businesses need to have non financial resources.  The importance of human resources, for one, cannot be stressed enough.  It has been said often that the strength of a company lies in its people and we have seen this repeatedly to hold true.  Whether it is the more socialist view of human resources who sees value as being created primarily by the activity of the people involved or the more capitalist view that value is created more by the intellectual capital provided, there is no denying the central role that human resources play in successful enterprises.  Physical resources also play key roles.  Efficiency and effective processes and production, for instance, are highly influenced by the type of physical resources available to the business.

 

A key feature of resources is that they are limited and businesses aim to maximize the potential of all the resources available to them in order to maximize profits.  In this regard, the budget becomes a powerful tool employed by companies, providing the guide so that the best use can be made out of the limited resources.

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A budget is defined as “a quantitative expression of a plan of action that helps managers coordinate and implement the plan” (Horngren, Harrison & Robinson, 1998).  Some budgets are long-range, while others may look at a short-term horizon, depending on its intended use.  A budget, for instance that is prepared as part of the groundwork on a firm’s decision for expansion or acquisition looks at a longer term rather than a budget that is prepared in order to program cash flows.

 

Horngren, Harrison & Robinson (1998) cites four benefits to budgeting.  First, budgets compel managers to plan.  “Budgeting helps managers set realistic goals by requiring them to plan specific actions to meet their goals.  Budgeting also helps managers prepare for a range of conditions.   It leads them to ask what-if questions and to plan for contingencies.”  It is important to recognize, however, that budgetary biasing may take place when budgets are being prepared in organisations. Budgetary biasing is usually associated with people introducing slack into their budgets so that they can achieve their targets more easily. However, there is also evidence that managers operating in tough environments may bias their estimates in the opposite direction and set themselves budgets that they are unlikely to achieve. The reasoning behind this is that managers may be feeling insecure because of past poor performance and feel that by promising improvement, they would gain immediate approval despite the risk of future disappointment. Luka (1988) found evidence of both forms of budgetary biasing in the organisation he looked at. The important message for organisations is that they need to try to understand the reasons why this biasing is taking place.

 

Second, budgets promote coordination and communication.  A master budget, for instance, synchronizes the activities of various divisions or departments.  The various contributors to the supply chain, for instance, must be considered.  In order for this coordination to work, there must be effective communication among all the members of the supply chain.  “Budgets are effective tools to communicate a consistent set of plans throughout the company.” (Horngren, Harrison & Robinson, 1998)

 

Third, budgets aid performance evaluation by providing a benchmark for performance.   However, budgetary control systems are often viewed very negatively. The major problem seems to be associated with the way in which the budgetary control information is used in performance evaluation. This was studied in detail by Hopwood (1976), based on observations in a manufacturing division of a large US company. Three distinct styles of using budget and actual cost information in performance evaluation were observed and were described as follows:

 

  • Budget constrained style – evaluation is based on the ability of the responsibility manager continually to meet the budget on a short- term basis. This criterion of performance is stressed at the expense of other valued and important criteria. Budget data is therefore used in a rigid manner in performance evaluation.
  • Profit conscious style – the performance of the responsibility manage is evaluated on his/her ability to increase the general effectiveness of his/her unit’s operations in relation to the long-term goals of the organisation. The accounting data must be used with some care and in a rather flexible manner, with the emphasis for performance evaluation on contributing to long-term profitability.
  • Non-accounting style – accounting data plays a relatively unimportant part in the supervisor’s evaluation of the responsibility centre head’s performance.

 

 

The three styles of evaluation are distinguished by the way in which extrinsic rewards are associated with budget achievement. In the rigid (budget constrained) style there is a clear-cut relationship; not achieving budget targets results in punishment, whereas achievement results in rewards. In the flexible (profit conscious) style, the relationship depends on other factors; given good reasons for overspending, non-attainment of the budget can still result in rewards, whereas the attainment of a budget in undesirable ways may result in punishment. In the non-accounting style, the budget is relatively unimportant because rewards and punishment are not directly associated with its attainment. Negative reactions to budgets often result from the use of the budget constrained style of budgeting identified by Hopwood and the introduction of slack into budgets is often associated with this rigid style of budgeting.

 

Fourth, budgets motivate employees to help achieve the company’s goals.  Behaviour is affected by the presence of budgets.  Hofstede (1968) suggested that the highest level of performance is achieved by setting the most difficult specific goal which will be accepted by the manager concerned. Stedry (1960) suggested that the formulation of a specific target improved performance. However, he added that the participant’s own goals or ‘levels of aspiration’. Emmanuel, Otley and Merchant (1990) indicate that the crucial feature of targets seem to be that they must be accepted by the person to whom they are assigned.

 

On the one hand, some companies employ zero based budgeting in which case, all amounts in the budget that are being requested must be explained and justified rather than just the amounts that differ significantly from the previous budget and funding.  Zero based budgeting is ideal for government expenditures.  Some companies whose resources are more limited or scarcer than others also use this type of budgeting in order to see that all resources are really being maximised.  Quite a few companies, on the other hand, employ what is known as incremental budgeting in which case, the resources are allocated based on the previous budget with gradual changes added for the new budget.  There are some disadvantages when using this type of budgeting.  For instance, managers are encouraged to spend up to the limit of their budgets so that these items can be maintained at least its present level or increased as non-usage will mean a lowering of the amounts allocated.  A budgetary slack may also go unnoticed since not all items have to be justified during each budget period.

 

One of the most salient items in budgeting is capital budgeting, which is “the decision-making process with respect to investment in fixed assets.  Specifically, it involves measuring the incremental cash flows associated with investment proposals and evaluating those proposed investments.” (Keown, Scott, Martin & Petty, 1994).  Usually investments in fixed assets tend to involve large amounts of the firm’s financial resources at the outset and because of this, commit the firm to use these assets over a long period of time.  Should these investments not pay off as planned, it can prove to be costly to the firm.  Capital budgeting decisions, therefore, tend to focus on cash flows that represent the benefits of the investment.  Four common criteria used in determining the investments in fixed assets are the payback period, the net present value, the internal rate of return and the profitability index or the benefit/cost ratio which “provides a ratio of the present value of its future net benefits to its initial cost.”

 

“These fixed assets are usually long-lived assets such as land, buildings, furniture, machinery and equipment used in the operations of the business and all of these assets, except for land decline in usefulness as they age.  This decline is an expense to the business.  Accountants systematically spread the cost of each plant asset, except land, over the years of its useful life. This process of allocating cost to expense is called depreciation.” (Horngren, Harrison & Robinson, 1998)

 

Let us say that we have 20,000 to spend on an online tutorial business that will employ at least 6 tutors. A capital expenditure would be on the desktop computers that will be used in the business.  If each computer would cost 1,500 each and you would need at least 7 of these (i.e. 6 for the tutors and 1 for administrative use), then 10,500 or slightly more than 50% of your financial resource has been allocated for this capital expense alone.  But you know that the computers have a life of at least 3 years in which case you can divide the cost of your computer over this period.  This translates to 500 per unit, in which case, your annual depreciation expense for the 7 computers would be 3,500.  Why would you invest in these desktop computers?  Primarily, because these are necessary tools in order for the tutors you employ to get in touch with their market – students online.  You know for instance, that you can charge 20/hour for each student and you estimate that the tutors will have students at least 5 hours each day on the average.  This means that your gross revenue for 6 tutors on a daily basis is 600.  From this inflow, you can recoup the expenses that you spent over an acceptable period of time.

 

Budgets are very useful as management tools, but as discussed earlier, these budgets must be accepted by those who will play a significant part in seeing that these budgets are followed.  Encouraging others to take and share responsibility for identifying and communicating resource requirements, planning, recording and monitoring resource use is a way to do so.  This encouragement can take the form of budget meetings where everyone involved are given a choice to voice their ideas and concerns.  Thus, when a consensus is arrived at, each one feels that he/she is part of the decision-making process thereby owning the decisions arrived at.  Deviations from budgets must also be explained thoroughly so that the budget is established as a framework.  Not a rigid one which cannot take into account the changing environment or extraordinary events, but one which will remain the backbone of the firm’s operations.

 

 

REFERENCES

 

Horngren, C., Harrison, W. Jr. & Robinson, M. (1998). Accounting (3rd ed). New Jersey: Prentice Hall

 

Keown, A., Scott, D. Jr., Martin, J. & Petty, J. (1994). Foundations of finance The logic and practice of financial management. New Jersey: Prentice Hall