Question

You have recently been introduced to the concept of budgeting. Issues discussed included:

1. the purpose of budgeting,
2. approaches used in budget preparation,
3. advantages and limitations of budgeting.

Your secondary school old students’ association has invited you to make a presentation on the above-mentioned concepts. Due to the threat of contracting the COVID 19 virus, you would not be able to travel to make a physical presentation at the meeting. The executives of the association have however, made a passionate appeal for you to write a memorandum that discusses the concepts in a to c.

Answer 1

Purpose of Budgeting:

The purposes of budgeting are for resource allocation, planning, coordination, control and motivation. It is also an important tool for decision making, monitoring business performance and forecasting income and expenditure. With proper budgeting, limited resources are managed efficiently.

Budgeting is critical in the business planning process. A business owner has to predict whether the company will be profitable. Budgeting provides a model of the potential financial performance of a business, given that specific strategies and plans are followed. It provides a financial framework for making important decisions. To manage a business effectively, expenditure must be properly controlled. An example of how budgeting plays a role in decision making is when spending money on advertising. When the budget allocated for this aspect has been completely used, the decision is likely to stop spending money on it. Budgeting also helps measure the forecast business performance against the actual business performance.

Various approaches used in Budget Preparation:

Incremental budgeting: Incremental budgeting takes last year’s actual figures and adds or subtracts a percentage to obtain the current year’s budget. It is the most common method of budgeting because it is simple and easy to understand.

Activity-based budgeting: Activity-based budgeting is a top-down budgeting approach that determines the amount of inputs required to support the targets or outputs set by the company. For example, a company sets an output target of $25 million in revenues. The company will need to first determine the activities that need to be undertaken to meet the sales target, and then find out the costs of carrying out these activities.

Value proposition budgeting:

In value proposition budgeting, the budgeter considers the following questions:

• Why is this amount included in the budget?
• Does the item create value for customers, staff, or other stakeholders?
• Does the value of the item outweigh its cost? If not, then is there another reason why the cost is justified?

Zero-based budgeting: Zero-based budgeting is a budgeting technique that allocates funding based on efficiency and necessity rather than on budget history. Management starts from scratch and develops a budget that only includes operations and expenses essential to running the business; there are no expenses that are automatically added to the budget.

Advantages of Budgeting:

1. Budgeting forces the management to study about the problems relating to the timely implementation. It generates a sense of caution and care among the line managers.
2. It guides the management relating to the planning and formulation of policies.
3. Budgeting provides a means of controlling income and expenditure of a business. It gives a plan for spending.
4. It defines the objectives of an organization in numerical terms for a specific period.
5. Budgeting is used to evaluate the policies and goals of an organization. Moreover, such policies and goals are tested with the help of budgetary control.

Disadvantages of Budgeting:

1. Sometimes budgets become an end. People believe that if they do not spend the budgeted amount in the given time span, their future allocations will be reduced. This may result in spending in areas where it is not even required.
2. Budgets specify the amount to be spent on various items. If managers do not have the discretion to change the amount allocated for different items depending on the situation, there will be overspending in some areas and under-spending in others.
3. Since budgets are based on future predictions, if the events do not occur as projected, budgetary allocations will have to be reallocated. Thus, uncertainties in future can affect the reliability of budgets.
4. When funds are allocated to different operating budgets, procuring additional funds and resources to take advantage of environmental opportunity may not be possible and budgets, thus, may affect the possibility of innovation and change.
5. To remain within the limits of budgeted goals, managers may ignore overall goals of the organisation and achieve the budgeted goals at the cost of organisational goals.