Question

Budgets are useful tools to help manage a businesses' performance and can be used to guide important operating decisions, but are their risks to being too focused on the meeting financial budgets? Are their other performance measurements that a manager should consider in the decision making process?

Answer the following questions:

In your opinion, what do you consider the most important reason for a business to use a budget? Why?

Are their any risks to using only a budget to measure performance? If yes, describe at least one risk. If no, explain why not? How does the Balanced Scorecard concept expand beyond traditional financial measurements?

What other measure, besides financial, would you consider to be the most important for your business? Why?

Answer 1

Without a budget, the business owner is literally shooting in the dark when it comes to trying to create an action plan for a company. A solid budget identifies current available capital, estimates expenditures and anticipates revenues. Businesses should continually refer to them as a way of measuring performance against expectations.

Planning

Think of your budget as a planning tool. Use it to attain your goals by determining how much money you can spend on different elements of your operation.

Your periodic budgets should be archived so you can revisit previous periods (for example, month-over-month or quarter-over-quarter) and evaluate whether your company's results are improving. A master budget provides an overview of financial activities involving assets, liabilities, equity, revenue, expenses, and costs over a specific period.

Owners first develop a master or static budget with numbers based on planned inputs (sales revenue) and outputs (expenses). Think of this data in very simple terms. You'll use it to estimate what the firm will take in from sales revenue and what the firm will pay out in expenses.

Control

Businesses also use budgets to control expenditures for specific periods by comparing what was spent during that period to the master budget. Continual monitoring of expenses and revenues should prevent businesses from exceeding their budgets.

Ideally, budgets should contain some flexibility.

Expenditures and revenues often will stray from their forecasts. You may receive an unexpected discount from a vendor, or your sales may exceed your best guess estimates for any given period. Or, you may incur unexpected charges during a time when sales drop without warning. Successful businesses are able to adapt and compensate for those changes.

Evaluation of Performance

Budgets are a valuable tool for evaluating the performance of your company and the efficacy of your budget. Owners can use it to review actual expenses, for example, as compared to the estimated expenditures. If there's a large divergence between the two, the owner and the financial planner can review the budget for flaws.

Preparing a budget can be a lot to get your head around. All those numbers spread among so many tasks over so many months can leave you dazed. But, it's an essential part of maintaining your business, as important as any marketing plan or advertising campaign. After all, you can plan for either of those unless you know how much money you can spend.

Business managers should make detailed analyses to determine how to improve the financial performance and condition of their business. The status quo is usually not good enough; business managers are paid to improve things — not to simply rest on their past accomplishments.

For this reason, managers should develop good models of profit, cash flow, and financial condition for their business. Models are blueprints or schematics of how things work. A financial model is like a roadmap that clearly marks the pathways to profit, cash flow, and financial condition.

Business managers need a model for planning cash flow from operating activities. Managers should definitely forecast the amount of cash they will generate during the coming year from making profit. The best advice is to prepare all three budgeted financial statements:

• Budgeted income statement (profit report): A Profit & Loss report separates variable and fixed expenses and includes sales volume, margin per unit, and other factors that determine profit performance. The P&L report reveals the factors that must be improved in order to improve profit performance in the coming period.

• Budgeted balance sheet: The key connections and ratios between sales revenue and expenses and their corresponding assets and liabilities are the elements in the model for the budgeted balance sheet. The budgeted changes in operating assets and liabilities provide the information needed for budgeting cash flows during the coming year.

• Budgeted statement of cash flows: The budgeted changes during the coming year in the assets and liabilities used in making profit (conducting operating activities) determine cash flow from operating activities for the coming year.

  In contrast, the cash flows of investing and financing activities depend on the managers’ strategic decisions regarding capital expenditures that will be made during the coming year, how much new capital will be raised from debt and owners’ sources of capital, and the business’s policy regarding cash distributions from profit.

Budgeting requires good working models of making profit, financial condition (assets and liabilities), and cash flow. Budgeting provides a strong incentive for business managers to develop financial models that help them make strategic decisions, exercise control, and do better planning.

PLANNING REASONS FOR BUDGETING

Budgeting forces managers to create a definite and detailed financial plan for the coming year. To construct a budget, managers have to establish financial objectives for the coming year and identify exactly what has to be done to accomplish these objectives. Budgeted financial statements and their supporting schedules provide clear destination points — the financial flight plan for a business.

The process of putting together a budget directs attention to the specific things that you must do to achieve your profit objectives and optimize your assets and capital. Basically, budgets are a form of planning that push managers to answer the question “How are we going to get there from here?”

Budgeting can also yield other important planning-related benefits:

• Budgeting encourages a business to articulate its vision, strategy, and goals.

• Budgeting imposes discipline and deadlines on the planning process.

MANAGEMENT CONTROL REASONS FOR BUDGETING

Budgets serve a management-control function. Management control, first and foremost, means achieving the financial goals and objectives of the business, which requires comparing actual performance against benchmarks and holding individual managers responsible for keeping the business on schedule in reaching its financial objectives.

By using budget targets as benchmarks, managers can closely monitor progress toward (or deviations from) the budget goals and timetable. Significant variations from the budget raise red flags, in which case you can determine that performance is off course or that the budget needs to be revised because of unexpected developments.

For management control, a budgeted profit report is divided into months or quarters for the coming year. The budgeted balance sheet and budgeted cash flow statement may also be put on a monthly or quarterly basis. The business should not wait too long to compare budgeted sales revenue and expenses against actual performance.

Profit is the main thing to pay attention to, but accounts receivable and inventory can also get out of control (become too high relative to actual sales revenue and cost of goods sold expense), causing cash flow problems. A business cannot afford to ignore its balance sheet and cash flow numbers until the end of the year.