Question

Describe the purposes of budgeting for operations and identify the roles and responsibilities of those involved in the budgeting process.

minimum 300 words

Answer 1

Conflicting Roles in Budgeting for Operations

A senior design engineer for a large American automobile manufacturer recently complained to one of his colleagues.

“Those marketing guys want everything. They’ve decided that what they need in the next design series is ‘The All-American Car.’ They say it’s got to be large enough for a family of five (plus dog), small enough to drive in city traffic, powerful enough to pull a camp trailer, sporty enough so that the man of the house feels that what he’s driving is only a few steps removed from a Formula One, luxurious enough to be seen at the country club, safe enough to meet all the federal standards, and it must get 35 miles per gallon and list for under $3,499. What the hell do they expect? One car can’t do everything.”

The frustrations of the automobile design engineer are not entirely different from those of the company controller who was recently asked why he could not design a budgeting system to meet all the requirements that managers throughout his company were placing upon it. The treasurer said he wanted a budget that was realistic enough for cash planning purposes. The marketing vice president said he needed a budget that would motivate the sales force. The production chief told the controller he needed it to evaluate operating efficiency. The president asked that the budget be used as the primary coordination device to harmonize all the company’s activities. Finally, a consultant came in and told the controller that he ought to be using the budget as a tool for management development. Like the design engineer, the controller rightly asked, “How can one budget be expected to do everything?”

The problems the design engineer and the company controller face in these hypothetical examples arise from the fact that both automobiles and budgeting systems serve multiple roles—at the same time they must be many things to many people. And the problems would be greatly simplified if none of these multiple roles conflicted with any of the others. Unfortunately, this is not the case. A car cannot be luxurious and powerful if at the same time it must also be inexpensive and economical. Similarly, a budget cannot fulfill equally well all the tasks that managers within an organization may wish to assign to it.

Operational Budgeting Defined

Budgeting is part of the management control process by which “managers assure that resources are obtained and used efficiently and effectively in the accomplishment of the organization’s objectives.”1 There are several kinds of budgets, and while specific terminology may vary from company to company, budgets generally fall into one of three categories.

Capital budgets. These budgets portray the corporation’s planned and approved capital expenditures for periods from one to ten years.

Financial budgets. Such budgets typically project cash flow statements, balance sheets, and statements of sources and uses of funds.

Operational budgets. These usually consist of projected income statements and a series of supporting statements—such as budgeted sales, budgeted production (in detail), budgeted cost of goods sold, budgeted selling expenses, and budgeted general and administrative expenses.

We shall deal solely with operational budgeting. We define it as the process of formalizing, quantifying, and expressing in a set of detailed operating plans the near-term performance expectations and objectives of a company’s management.

Roles of Operational Budgets

Budgets can be called upon to play a variety of roles. We shall discuss five of these. Three are major roles: planning, motivation, and evaluation; two are minor: coordination and education.

Planning—Operational budgets are plans; they provide details of what management hopes to accomplish and how. Their value in the planning process comes from the fact that budgeting forces management to examine in detail both the general economic situation of which the company is a part and the economic interrelationships among all the company’s various activities. Budgeting allows managers to explore how costs and revenues will behave under specific sets of operating assumptions.

The process often points out conflicts between top management’s objectives and the realities of the company’s capabilities. Through budgeting, management can both identify resources that will be necessary to achieve objectives and learn how those resources must be applied. If present resources cannot meet planned objectives, the process of operational budgeting may bring about an examination of the financial implications of additional asset procurement (capital budgeting).

Motivation—Management can use operational budgets to motivate persons to help achieve the organization’s overall objectives by committing them to a predetermined plan of action. Motivation can be said to have two elements: direction and strength.2

Budgets provide the direction in that a budget represents a quantification of management’s objectives. When the budgeting process is complete, each manager ends up with a specific target for which to aim. But an objective alone is rarely enough. To achieve objectives, a manager must be committed to working toward them.

Managers can gain commitment (the strength element of motivation) in a variety of ways. One frequently used technique is to link the performance evaluation of the manager with the company’s incentive system. When managers realize that their level of compensation and their upward mobility depend to a large degree on their performance, their commitment to budgeted objectives may be enhanced.

Evaluation—The data in an operational budget serve as a standard against which to compare a manager’s or a business unit’s actual results. Without such a standard, senior management would have little but the past against which to measure the results of the present. While present-to-past comparisons may be interesting from a historical perspective, they often provide little meaningful evaluation of a company’s or a manager’s performance.

Evaluating present performance in terms of past performance assumes that the company’s present condition and operating environment are the same as in the past. This is rarely the case.

If the purpose of the evaluation is to measure managers’ operating abilities as opposed to their forecasting skills, it might also be desirable to remove the effects of uncontrollable or unforeseeable environmental changes that have occurred during the budget period. Examples of uncontrollable environmental variables might be changes in government regulations, labor unrest, and either shortages or unexpected increases in the costs of raw materials.

In the evaluation role, budgets receive support from other elements of the management control system. The budget serves as a useful standard of measurement, but it falls to the reporting system to provide data on the actual results that are to be measured against the standard. Predetermined measurement criteria (return on investment, return on assets, and so on), formal evaluation procedures, and management review meetings also support the budget’s role in evaluation.

Coordination—Operational budgets also have a coordinating role. When combined with the financial budgets into an overall master budget, operational budgets help coordinate the activities of the various parts of the organization by providing a consolidated plan of action.

Budgets can coordinate in two ways. First, the budgeting of operations in a large organization must be decentralized to some extent. In most companies, managers of the various organizational elements prepare budgets for the coming year. As these budgets flow to higher levels in the organization, they are reviewed and consolidated, and, in the process, incompatibilities among the planned operations of the various organizational elements are removed.

Output is matched to projected sales, material procurement schedules are coordinated with production plans, distribution across product lines is coordinated, redundancies in the marketing or sales operations are reviewed, and so on. In short, the operational budget, once it is fully consolidated, serves as a means of harmonizing the activities of the entire organization with the purpose of seeing that resources are not over- or underused.

The second coordinating function of the operational budget comes after operations have actually begun. If each organizational element is managed so as to meet its budgeted objectives, then the coordination that was built into the budget during the planning process will not be lost. If, as is more common, conditions change and the budget is not met by all units, then the knowledge gained earlier about the economic interrelationships between the company’s various activities can be useful in developing revised plans or budgets.

Education—The budget’s role in education is related to the coordination role. To prepare their budgets properly, managers at all levels of the organization must take a systematic and rigorous look at how their part of the business functions and be aware of the behavior of costs and revenues in their units. Budgets can also be useful analytical tools in determining how performance might be improved.