Unit 5 Budgeting

Overview

Welcome to Unit 5 of the course. In this unit, our focus will be on budgets. In day-to-day conversations, budgets are associated with financial constraints. For instance, we have heard expressions like, “this purchase is beyond my budget”, “I just love that item, but my budget does not allow me to buy that”, or “I don’t have a budget for that”. However, if we take a step back and drill deeper, we will recognize that both personally and organizationally, the budget or budgeting is an important exercise to ensure that our resources are being spent wisely, and unplanned expenditure is minimized. In this unit, we look at several aspects of budgets and budgeting, and how organizations can use budgeting tools to ensure optimization of resources.

Topics

This unit is divided into the following topics:

  1. What is a Budget?
  2. Why Budgets Matter
  3. How and Why Managers Use Budgets
  4. Operating Budgets
  5. Financial Budgets
  6. Flexible Budgets
  7. How Budgets are used to Evaluate Goals

Learning Outcomes

When you have completed this unit, you should be able to:

  • Describe the fundamentals and advantages of budgeting
  • Develop a simple budget for your organization
  • Explain how budgets are used to evaluate goals
  • Assess the financial health of the organization
  • Analyze financial statements and describe how they contribute to the overall financial health of the organization
  • Identify nonfinancial measures and controls for an organization

Activity Checklist

Here is a checklist of learning activities you will benefit from in completing this unit. You may find it useful for planning your work. Expected time commitment: 3 hours

Learning Activities

  • Read section 7.1 from Principles of Accounting on budgeting and why it matters.
  • Reflect on the scenarios provided and discuss the advantages and disadvantages of the top-down and bottom-up approach to preparing budgets.
  • Read section 7.2 and reflect on the case of Big Bad Bikes.
  • Read section 7.3 from Principles of Accounting and watch the video on budgets and their interconnections.
  • Read section 7.4 and watch the video on flexible budgets.
  • Read section 7.5 and watch the video Building a Robust Budgeting Framework.
  • Interview a manager on the use of static and flexible budgeting.
  • Take the ungraded quiz to review some of the major concepts from the text.

Assessment

  • Unit 5 Discussion (Please confirm assignment instructions in Moodle)

Resources

Here are the resources you will need to complete this unit.

5.1 What is a Budget?

In the broad overarching POLC frame of management (which we talked about in Unit 1). Budgets fit into the C, or the controlling facet of management. In management, controlling has to do with measuring, evaluating, or assessing progress made in light of objectives, and initiating course corrections and remedial measures to get the organization back on track. There are two types of controls organizations use to measure progress: financial and non-financial. Budgets help measure the financial progress of an organization. Though not emphasized enough, the non-financial controls of an organization are important in contributing in so many ways towards the overall success of the organization. A look at the examples of non-financial controls in the lists below will help underscore their importance to the growth of the organization.

Non-financial Controls Examples
Human Resources
  • Employee satisfaction
  • Average tenure
  • Turnover
Purchasing
  • New products introduced by suppliers
  • Quality of purchased inputs
Marketing
  • New products launched
  • Customer satisfaction
  • Brand power
Research & Development
  • New patents
  • Number of employees with PhDs
Production
  • Number of defects
  • Product returns
  • Capacity utilization
Customer Service
  • Average complaint response time
  • Average wait time

Organizational controls in the POLC frame serve two basic functions:

  1. Help leaders determine whether and why their strategy is achieving the desired results.
  2. Be an early warning system in cases where the organization is getting a little (or a lot) off track.

Organizational control involves four steps:

  1. Establish standards
  2. Measure performance
  3. Compare performance to standards
  4. Take corrective action as needed.

Note: Corrective action can include changes made to the performance standards—setting them higher or lower, or identifying new or additional standards.

Examples of controls:

  • simple checklists
  • budgets
  • financial statements
  • inventories
  • job descriptions
  • day-to-day operational safeguards (see 10 controls in section 15.3)
  • evaluations and reviews
  • balanced scorecards

Control and Strategy: It is important to note that financial and nonfinancial controls in place must reflect and reinforce the unique strategy of the organization. If the strategy should change, link between controls and strategy must be revisited and/or revalidated.

5.2 Why Budgets Matter

By way of a simple introduction a budget is a spending plan. It helps you balance your expenses with your income over a future period of time (see exhibit below). If you spend (expenses) more than you make (income), you will have a problem and slowly sink deeper into debt every year. Therefore, budgeting is the process of creating a plan to spend your money. A budget allows you to determine in advance whether you will have enough money to do the things you need to or like to do. If you don’t have enough money to do everything you would like to do, then you can use this planning process to prioritize your spending and focus your money on the things that are most important to you.

Rocks stacked precariously at the beach

Source

Similarly, at organizational level, budgets are important and matter for a variety of reasons:

  • Budgets help keep track of organizational income and expenditures.
  • Performance evaluation becomes easy as there is a set target or goal to achieve in the budget for a pre-determined period.
  • Budgets help forecasting and planning.
  • Management can question any deviation from the set goals.
  • Helps identify and take corrective action in a timely manner in cases of under-achievement, or excessive expenditure.
  • Ascertains if money is being spent/invested wisely.

Activity: Read and Reflect

Read section 7.1 from Principles of Accounting on budgeting and why it matters.

Questions to Consider

After completing the activities above, consider the following questions:

  • Imagine working in an organization that did not have a budget. What are some of the risks and dangers the organization is open to?
  • What are some of the non-financial measures in your organization?
  • Reflect on how these non-financial measures impact the bottom line of your organization? For instances, poor customer service, will lead to low customer satisfaction, customer migration and negative publicity for the organization. All of these will lead to loss of revenue for the organization. What are some other examples you can think of?

Note: learning activities in this course are ungraded, unless specified. They are designed to help you succeed in your assessments in this course, so you are strongly encouraged to complete them.

5.3 How and Why Managers Use Budgets

As the organization puts it strategy and strategic plan together, the budget is an important component in taking the organization from where they are to where they want to be. A budget deals with projected revenues, expenses, financing options etc. A budget is a helpful tool for key internal stakeholders of the organization to monitor and evaluate the organizations financial performance.

Source: Strategic Budgeting

When discussing budgets, managers use the term master budget. The master budget is the collection of many budgets (sales, labour, manufacturing, materials, administration etc.). Each budget contributes and feeds into the overall performance of the organization. While there are many budgets that feed into the master budget, the master budget has two major categories: the financial budget and the operating budget. Figure 7.6 from section 7.1 of the readings, depicts how the different budgets connect to the operating and financing budgets of the organization. For further details on financial and operating budgets read section 7.1.

Figure 7.6 Operating Budgets, Financial Budgets, and the Relationship between Budgets.

Attribution: Copyright Rice University, OpenStax, under CC-BY 4.0 license

In preparing budgets, organizations use one of two approaches. One, the top-down approach where management prepares budgets, and the budget is then passed down to teams and departments. The second, is the bottom-up approach, where teams and departments prepare the budgets to be sent up to top management for evaluation and incorporation into the master budget (see diagrams below). Each approach has its advantages and disadvantages.

Figure 7.2 Top-Down versus Bottom-Up Approach to Budgeting. The top-down approach to budgeting starts with upper-level management, while the bottom-up approach starts with input from lower-level management.

Attribution: Copyright Rice University, OpenStax, under CC-BY 4.0 license

Activity: Case Study

Let’s take two examples. Organization A and Organization B. Both organizations A and B are private educational institutions run by a board of directors. The CEO reports to the board and serves as ex-officio board member. Department/unit heads report to the CEO.

In organization A, the board meets once a year to discuss plans and budget for the upcoming school year. They draw on information from last years budget, other financial statements, school’s enrollment, feedback and performance from each department/unit, current market conditions for education, etc. With this information, the board formulates the master budget for the entire school and from this, departmental budgets are allocated and handed down to the CEO and unit heads.

In organization B, when it is “that time of the year” for budgets, the CEO calls a meeting of department/unit heads, where they discuss goals and projects in alignment with vision/mission of institution. The unit heads are then requested by the CEO to meet with their respective teams to discuss these further – the projects each team intends to implement for the upcoming year and the costs associated with implementing these projects. The departmental/unit heads send these budgets to the CEO, where further discussions could be held to fine tune the details. The master budget is then prepared by the finance department and submitted to the school board for approval.

Reflect on these scenarios with organization A and B. What are advantages and disadvantages of the top-down and bottom-up approach to preparing budgets?

5.4 Operating Budgets

Imagine embarking on a very long journey. Your destination has been established. But now you must work out the little preparatory details that will get you to your destination. You compile a list of things to get done. As each item is completed and you place the tick mark, you know you are on track to reach your destination. Even as you are travelling towards your destination, as you pass cities and towns, you know you are on track and headed in the right direction.

Or imagine beginning a course of study with a university. You have your grand big goal of graduation. You are given a list of courses to complete to reach that goal. Each course has things to do and be completed. As you complete each assignment and each course successfully and on time, you know you are on your way to reach your big goal of graduation.

An operational budget resembles the little steps we need to take, or the list of things needed, to reach the desired destination. Now that the strategic goals have been set for the organization, and the master budget has been set, the operational budget focuses on target revenue and the expenses required to generate that revenue. Operational budgets can be broken down for the quarter, the month, and, in some cases for each week (this frequency varies depending on organization and the industry). This in turn will involve the compilation of the number of units to be produced, number of units to be sold to reach these targets, the material needed, the manpower needed, etc. These are known as production budget, sales budget, material budget and labour budget respectively.

Activity: Read and Apply

Section 7.2 in your text provides a detailed explanation using the case of Big Bad Bikes. Read through the Bad Bikes case to understand the different budgets and how they all fit in to the master budget.

5.5 Financial Budgets

Having looked at operational budgets, we now turn our attention to the other component of the master budget, which is the financial budget.

The financial budgets focus on expectations and avenues to finance the operations of the business to generate targeted revenues. It also involves planning for the cash needs of the organization towards this end. Financial budgets help estimate the source, amount, and timing of cash collection and cash payments, and also look into when additional financing is needed, or debt can be paid.

Reproduced below is Figure 7.15 from section 7.3 to give us a greater understanding of how the budgets fit into the master budget to help assess organizational health and growth.

Figure 7.15 Relationship between Budgets.

Attribution: Copyright Rice University, OpenStax, under CC-BY 4.0 license

Activity: Read and Watch

  • Read section 7.3 from Principles of Accounting.

  • For further study, watch the video below for an explaination of the different budgets and their interconnections.

5.6 Flexible Budgets

A flexible budget is a budget that adjusts or flexes with changes in volume or activity, whereas a static budget is where the amounts will not change with significant change in volume and activity. For instance, if an organization is using the flexible budget, the budget for sales commissions expense might be expressed as 5% of sales. This means that the budget for sales commissions expense will flex with sales volume. When sales are $2 million, the flexible budget for sales commissions will be $100,000. When sales are $4 million, the flexible budget for sales commissions will be $200,000. When sales are $8 million, the flexible budget for sales commissions will be $400,000. However, if an organization’s annual budget is a static budget, the sales commissions expense budget is fixed at $200,000. This means that the budget for sales commissions expense will be $200,000 whether the actual sales for the year are $2 million, $4 million or $8 million.

Activity: Read and Watch

Read section 7.4 from Principles of Accounting on flexible budgets.

For further study, watch the short video below on using a movie theatre as an example to explain flexible budgets.

5.7 How Budgets Are Used to Evaluate Goals

If used wisely, a budget is a useful assessment tool to evaluate an organization’s progress towards its goals and objective. This ties into our discussion in previous units about the importance of clearly defined organizational goals and objectives.

Evaluating performance through budget analysis provides management needed information to adjust production, shipping, inventory, build better communication channels (both inside the business organization and with suppliers and customers), etc., for better customer service. Evaluating performance through budget analysis also makes it possible for management to weigh the costs of specific products and services against the actual profits earned for the particular products and services.

Activity: Read and Watch

Read section 7.5 from Principles of Accounting.

For further study watch the video below on Building a Robust Budgeting Framework.

Activity: Interview

Interview a manager on the use of static and flexible budgeting. Discuss when and how each approach is used, benefits in each case, etc.

Ethical Guidelines for Interviews Just a reminder to follow ethical guidelines when interviewing.
- Identify the course you are taking.
- Explain the purpose of your questions (e.g. ungraded learning activity to explore course concepts).
- Assure the participant that your conversation is confidential and optional.

Activity: Key Terms Quiz (ungraded)

Take the following unmarked quiz. Although you will not be evaluated on these terms, they will assist you in the assignments for this course.

Unit 5 Summary

In this unit, you have had the opportunity to understand the place of controlling or evaluating in the management process, and how different types of controls (both financial and nonfinancial) are available to organizations to ensure progress towards goals and objectives. You have learnt about the importance of budgets from a managerial perspective, the different types of budgets and how budgets can be utilized to evaluate organizations progress towards goals.

Personal Application

Before participating in the assessment for this unit, consider how you might apply what you have learned.

  1. Discuss the place of budgets in evaluating organizational goals. Share your perspectives. Cite any experiences or examples.

  2. If management is being evaluated on their ability to manage a budget, what can they do to increase cash flow? What can they do to decrease cash outflow?

Please see the Assessments section in Moodle to confirm assignment instructions, including the grading criteria and due dates.

Checking Your Learning

Before you move on to the next unit, you may want to check to make sure that you are able to:

  • Describe the fundamentals and advantages of budgeting
  • Develop a simple budget for your organization
  • Explain how budgets are used to evaluate goals
  • Assess the financial health of the organization
  • Analyze the three financial statements and describe how they each contribute to the overall financial health of the organization
  • Create a list of nonfinancial measures and controls for your organization