Primary Reasons for Budgeting in a Business
Budgeting demands a fair amount of managers’ time and energy. So why should a business go through the time and effort of budgeting? Business managers budget and prepare budgeted financial statements for three main reasons: modeling, planning, and control.
Many budgeting computer programs are on the market today; ask your CPA or other financial consultant which one he or she thinks is best for your business.
Modeling reasons for budgeting
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.