Why Do Businesses Need To Do Yearly Budgets

By Dominic Shum

A budget is a financial blueprint of a business in respect to planned activities in a specific period of time which is usually a year. Sometimes it is referred to as the yearly budget or annual budget. It is a plan of action in monetary terms that is compiled from departmental or functional budgets for the given period. This includes budgets prepared by various departments as follows;

  • Revenue Budgets
  • Budgeted Cost of Goods sold
  • Production Quantity and Mix budget
  • Cash Budget of Cash flow budgets
  • Manufacturing cost budgets
  • Operating Expenses or OPEX budgets

It is pertinent to note that in order to prepare a good budget the compiled “master Budget” must fully reflect the aggregate sum of all individual budgets and no departments or functions in the organization must be left out. The final deliverables in the budgeting process is usually in the form of a budgeted income statement, a budgeted cash flow statement and budgeted balance sheet. There are also collectively known as pro-forma financial statements or budgeted financial statements. Once prepared and approved, the budgeted income statement and balance sheet are used for controlling the activities of the business in the specific budgeted period of time.

Large organizations with multiple departments or sections require a high degree of co-ordination between staff of various departments and functions to operate efficiently. The benefits for doing budgets are a plenty for such. However, that does not mean that budgeting as a process is irrelevant for smaller organizations or even one man operated businesses. We can do budget for any endeavours even with our own personal projects such as building a dream home or running a freelance service businesses. Some of the reasons why we do budgets;

  • To plan for the purchase of something of substantial value in the future like education fees, building a new house etc.
  • To monitor and control our income and expenditures
  • To help one control spending

Organizations big or small requires to a lesser or higher degree of complexity and effort when doing budgets but the principles and concepts that you are about to learn in this book applies to all budgets big or small.

While we have learned earlier that budgets may never accurately reflect the future, it is nevertheless an important process for businesses as it provides the business a set of revenue and expenditure targets to base activities on and for monitoring performance as it happens. Actual performance can be compared with budgeted performance which will allow top management to take the necessary steps for adjustment but accuracy of budgets vis-a-vis the future is not as important as the agreed upon targets set which provides benchmarks for performance monitoring and appraisal that is acknowledge by both management and departmental heads. There are also other reasons which we will discuss below but it is important to note that since planning is an important part of the management functions of Planning, Organizing, Motivating and Controlling, budgeting as part of the planning function is indispensable to businesses.

Some questions to ask yourselves;

If any the answer is no then it helps to do a budget, even a simple one if you are just a small business.

  • Do you know exactly which part of your business is profitable?
  • Do you know how much cash you will end up with at the end of the next financial period?
  • Are you aware of any inefficiency in your operations that can be eliminated?
  • Do you roughly know how much you will make in terms of profits in the coming year?

Budgets can be requested by management and prepared for many different situations in addition to the routine annual budgets. For example; a budget would need to be prepared before a department can start on a new major project where expenditure to be incurred is substantial. Budgets may also be required when large capital purchases are planned for.

For example; the setup of a new Production Line with new equipment and its requirement for more human resources will require a budget. An investment budget must be prepared to justify the additional line. The additional revenue from the production line must be higher than the incremental cost incurred and the depreciation expense from any of the new assets. Such surplus will normally have to be higher than the company’s normal rate of return to be considered. Such budget s may be called capital budget or project based budgets and the main usefulness of such budgets is to ensure that the investment works and treasury can allocate the funds needed on a timely basis.

Although businesses use budgets for performance monitoring, the ultimate aim of the budget is to prevent cost overrun and provides a basis for decision making when situation changes. For example; when revenues drop by 20% against the budgeted sales, management will expect cost of goods sold to drop likewise against budgeted expenditure and operating cost should be tightened. In your opinion What are some of these cost which can be tightened?

For most businesses however, budgets are used as tools for organizations to monitor and review the performance of managers by comparing actual versus budgeted performance using financial measures such as gross margins, cost per item manufactured, overheads used and many other forms of measures. For example; one way of monitoring profitability is to monitor the gross margins of the business against the budgeted gross margins. The review of this measure can be further analysed by reviewing relevant variables such as material cost per unit sold and average selling price of the products. All such measures can be compared against similar measures in the budget. That is provided the budgets are done in proper levels of details and are realistic while at the same time challenging.

While smaller companies can survive without budgeting, large and complicated organizations will struggle to coordinate day to day operations without proper budgets. This is because all departments need to work towards a single overall corporate objective while maintaining their performance level to meet individual department’s targets. Therefore budgets are important as well as the budgeting process which foster teamwork and communication amongst department. DS

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