Skills to Develop
- Understand how operating budgets are used for planning and control.
Question: If you have established a personal budget, you know the importance of planning to achieve your goals. Assume one of your goals is to purchase a new car. It is not enough to simply state, “I want to buy a new car next year.” If you do not plan ahead for a big expense like this, you may find that you don’t have enough money for a reasonable down payment or that you have very large monthly payments. If you plan ahead, you may see that working some additional hours, cutting back on entertainment, or a combination of both, allows you to buy the car and avoid these problems. Organizations are no different, except their needs tend to be more involved. How do organizations formally plan for the future?
Let’s look at Jerry’s Ice Cream to answer this question. The company wants to increase sales next year, but will have difficulty doing this without some type of plan, often called a budget. A budget1 is a plan of the resources needed to achieve the organization’s goals. An operating budget2 is a short-term budget (typically one year) that focuses on the daily operations of the organization. Before presenting the detailed schedules of an operating budget, we first discuss how organizations use budgets to plan and control their activities.
The Planning Phase
Question: How are budgets used to help organizations plan future activities?
Budgets are established in advance to help organizations communicate their plans to employees and to help employees coordinate activities across the entire organization. Imagine Jerry’s Ice Cream operating without a budget. If production has no forewarning of an increase in customer demand, Lynn Young, production manager, has no opportunity to plan for an increase in production. Inefficiencies will occur as Lynn struggles to keep pace with demand (e.g., employees working overtime or materials purchased at the last minute at a premium). Cash flow may suffer as spending initially outpaces cash receipts, which would force the company to borrow money quickly at a high interest rate. In the worst case, the company would run out of product, miss out on sales, and perhaps run out of cash.
Turn the example around and assume Jerry’s Ice Cream does have a budget in place for the coming year. The budget communicates the organization’s plans to Lynn, production manager, and Michelle, treasurer and controller, showing that sales are expected to increase. Lynn can then plan accordingly by hiring additional employees, arranging for the purchase of additional materials, and finding more space for production. Michelle can also plan accordingly by arranging for a shortterm loan at a reasonable interest rate to meet short-term cash needs. As described here, the planning phase uses the budget to communicate plans to employees and to help employees coordinate activities across the organization.
The Control Phase
Question: How do organizations use budgets to control operations?
Organizations use budgets to evaluate performance. By comparing the budget with actual results, companies can determine whether employees, and the company as a whole, have performed as expected.
For example, assume Jerry’s Ice Cream estimates sales for the first quarter of next year will be 40,000 units at $6 per unit. Actual sales turn out to be 38,000 units at $6.20 per unit. The company can evaluate sales manager Tom Benson’s performance by comparing the budget to actual results. For unit sales, Tom did not perform as well as expected (38,000 units actually sold versus 40,000 in budgeted unit sales). However, Tom exceeded expectations for sales price ($6.20 per unit actual sales price versus budgeted sales price of $6).
The next chapter covers the control phase of budgeting in depth. We now turn to the process of creating an operating budget to plan a company’s operations for the coming year. Creating an operating budget is an essential part of business. Depending on the type of product offered and the size of the company, operating budgets vary widely in complexity. International companies in particular face difficult hurdles when it comes to budgeting, as described in Note 9.4 "Business in Action 9.1".
Business in Action 9.1
Challenges of Budgeting for International Operations
Companies with operations in several different countries, called multinational companies, face numerous challenges in establishing operating budgets. Most experts agree that foreign exchange rates have the biggest impact on budgeting for multinationals. Specific exchange rates are used when the budget is established. However, these rates can fluctuate significantly and are likely to differ when companies compare actual results with the initial budget. This makes the budget control process difficult because exchange rate variations might cause the differences between actual results and the budget.
Exchange rate fluctuations, along with other market characteristics—such as economic uncertainty and unpredictable government activities—make budgeting for multinational companies a challenging task.
Source: Ken Milani and Juan Rivera, “The Rigorous Business of Budgeting for International Operations,” Management Accounting Quarterly 5, no. 2 (2004): 38–50.
Organizations establish budgets to communicate their plans to employees and to coordinate the activities of employees across the entire organization. Budgets are often compared with actual results to evaluate employee and organizational performance.
REVIEW PROBLEM 9.1
Why do most organizations prepare an operating budget?
Most organizations prepare an operating budget for two reasons. First, budgets help managers communicate plans to employees, which in turn helps employees coordinate activities across the entire organization. Second, budgets are often compared to actual results to evaluate employee and organizational performance.
- A plan of the resources needed to achieve the organization’s goals.
- A short-term budget (typically one year) that focuses on the daily operations of the organization.