The Role of Planning, Budgets, and Control in Business Success - Essay Example

? PLANNING, BUDGETS AND CONTROL Finance and Accounting ………………………….. College ……………………………… ……………….. Words count: 3073 Table of Contents Table of Contents 2 Introduction 3 Planning, Control and Budgeting 3 Interconnection of planning, budget and control 5 Annual Master Budget 6 Potential issues related to budgeting process 10 Budgetary Slack 10 Participative Budgeting 12 Ethical issues in budgeting 12 Conclusion 12 References 14 Introduction One of management’s major responsibilities is planning which is the process of establishing enterprise-wide objectives. Long or short term planning processes are core management functions that are extremely important to an enterprise for future survival and business success. Management may prepare a budget for planning propose as a quantitative plan about management’s beliefs of what business costs and revenues will be over a given future period or a budget for control purpose as motivational tool to influence improved departmental performance. This paper compares three basic terms that are planning, control and budgeting and describes the process involved in preparing a master budget and behavioral issues that a firm may face while preparing the budget. Planning, Control and Budgeting A successful organization prepares both short and long term planning. Weygandt, Kimmel and Kieso, 2009, p. 388) pointed that planning is the process of establishing enterprise wide objectives because plans not only set forth the objectives of the company but also the proposed ways of accomplishing them. As Davies and Pain (2002, p. 410) described, planning refers to the establishment of objectives and the formulation, evaluation and selection of the policies, strategies and tactics that are required for achieving the established objectives. Planning includes long term planning or commonly termed as strategic planning and short term planning. Short term planning refers to a planning usually for a period of one year whereas long term planning is planning for something for a period of more than one year such as long-term profitability, becoming market leader or achieving competitive advantage within three or five years (Davies and Pain, 2002, p. 410). Long term planning involves strategic planning over two or more years and the identification of the basic strategy that the firm may follow and the gaps between future needs and present capabilities of the firm (Drury, 2006, p. 426). As long-term plans include looking in to future for two or several years, the plans may become uncertain, imprecise and subject to change. Long term planning or strategic planning expresses certain steps required to achieve an organization’s goals because it considers intermediate and distant future. Long-range plans give detail about major capital investments required for maintaining present facilities, increasing capacity, diversifying products or procurement and developing markets. Long-range plans may aim at cost control or increasing market share for duration of three or more years (Hilton, Maher and Selto, 2005, p. 597). Budgeting involves the coordination of both financial and non-financial planning with a view to satisfy organisational goals and objectives. It involves planning for future profitability because maintaining long-term profitability is very critical to organizational objectives. Kimmel, Weygandt and Kieso (2008, p. 1010) emphasized that budgeting and long-term planning are not the same. The main difference between them is the time period involved. Maximum length of a budget is one year and therefore budget is a kind of short-term plan. Other major differences between the long-term planning and budgeting are the emphasis and the amounts of details presented. Budgeting is meant for achieving certain short-term goals like meeting annual profit goals whereas long-term planning is meant to identify long-range goals, find and select effective strategies and develop policies and plans to implement the strategies. Budget is normally quite detailed whereas long range plans encompass comparatively less detail. A budgetary system forces managers to plan, provides significant information that can be further used for decision making, provides a standard for performance evaluation and improves the communication as well as coordination. There are basically different kinds of budgets such as master budget, continuous budget, sales budget, direct materials and purchase budget, operating budget, direct labor budget, overhead budget and so on (Heitger, Mowen and Hansen, 2007, p. 293). Control in management perspective is a tool and mechanism for correcting mistakes or deviation from the standards set in planning. Planning is looking forward to see what specific actions can be taken to realize particular goals whereas control is looking backward to determine what actually happened and comparing the actual results with the previously planned outcomes. Planning and control are linked each others. Control is thus a tool for finding mistakes or errors in the actual outcomes and for comparing the budget for further adjustment (Hansen and Mowen, p. 316). Interconnection of planning, budget and control As the depiction above shows, planning, control and budgets are closely interconnected. Planning and control are tied together in a significant way because planning looks ahead to see what actions can be considered to reach to a specific goal and control looks backward to determine what actually happened and thus to compare the actual outcomes with planned outcomes. Budgets are fundamental components of planning and they are used for identifying objectives and actions required to achieve those objectives (Rich, Jones and Heitger, 2011, p. 970). As shown in the figure, planning includes short term planning and long term planning. Long term planning is also termed as strategic planning. Forming organization’s objectives for both short and long terms are key components of planning. Budgeting is an important component of planning. Control is an important function of financial management related to monitoring the actual activities and comparing the actual outputs with planned outputs. Investigation and corrective action are other two important components of control through which feedback is analyzed to determine what actually happened and to see whether the planned outcomes could be met. Annual Master Budget A master budget or profit plan is a comprehensive set of budgets that cover all different phases of the operations of an enterprise for a specific period of time (Hilton, Maher and Selto, 2005, p. 598). A master budget consists of projected income statement and projected balance sheet along with objectives and proposed ways that the enterprise propose to achieve them. The master budget provides a comprehensive financial plan for the firm, typically for one year. It is an integrated set of budgets that are tied together a firm’s operating, financing and investing activities in to an integrated plan for the year to come (Warren, Reeve and Duchac, 2011, p. 985). Williams, Haka and Bettner, (2004, p. 953) described that a master budget consists of a number of interrelated budgets that together present and summarize all the planned activities for the enterprise. The components of the master budget vary from firm to firm depending on the size and nature of the business. Major components of master budget 1- Operating budgets a- Sales budgets b- Production budgets. Production budgets include units to produce, direct materials, direct labor and overhead. c- Cost of goods manufactured and goods sold budgets, d- Selling and administrative budgets. This includes marketing, administrative expenses and research and development. e- Cash budget 2- Financial budgets a- Budgeted income statement b- Budgeted cash flow statement c- Capital expenditure budget, and d- Balance sheet (Williams, Haka and Bettner, 2004, p. 953). Processes involved in preparing master budget Preparing master budget is an increasingly difficult and critical task since some parts of the budget cannot be prepared until other parts can be completed. For instance, manufacturing, sales and operating expenses are very important for the preparation of budgeted financial statements. Following are the logical sequence and processes involved in preparing the annual master budget. 1- Preparing the sales budget: A master budget begins with the preparation of identifying and preparing the sales forecast which is based on the business long term plan, past experiences, economic conditions, level of competition expected etc. Sales budget is meant to display projected sales in units and projected revenues. This projected sales will be displayed in units for each quarter and then by multiplying the unit sales by the sales price (Hilton, Maher and Selto, 2005, p. 604). 2- Preparing the budget for production, manufacturing costs and operating expenses. In the preparation of master budget, when the sales forecast is carried out, production needs to be scheduled and estimates need to be done for the manufacturing costs and operating expenses. Sales and cost-volume relationships are major important factors that the master budget is highly depending on. 3- Preparing budgeted income statement: At the third step, a budgeted income statement needs to be prepared based on sales forecast, manufacturing costs and the budgeted operating expenses. 4- Preparation of cash budgets: Cash budget provides detailed forecast of cash receipts and cash payments during the budget period. Sales forecast, credit terms that the company offers to others and company’s experiences in collecting accounts receivables etc are major determinants of cash receipts. Similarly, cash payments are likely to be affected by forecast of manufacturing costs, operating expenses and capital expenditures. 5- Preparation of budgeted balance sheet: After the determination of effects of cash transactions on various assets, liabilities and owners equity accounts, the balance sheet is to be prepared (Williams, Haka and Bettner, 2004, p. 954). Though these are the general steps involved in preparing the master budget, Crosson and Needles (2010, p. 256) argued that there is no standard format for master budget preparation as procedures for preparing budgets vary from firm to firm. But, it is highly important to follow some guidelines to ensure maximum accuracy and effectiveness especially to deliver appropriate information to the reader or to the party to whom budget is meant for. These guidelines are: 1- Understanding the purpose of master budget and identifying who is responsible for carrying out the activities in preparing the budget. 2- Identifying the user-groups and their information requirements. 3- Identifying sources for accurate and meaningful budget information. Documents, interviews with employees, suppliers, or interviews with managers etc may be helpful for that. 4- Develop a clear format for the budget in a way that is most appropriate for the firm. 5- Revising the budget until it includes all planning decisions (Crosson and Needles, 2010, p. 256). Potential issues related to budgeting process As Jackson, Sawyers and Jenkins (2008, p. 328) noted, conflicts invariably occurs when budgets are prepared for planning and control and when they are used by managers. Behavioral impacts such as budgetary slack are more important in budgeting than any other areas in management. A budget affects various groups of people and departments in an enterprise such as those who prepared the budget, those who used it and those who evaluated the budget. The interactions and reactions of these groups to the budgeting process scan have significant influence on the overall performance and effectiveness of the organization (Hilton, Maher and Selto, 2005, p. 618). Budgetary slack, participatory budgeting and ethical issues are major behavioral impacts related to budgeting process. These are detailed below: Budgetary Slack Budgetary slack is the difference between the revenue or cost projection that a person or department provides and the realistic estimate of the revenue or cost. It is more likely that an individual or specific department involved in budgeting overestimates the costs or underestimates the revenues due to some different kinds of incentives they may be expecting (Hilton, Maher and Selto, 2005, p. 619). Those who prepare budget may be influenced of several factors such as expected incentives or other benefits for improved performance for a specific department. Budget padding or budgetary slack occurs because managers may plan slack in the budget to provide a cushion for unexpected events or to show improved performance of operations. Budgetary slack occurs when managers display less revenues or higher costs with an effort to make the future period appear less attractive in the budget than they think in real terms and means. With these both approaches, manager not only feels reduced burden to achieve the budget but also expects less risks related to achieving the budget (Mowen, Hansen and Heitger, 2011, p. 379). As Davis and Davis (2011, p. 221) noted, budgetary slack may appear to be harmless, but it has real consequences for the enterprise. When there is budgetary slack, there won’t be optimal allocation of resources. Moreover, managers receive bonus based on their padding of budget, and thus increases organizations’ expenses. Examples for budgetary slacks: A plant manager expects the annual utility cost to be $ 12,000, but he gives a budgetary projection of $ 18,000, he builds a $4000 slack in to the budget. Similarly, when he projects revenues from the operation, he expects the actual revenues to be $25,000, but he shows an amount of $20,000 as revenues with a view to reduce his risks and burden that he may feel later to face to achieve the higher revenue levels. Reasons why people may pad with slacks Hilton, Maher and Selto (2005, p. 619) described three reasons to explain why managers often pad with budgetary slacks. 1) People often perceive that their performance will be considered better by their superior managers when they can beat the budget. 2) Mangers or people who prepare budgets think of coping with uncertainty, and 3) Budgetary cost projections are often cut in the process of resource allocation. Budgetary slacks occur because budgetary projections are cut as they are likely to be padded. Participative Budgeting Participative budgeting is a practice wherein employees throughout the organization are involved in the preparation of budgets. This participation gives employees a positive feeling of commitment as ‘it is our budget’ rather than thinking the other way such as ‘it is a budget you imposed on us’. The participative budgeting, however, leads to vacillation and time delay in preparing and processing the budget. It is also very likely that employees or others involved in the participative budgeting may disagree in significant ways and these in turn may cause differences in budget’s information. Ethical issues in budgeting Managers are those who prepare the budgets and there can be serious ethical issues in situations when the budget is a basis for rewarding managers. For instance, a superior level manager may split a bonus of 15 percent of the amount by which actual divisional profit exceeds the budget. Budgetary slack is a kind of ethical issues related to preparing the budget. Conclusion Plans and budgets are roadmaps that business firms can achieve its organizational goals by keeping a track on them. Control is a tool that firms can keep tracks of monitoring and evaluation on the budgets and plans. This paper has illustrated these three terms in comparison to each other and explained basic processes involved in preparing a master budget. This paper also has detailed behavioral impacts related to preparing the budgets including budgetary slack. References Crosson, S.V and Needles, B.E., 2010, Managerial Accounting, Ninth edition, Cengage Learning Davis, C.E and Davis, E., 2011, Managerial Accounting, John Wiley & Sons Davies, T and Pain, B, 2002, Business accounting and Finance, McGraw Hill Publishing Company Drury, C, 2006, Cost And Management Accounting: An Introduction, Sixth edition, Cengage Learning EMEA Hansen, D.R. and Mowen, M.M, 2006, Hansen & Mowen Managerial Accounting, Eighth edition, Cengage Learning Heitger, D.L., Mowen, M.M and Hansen, D.R., 2007, Fundamental Cornerstones of Managerial Accounting, Cengage Learning Hilton, R., Maher, M. and Selto, F., 2005, Cost Management, Strategies for business decisions, McGraw Hill Companies Jackson, S.R., Sawyers, R.B and Jenkins, J.G, 2008, Managerial Accounting: A Focus on Ethical Decision Making, Fifth edition, Cengage Learning Kimmel, P.D., Weygandt, J.J and Kieso, D.E., 2008, Accounting, Third edition, John Wiley and Sons Mowen, M.M., Hansen, D.R and Heitger, D.L., 2011, Cornerstones of Managerial Accounting, Fourth edition, Cengage learning Rich, J.S., Jones, J.P and Heitger, J.L., 2011, Cornerstones of Financial & Managerial Accounting, Second edition, Cengage Learning Warren, C.S., Reeve. 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