Planning

Creating a Budget

A budget is the financial expression of an organization’s operating plan for a period of time, usually at least a year.

Learning Objectives

Outline the process of budgeting

Key Takeaways

Key Points

  • The budgeting process may be carried out by individuals or by companies to estimate whether the person or company can continue to operate with its projected income and expenses.
  • In summary, the purpose of budgeting is to provide a forecast of revenues and expenditures; enable the actual financial operation of the business to be measured against the forecast; and establish the cost constraint for a project, program, or operation.
  • The process for preparing a monthly budget includes: listing all sources of monthly income; listing all required, fixed expenses, like rent and mortgage, utilities, and phone; and listing other possible and variable expenses.

Key Terms

  • fixed expenses: In economics, fixed costs are business expenses that are not dependent on the level of goods or services produced by the business.

The Purpose of Budgeting

A budget is the financial expression of an organization’s operating plan for a period of time, usually at least a year. Prior to the beginning of the year, managers prepare a plan for what they hope to accomplish in the coming year in terms of revenue, expenses, and net profit.

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Budget: A budget is the financial expression of an organization’s operating plan for a period of time, usually at least a year.

Budget can be more formally defined as “a financial document used to project future income and expenses. ” The budgeting process may be carried out by individuals or by companies to estimate whether the person or company can continue to operate with its projected income and expenses. A budget may be prepared simply using paper and pencil, or on computer using a spreadsheet program like Excel, or with a financial application like Quicken or QuickBooks.

In summary, the purpose of budgeting is to:

  • Provide a forecast of revenues and expenditures
  • Construct a model of how a business might perform financially if certain strategies, events, and plans are carried out
  • Enable the actual financial operation of the business to be measured against the forecast
  • Establish the cost constraint for a project, program, or operation

The Process of Preparing a Monthly Budget

The process for preparing a monthly budget includes:

  • Listing all sources of monthly income
  • Listing all required, fixed expenses, like rent and mortgage, utilities, and phone
  • Listing other possible and variable expenses

Then, as the year unfolds, actual income and expenses are posted to the accounting records, and compared to what was budgeted, and a variance from budget for each item budgeted (e.g., sales, selling expenses, advertising costs) is calculated. Managers responsible for the various income and expense items then examine each variance and, if it is substantial, search for an explanation. For example, it is one thing if electricity costs are 20% higher than what was budgeted for one month because workmen were using power tools to repair the roof. In that case, we can expect costs to return to normal when the repair work is completed. It is quite another thing if costs are higher because the electric company raised its rates. In that case, we can expect that costs will be at least 20% higher in the future.

The Role of Budgeting in Operations

Budgeting helps aid the planning of actual operations by forcing managers to consider how the conditions might change. It thus encourages managers to consider problems before they arise and think of the steps that should be presently taken. It also helps coordinate the activities of the organization by compelling managers to examine relationships between their own operation and those of other departments. Other essential functions of budgets include:

  • To control resources
  • To communicate plans to various responsibility center managers
  • To motivate managers to strive to achieve budget goals
  • To evaluate the performance of managers
  • To provide visibility into the company’s performance

The Two Approaches to Budgeting

There are two basic approaches or philosophies when it comes to budgeting. One approach is based on mathematical models, and the other on people.

The first school of thought believes that financial models, if properly constructed, can be used to predict the future. The focus is on variables, inputs and outputs, drivers and the like. Investments of time and money are devoted to perfecting these models, which are typically held in some type of financial spreadsheet application.

The other school of thought holds that it’s not about models, it’s about people. No matter how sophisticated models can get, the best information comes from the people in the business. The focus is therefore in engaging the managers in the business more fully in the budget process, and building accountability for the results. The companies that adhere to this approach have their managers develop their own budgets. While many companies would say that they do both, in reality the investment of time and money falls squarely in one approach or the other.

Financial Plan and Forecast

Financial planning aims to ensure that a firm is properly capitalized and makes appropriate investments.

Learning Objectives

Explain how financial planners use forecasts in decision making

Key Takeaways

Key Points

  • Management must identify the “optimal mix” of financing—the capital structure that results in maximum value. Equity financing is less risky with respect to cash flow commitments, but results in a dilution of share ownership, control and earnings.
  • Management must attempt to match the long-term financing mix to the assets being financed as closely as possible, in terms of both timing and cash flows.
  • Most organizations prepare a revised forecast for the balance of the year, taking into account earlier budgets and forecasts. This step is particularly important if material variances from the original budget exist.

Key Terms

  • corporate finance: Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions.

Financial Planning

Financial planning is important in ensuring that corporate investment is financed appropriately, as well as seeing to it that money is spent in worthwhile investments. Achieving the goals of corporate finance requires that any corporate investment be financed appropriately. The sources of financing are capital self-generated by the firm and capital from external sources, obtained by issuing new debt and equity. The financing mix will impact the valuation of the firm (as well as the other long-term financial management decisions). There are two interrelated considerations here:

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Financial planning: Financial planning is important in ensuring that corporate investment is both financed appropriately, as well as seeing to it that money is spent in worthwhile investments.

  • Management must identify the “optimal mix” of financing—the capital structure that results in maximum value. Equity financing is less risky with respect to cash flow commitments, but results in a dilution of share ownership, control and earnings.
  • Management must attempt to match the long-term financing mix to the assets being financed as closely as possible, in terms of both timing and cash flows.

Forecasts

Most organizations prepare a revised forecast for the balance of the year, taking into account earlier budgets and forecasts. This step is particularly important if there are variances from the original budget. For example, if sales are less than projected because market conditions are less favorable than anticipated when the budget was prepared, managers may look for ways to increase sales or reduce expenses in order to avoid a loss for the year.

Organizations may carry out a form of economic forecasting which is the process of making predictions about the economy. Forecasts can be carried out at a high level of aggregation like gross domestic product (GDP), inflation, unemployment, or the fiscal deficit. They may also happen at a more dis-aggregated level, for specific sectors of the economy or even specific firms. Some forecasts are produced annually, but many are updated more frequently.

Scenarios

There are many other forecasts that managers ask for in order to try and anticipate what the future might hold and so that they can prepare contingency plans in case of unforeseen events. Examples of unforeseen events that may affect future outcomes are the arrival of a new competitor, a change in the overall economic outlook which could affect costs and/or revenues either positively or negatively, or even the arrival of a new company in another line of business that could raise prevailing wage rates in the region.

Managers like to develop forecasts of figures such as sales, costs, cash, profits, interest rates using different assumptions. Another word for forecasts is scenarios. For example, let us assume that a forecast of the income statement for a business at the end of the year assumes that sales will grow by 8 percent over the previous year and costs will grow by 6 percent. A manager might ask for an alternative scenario where sales increase by 12 percent and costs increase by 9 percent and another scenario where sales decrease by 3 percent and costs increase by 1 percent.