A plan which outlines the financial or operational goals of the organization is known as budget. It helps in allocating resources, evaluating the performance and for formulating plans. For successful financial planning budgeting is the first step in this process. In this report there is a brief understanding about the purpose of preparing budget and the process for budgeting which company should follow for developing business model. The important cost drivers has been identified and in what areas cost budgeting will be important. Application of traditional budgeting approaches has been classified. Various alternative budget methods like Rolling budgets, zero based budgets and activity based budget has been explained with its application, merits and demerits.
1.1 Purpose and process of preparing budget
There are three aspects for preparing budget i.e. forecasting of income and expenditure, a tool for decision making and to monitor the business performance. Budgeting is an important part while planning of business process. Managers and owners of the business should be able to predict that it will make profit or not. The main purpose is to create a model that how business should be performed or to decide strategies, plans and events which are being carried out. It is a tool for decision making as it gives financial framework of the action which is planned or not. Expenditure should be tightly controlled for managing business. It helps in enabling t business performance that should be measured against performance of business which is forecasted. The steps to be followed while preparing budget are as follows:
- All the assumptions about company's business environment should be reviewed and on the basis of last budget, it should be updated as soon as possible.
- The capacity level of business should be determined and the constraints of the company while generating sales should be classified and their impact on company's revenue growth. They should be able to determine available fund during the budget period and step cost which can occur in business activity is also been determined.
- Budget package should be created from the preceding year and it should be issued personally wherever it is possible(Zeller and Metzger, 2013).
- Revenue forecast should be obtained from the sales manager for validation with help of CEO. Budget from all departments should be obtained and tries to rectify the error.
- All capital budget should be obtained for validation with the help of senior management team for suggestions and recommendations. Budget model should be updated in a master budget model. Budget should be reviewed along with senior management and all the last alterations should be done.
- Finally, the budget will be issued to all authorized recipients and it will be loaded in financial software.
If budget is developed properly then it allows business to track the financial position of their own. It gives long term planning for everything such as operating costs to expansion. It benefits the business by identifying potential for attracting new investors, goal setting ability, line of credit, decision making about salaries, bonus and easy tax preparation(Hansen, 2011).
1.2 Cost drivers of business and traditional budgeting approach
Cost driver can be classified in two categories i.e. internal and external forces . It cause change in cost of any activity. Overhead cost should be assigned properly to the number of units which are produced. In external, it includes government regulations,weather, access to resources, location and most important is the workforce. In internal, it includes indirect costs, overheads, personnel and capital. If business is registered l with specific regulations which are governing day to day operations. Workforce leads that the business operation is being performed by the workers properly or not. The cost driver in manufacturing sector may be number of steps or processing time for producing a product. The cost driver of service sector can be compensation package of cost for labor.
Traditional budgeting is used for projecting business expenses and revenues for the coming year on basis of previous year budget. It also helps in predicting profits. Previous year's budget can be used for adjusting changes which are caused due to inflation. Past budget's revenue can be used for traditional budgeting process(Myers, 2018). It also helps in decision making and budget always makes easy in sorting out issues and according to that issues can be resolved as soon as possible. If the budgeted expenses are exceeding then business expenses can be reduced or alternative vendors can be checked out for different prices. Traditional budget provides a plan that how business can be operated. If there is requirement of finance, then too, traditional budgeting can be used. All investors and lenders always give priority before investing or giving loan to keep track on financial plans of that particular company. So, traditional budgeting helps in forecasting the projections related to revenue, expenses and all as well as proper reasoning with the specific preference to previous year’s budget. Traditional budgeting is a part of organizational culture for most of the companies. Practicing fundamental method of operating can be a risky decision.
1.3 Whether traditional Budgetary system is appropriate or not there are basically three major problems with traditional budgeting which are as follows:
Time consuming and expensive: Traditional budgeting consumes too much time and many management resources. Only some people have the mentality that this is worthwhile. Many companies take six to eight months, . Mostly, budgets require input and very detailed and even negotiation of many people is throughout the company, which only sums up the number of resources which are used by traditional budgeting.
The main reason for consuming too much time is use of spreadsheet which contains inherent shortcomings like issues related to version control, data entry errors and difficulty in accurate formulations.
Unrealistic objectives: Usually, the senior executives set goals which have specific guidelines in context of expenditure and specific revenue growth target. Specific goals like increasing revenues by 20% and cutting cost by 10%. The department managers who have the responsibility for getting these results are not asking or trying to this then it is next to impossible. The objectives cannot be achieved by lower level if top level is not giving top solicit input.
Fixed, flexible and easily irrelevant – Traditional management quickly becomes irrelevant i.e. once the budget has been made then it is fixed that no changes can happen. In the initial stage, it is top down but afterwards it becomes bottom up to meet fixed goals which are set by management(Oseifuah, 2018). If market conditions, economy or industry changes, new entrants may emerge. Innovations, partnerships or any other internal factor with the repercussions may occur. But budget cannot be changed in the traditional approach.
Executive and Employee compensation against budget: Many companies negotiate over achieved benchmark of budget so that they can easily accomplish their goal. Most of the companies tries to execute and employee compensation which are directly related to performance against the budget. Traditional budgeting process usually focuses on reduction of cost more than creating value. So, there is a disconnection from strategic plan or the strategic initiatives are given with low priority(Østergren and Stensaker, 2011).
Fails to motivate: The desirable behavior of people has not been encouraged in traditional budgeting system. It always gives unprofessional attitude in budget center mangers, bureaucracy and vertical control has been strengthened in this approach and it undervalues the employees. Reinforcement of departmental barriers instead of sharing knowledge.
2.1 Alternative Budget methods
Rolling Budget methods – It is a plan which is updated in which time frame remains same and it is not static. It renews the budget for next period and information is incorporated from the experience which is to be build (No and Park, 2018). Rolling budget are up to date than static budget. They do not require huge investment of money and time for planning. All the alterations are incorporated from previous period. This is more responsive to all unexpected changes. Performance can be assessed against rationalized and realistic targets. On the other side it is similar to form new budget again. It regularly requires facts and to gather them from previous period or robust information system is required for extracting specific information for sub categories. Constant revision distracts or disturbs the employees. Rolling budget is not recommended when conditions are not changing constantly. For unvarying environment it is waste of time.
Zero based Budgeting – It is a reverse approach of traditional budgeting. Managers review the budget of previous year in traditional budgeting but in zero base budgeting managers justify all expenses which are budgeted, not only of previous year. The baseline of ZBB is zero not last year's budget. There is a proper allocation of resources and it helps managers to improve activities by cost effective ways. Criteria are not always easily identified so this is an advantage for service departments. It is time consuming as sometimes the expenditures are very difficult to define for managers. Every expenditure needs to be defined in zero based budgeting so this requires huge manpower and even knowledge is required so proper training has to be given to managers. Risk has been faced by managers in zero based budgeting because the volume of data is very large and no one has that much ability to know every detail of everything. Consistency of manager must be uniform and reliable.
Activity Based Budgets : This method is designed to give transparency in the budget process. It records, analyses and researchers activities which increases the cost to the business. The major disadvantage is the consumption of resources of organization. If there is a too much spending then activity base budgeting becomes counterproductive. It does not substitute any of the process but sums up to the administrative activities of the company. It focuses on immediate and short term and avoids long term.
2.2 Application of Alternative budget methods with example
Rolling Budget methods : Rollings budget reduces uncertainty in budgeting as they give proper concentration on the short term especially when the degree of uncertainty is less. Budget can always be extended into future normally for twelve months. Accurate budget leads to specific planning and control. Reassessment of the budget is always be forced to the management in Rolling based budgets. It saves cost and time as compared to traditional budget which helps for timely adjustments of income and expenses.
Zero based Budgeting : Staff involvement has been increased at all the levels in zero based budgeting because in this method lots of information, facts and work is required for completing the budget. Allocation of resources should be more economical and efficient. Organization's knowledge and understanding of cost behavior pattern will be enhanced. It is more responsive to business environment. The operations which are not efficient and obsolete cab be discontinued. It also helps in identifying the opportunities for outsourcing. It increases the coordination and communication about some important decisions about the company.
Activity Based Budgets : It focuses on cost of overheads which is huge proportion of aggregate of operating costs. It identifies the activities which increases the cost and if cost is been controlled then it should be properly managed and understood. The most essential one is that it gives information in total quality environment, by relating level of service provided and cost of an activity.
2.3 Which method is more efficient
Companies of some industries always incorporate different variety of inputs for the creation of services and goods which are sold by them. There is the presence of wide range of expenses. As these companies can directly allocate costs to one of the most appropriate activity, cost management and budgeting of these firm to improvise there financial position. Assignment of cost is on the basis of activity Based costing. It allocates fixed administrative and overhead costs to the activities which also incur cost. Factors which are related to cost for activity based costing have a direct relationship with the particular cost of overhead. Activity based costing provides cost to all those products that actually is in need of activities. This approach has been originated from manufacturing sector because it is the best method of allocating overhead costs as compared to traditional method which was using direct labor. When labor intensive was transformed to automation and capital intensive facilities and processes, these firms are in need of that method which suits new operating environment. Whenever, the product lines are produced by manufacturers in various quantity there is huge requirement of different service support levels.
It is most important for this company because it gives customized products and services and customized production environment is always in need of allocation of indirect costs to a product which gives identification of true cost. It helps in improving the processes of business such as allocation of indirect costs which is based on cost driver of product and many more factors which increases the cost. Activity based method is also used to identify all the non value added activities and for efficiently allocating resources and activities which are profitable. These methods lead to add value to continuous improvement of any organization's processes. Activity based method also identifies the wasteful products which are increasing the cost of the company. This method helps in fixing the price of the products and services that are in large quantity or incorrect. It gives transparency in budget process and it records the activities which are increasing the cost of company. It does not substitute any of the process but sums up to the administrative activities of the company. It focuses on immediate and short term and avoids long term. Hence, activity based costing improves the productivity, efficiency and it resolves the issues which are giving impact to the cost of the organization.
From the above report, it has been concluded that traditional method of budgeting is not appropriate because it is time consuming and it has many more limitations which are been discussed in this case. It can be seen in the report that Alternative budgeting method are more flexible and easy for interpret the financial position and for comparison. Along with this, it has been articulated that while choosing Activity based budgeting method for manufacturing company is very essential. It can be summarized that budgeting improves efficiency, productivity and more margin to the company if it is well managed. Thus, company should go with alternative budget method in which activity based is most appropriate.
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