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BUDGETING

Describe How and Why Managers Use Budgets

Implementation of a company’s strategic plan often begins by determining management’s basic expectations about future economic, competitive, and technological conditions, and their effects on anticipated goals, both long-term and short-term. Many firms at this stage conduct a situational analysis that involves examining their strengths and weaknesses and the external opportunities available and the threats that they might face from competitors. This common analysis is often labeled as SWOT.

After performing the situational analysis, the organization identifies potential strategies that could enable achievement of its goals. Finally, the company will create, initiate, and monitor both long-term and short-term plans.

An important step in the initiation of the company’s strategic plan is the creation of a budget. A good budgeting system will help a company reach its strategic goals by allowing management to plan and to control major categories of activity, such as revenue, expenses, and financing options. As detailed in Accounting as a Tool for Managers, planning involves developing future objectives, whereas controlling involves monitoring the planning objectives that have been put into place.

There are many advantages to budgeting, including:

  • Communication
    • Budgeting is a formal method to communicate a company’s plans to its internal stakeholders, such as executives, department managers, and others who have an interest in—or responsibility for—monitoring the company’s performance.
    • Budgeting requires managers to plan for both revenues and expenses.
  • Planning
    • Preparing a budget requires managers to consider and evaluate
      • The assumptions used to prepare the budget.
      • Long-term financial goals.
      • Short-term financial goals.
      • The company’s position in the market.
      • How each department supports the strategic plan.
    • Preparing a budget requires departments to work together to
      • Determine realizable sales goals.
      • Compute the manufacturing or other requirements necessary to meet the sales goals.
      • Solve bottlenecks that are predicted by the budget.
      • Allocate resources so they can be used effectively to meet the sales and manufacturing goals.
      • Compare forecasted or flexible budgets with actual results.
  • Evaluation
    • When compared to actual results, budgets are early alerts and they forecast:
      • Cash flows for various levels of production.
      • When loans may be required or when loans may be reduced.
    • Budgets show which areas, departments, units, and so forth, are profitable or meet their appropriate goals. Similarly, they also show which components are unprofitable or do not reach their anticipated goals.
    • Budgets set defined benchmarks that may be used for evaluating company and management performance, including raises and bonuses, as well as negative consequences, such as firing.

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