Read Understanding Business Accounting For Dummies, 2nd Edition Online
Authors: Colin Barrow,John A. Tracy
Tags: #Finance, #Business
Understanding Business Accounting For Dummies, 2nd Edition (74 page)
The Reasons for Budgeting
Managers don't just look out the window and come up with budget numbers. Budgeting is not pie-in-the-sky wishful thinking. Business budgeting - to have real value - must start with a critical analysis of the most recent actual performance and position of the business by the managers who are responsible for the results. Then the managers decide on specific and concrete goals for the coming year. Budgets can be done for more than one year, but the key stepping-stone into the future is the budget for the coming year - see the sidebar ‘Taking it one game at a time'.
In short, budgeting demands a fair amount of management time and energy. Budgets have to be worth this time and effort. So why should a business go to the trouble of budgeting? Business managers do budgeting and prepare budgeted financial statements for three quite different reasons - distinguishing them from each other is useful.
The modelling reasons for budgeting
To construct budgeted financial statements, you need good models of the profit, cash flow, and financial condition of your business. Models are blueprints, or schematics of how things work. A business budget is, at its core, a financial blueprint of the business.
Note:
Don't be intimidated by the term
model
. It simply refers to an explicit, condensed description of how profit, cash flow, and assets and liabilities behave. For example, Chapter 9 presents a model of a management profit and loss account. A model is analytical, but not all models are mathematical. In fact, none of the financial models in this book is the least bit mathematical - but you do have to look at each factor of the model and how it interacts with one or more other factors. The simple accounting equation - assets = liabilities + owners' equity - is a model of the balance sheet, for example. And, as Chapter 9 explains, profit = contribution margin per unit × units sold in excess of the break-even point.
Budgeting relies on financial models, or blueprints, that serve as the foundation for each budgeted financial statement. These blueprints are briefly explained, as follows:
Budgeted management profit and loss account:
Chapter 9 presents a design for the internal profit and loss account that provides the basic information that managers need for making decisions and exercising control. This internal (for managers only) profit report contains information that is not divulged outside the business. The management profit and loss account shown in Figure 9-2 serves as a hands-on profit model - one that highlights the critical variables that drive profit. This management profit and loss account separates variable and fixed expenses and includes sales volume, contribution margin per unit, as well as other factors that determine profit performance. The management profit and loss account is like a schematic that shows the path to the bottom line. It reveals the factors that must be improved in order to improve profit performance in the coming period.
The key connections and ratios between sales revenue and expenses and their related assets and liabilities are the elements of the basic model for the budgeted balance sheet. These vital connections are explained throughout Chapters 5 and 6; Chapter 8 (specifically Figure 8-1) also presents an overview of these connections.
The changes in assets and liabilities from their balances at the end of the year just concluded and the balances at the end of the coming year determine cash flow from profit
for the coming year. These changes constitute the basic model of cash flow from profit, which Chapter 7 explains (see Figure 7-3 in particular). The other sources and uses of cash depend on managers' strategic decisions regarding capital expenditures that will be made during the coming year, and how much new capital will be raised by increased debt and from owners' additional investment of capital in the business.
In short, budgeting requires good working models of profit performance, financial condition (assets and liabilities), and cash flow from profit. Constructing good budgets is a strong incentive for businesses to develop financial models that not only help in the budgeting process but also help managers make day-to-day decisions.
Planning reasons for budgeting
One main purpose of budgeting is to develop a definite and detailed financial plan for the coming period. To do budgeting, managers have to establish explicit financial objectives for the coming year and identify exactly what has to be done to accomplish these financial objectives. Budgeted financial statements and their supporting schedules provide clear destination points - the financial flight plan for a business.
The process of putting together a budget directs attention to the specific things that you must do to achieve your profit objectives and to optimise your assets and capital requirements. Basically, budgets are a form of planning, and planning pushes managers to answer the question ‘How are we going to get there from here?'
Taking it one game at a time
A company generally prepares one-year budgets, although many businesses also develop budgets for two, three, and five years. However, reaching out beyond a year becomes quite tentative and very iffy. Making forecasts and estimates for the next 12 months is tough enough. A one-year budget is much more definite and detailed in comparison to longer-term budgets. As they say in the sports world, a business should take it one game (or year) at a time.
Looking down the road beyond one year is a good idea, to set long-term goals and to develop long-term strategy. But long-term planning is different than long-term budgeting.
