The following is a post to from Patrick Mackaronis. Patrick is the Director of Business Development for New York City-based social network Brabble. In this post , Patrick speaks about how budgets steer effective management . Patrick can be best reached on Twitter at @patty__mack.
The benefits of developing sound budgeting procedures for an entity are varied. The primary among these is that budgets are important tools that guide the firm against over expenditure. By having a budget an organization presents the method through which it can use the available resources prudently to achieve the projected performance.
How Budgets can be Used to Evaluate Responsibility
Budgets can also be used to assess the management’s ability to control a firm’s resources in achieving set goals. The success of a firm’s strategy is for instance determined by how well the actions to achieve the strategy are planned for. As noted in “A Guide for Managers to Assist in Informed Discussion” (Palmer) comparing outcomes of such actions to budgeted outcomes provides an important feedback to inform on the appropriate corrective action.
The importance of such comparison is heightened for organizations that are organized into responsibility centers. Organizing a firm into responsibility centers as noted in a journal article (Schoute), is essential for effective management of modern-day huge sized firms where a centralized management approach may not be beneficial. The responsibility centers may either comprise one or more of; cost, revenue, investment and profit responsibilities.
Comparing the results of each center to the budgeted amounts provides information on which an opinion to the leaders’ capacity to use the firm’s resources effectively is built. Such comparison is mainly through variance analysis. A variance in this respect denoting that amount with which the actual performance deviates from the budgeted values. By focusing on the differences between actual and budgeted values the management is able to pay close attention to deviations that show wide differences.
Variances can either be favorable or unfavorable. A negative figure, for instance, denotes adverse performance while a favorable performance is denoted by positive integers. Wide differences could however indicate unforeseen economic events or poor budgeting skills rather than management’s responsibility know-how. Thus, as the manager’s guide advises, punishing deviation may not be the best corrective action; but concentrating on the necessary actions rather than the reasons for the deviations would provide better outcomes.
How to Construct Effective Budgets
Only well constructed budgets provide credible information to base managerial decisions. In constructing a master budget for instance, the knowledge of association of its different components is essential. Calculation of different components of the operating budget such as sales, cost of goods sold and operating income also require astute knowledge of prevailing market rates and the unused capacity that the entity may employ.
The relationship between the operating budget, financial budget and capital expenditures budget in the master budget should also be determinable. Items such as projected cash sales and inventory purchases in the operating budget, should for instance, be reflected in the sources and applications of funds presented in the financial budget. With good forecasting skills the constructed budget can thus present a reasonable guide to effective use of the entity’s resources.