Business — Banking — Management — Marketing & Sales

Theoretical background for Budgeting methodology

Category: Budgeting Methodology

Putting together the budget for a company means to create a simulation of the

  • business activities, which the company plans to undertake during the period for which the budget is prepared, i.e. generally one year;
  • financial results which are expected from those business activities.

The budget further sets the sales, production, and cost targets (i.e. how much to sell, produce, buy at what price/cost) which have to be met by the different functions of the company in order to achieve the budgeted financial results. The budget, in this respect, is a key management tool which permits to steer, and control a company during it’s “day to day” business.

Three important preconditions, however, have to be fulfilled during the business preparation in order to enable the budget to carry out this steering, and control function.

  • (1) The budget has to be prepared as a joint and cooperative exercise involving all functions of the company. This has to be done in order to achieve full commitment of all function with regard to the set targets.
  • (2) All budgeting data, and the related targets have to be broken down into months. This breaking down into months is needed because most of the economic activity follows a monthly pattern e.g. production plans, salary/wage payments, energy bills, reimbursement of loans, interest payments, rents payments, etc. The budget has to apply the same planning pattern in order to permit monthly comparisons between budget data, and actual performance.
  • (3) The simulation of the future business activity must be realistic in order to be able to serve as yardstick for performance measurement.. In order to be accepted as a management tool by all levels of management it should be neither too tight, nor too loose. Budgeting theory designates this setting of the efficiency level as “attainable performance under efficient operating conditions”

Budgeting in the market economy, and in accordance with the functional organization which is typical for companies in this environment, always follows a certain pattern. Because in a market economy, selling of products with profit is the ultimate goal – sales are what is called in the budgeting theory a principal limiting factor — budgeting always starts with a sales budget..

For the same reason, and because they provide for summary information on the financial result of the business activities, the balance sheet, and the income- and cash flow statement for the end of the year for which the budget is prepared are the ultimately aimed at result of the budgeting exercise. A sequence of budgeting tasks (12 work-steps) which is typical for manufacturing companies is displayed on page 3.

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