What is Budgeting? | Types and Importance of Budgeting (2023)

What is Budgeting? | Types and Importance of Budgeting (1)

Budgeting Definition

Budgeting is a process of projection of revenues and expenses, cash flows, production lines, working capital requirements, capital expenditure, etc. in respect of near future years, which is based on some rationale logic about the future prospects and using the experience in past till date, presented to the management of the company for decision making.

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Explanation

  • “Budget” basically means a financial plan for the future. Plan can be made for cashflows, production lines, working capital requirements, etc. into many aspects of business, which has to be based on some estimation.
  • The budget preparer needs to consider internal as well as external factors relevant for the budget preparation.
  • The budget can be prepared for the whole of the financial statement or any one of the components of the financial statement.
  • Budgets are prepared by the finance team & presented to the management of the organization. The high-end management team basically uses budgeted information for further decision making.
  • The budget also certifies the financial health of the organization on the basis of the economic environment prevailing in the country.

Purpose of Budgeting

  • Budgets are prepared for executing various functions of the organization such as production-planning, human resource management, stores-planning, working capital management, etc. So, budgets serve the purpose of smoothening the entire purchase-production-supply chain.
  • Consistency is another purpose of budget preparation. One budget is dependent on another budget.
  • Budgets helps the different & wide spread departments to accomplish the common goal of the organization.
  • It also serves the purpose of target goals for the departments & it influences the efficiency levels of the departments to achieve the budgeted targets.
  • Budgets help different departments to understand their roles & responsibilities clearly.
  • It also ensures the availability of resources for production planning.
  • Management can ensure centralized control over different areas of the organization.
  • The budget depicts the future financial standing of the organisation since it gives a picture of sales, production, expenses, machineries & cash flows that are probable in the future.
  • This early intimation helps organisations understand & mitigate the probable losses or risks to arise in future.

Budgeting Process

The budget is like a blueprint of the organization’s future products, services, markets & everything they wish to grow into. Thus, the process of budget preparation is very important to understand.

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Step 1: Objective

  • This is the base for the preparation of the budget.
  • The objective can be cost savings, exploiting the new market segments, new products, etc.

Step 2: Management of Resources

  • Each figure requires some resources to work on.
  • Thus, management needs to decide on the availability of critical resources required for the accomplishment of the job.

Step 3: Estimation

  • Budgets are prepared on the basis of estimations. Thus, the company needs to have a basis for their estimations.
  • Estimations can be made on the basis of past experiences or modifying past experiences to fit future prospects.

Step 4: Approval

  • After the budget plans are ready, these are presented for approval form the budgeting committee of the organization.
  • All assumptions are studies in detail to justify the figures to the higher management.

Step 5: Disbursal of Funds

  • Once the budget is approved, the details are circulated to the finance team of the organization.
  • Finance is the blood for any of the activities in the organization.
  • Thus, funds are distributed across the units so that they can strive to manage the targets.

Step 6: Control, Monitor & Evaluate

  • The job is not done only by just distributing the funds. The management needs to monitor whether everyone is going correctly as per the plan.
  • Management further needs to amend the budget wherever required on the basis of the actual position.
  • Frequent evaluations are important to achieve the common goal of the organization.

Types of Budgeting

Each budget is prepared on the basis of the current financial standing of the organization. Here are some of the basic budgeting types:

What is Budgeting? | Types and Importance of Budgeting (10)

TypesExplanation
Base Budgets
  • We can also call this budget as a “going concern” budget. This is a basic budget prepared by the organization.
  • This defines the basic revenues & expenses that will help the organization to survive in near future.
  • As you understand by the word “going concern”, the organization is currently having only cash profits. Its focus is to strictly cut on the expenses to every extent possible.
  • This budget will only outline the expense which is of utmost necessity to keep the organization in track.
Activity-Based Budgets
  • This is a cost-saving budget. The focus is on the expenses incurred on each activity of the organization.
  • Organizations that are in the business for more than 5 years, typically prepare such budgets with the intent to cut down costs on few activities.
  • For example, hiring employees is an activity. Instead of outsourcing the hiring activity, the company can decide to do in-house interviews to select appropriate employees.
  • This budget should also specify the alternative means of doing the same activity.
  • Under this heading, different budgets may be prepared for the different activities of the organization.
Zero-Based budgets
  • As the name suggests, the budget is prepared without referring to past experiences & starting afresh. But that does not mean, to say ad hoc figures. Obviously, there has to have a basis for your thought.
  • Please note, zero-based budgets do not mean baseless or vague figures.
  • This helps an organization to develop innovative methods in doing certain activities within organizations.
Kaizen Budget
  • “Kaizen” is a Japanese word that means “change for better”. It also means continuous improvement in different phases of the organization.
  • Here, the main purpose of continuous improvements in quality, sales & costs.
  • Japanese firms never compromise with the quality front of the products.
  • This methodology of budgeting helps the organization to strive for cost-cutting together with achieving the best quality.
  • This budget is normally made for longer terms than other budgets.
Traditional Budget
  • Tradition means “having a base from past experiences”.
  • The traditional budget starts from a basic figure. Economic prospects such a growth, industry risk & trend are kept in place for the preparation of budgets.
  • Traditional budgets are also called incremental budgets

Importance of Budgeting

The following are the importance are:

  • The budget serves the purpose of communicating the common goal of the organization. If the units do not have a common goal in place, there results would be absurd.
  • The budget is a formal estimate & it contains figures to explain the situation. It also provides a quantifiable goal to the employees for production targets & sales targets.
  • With the budget in place, each department has a target to achieve their goals.
  • Budgets are connected through numbers. With the cost-cutting budgets, the departments can also prove their achievement by cost saving on the unrequired expenses. This approach helps cost-savings together with maintaining the quality of work.
  • This also becomes a basis for seeking bank finance or preparing for the Initial Public Offer of the company.
  • Budgets give convincing evidence to the stakeholders about the future prospects of the company.

Advantages of Budgeting

Some of the advantages are:

  • The management can have a small picture of past performances through the budgeted figures.
  • Management can also understand the rationale or assumptions used in preparing the budgets. It can then work on improving the basic assumptions underlying the budgeted figures.
  • It further helps the management to rebound or revamp the organization before it’s too late.
  • Budget becomes a medium of communication amongst the employees and different departments.
  • Management can see all the primary activities of the organization in one document.
  • It further helps the employees as a medium of motivation.
  • Management can also take corrective actions for the departments which are not supporting the common goal of the organization.
  • Most importantly, the co-ordination amongst the different units of the organization improves a greater extent than earlier.

Disadvantages of Budgeting

Some of the disadvantages are:

  • Biasness in preparation of the budgeted figures can be a major turn off for the organization. No one can easily predict the business implied in any projection.
  • With increased expectations, some employees may have to suffer corporate politics due to internal targets. So, the approach & mindset of the employees drive the business targets.
  • Too high is too difficult to achieve. Budgets should specify the achievable targets. High expectations can result in miserable results for the organization.
  • Lack of flexibility in budgets may demotivate the employees.
  • Rigid budgets are inception for a downturn of the growth of the company as a whole.
  • Rigidity in budgets does not give ample space for employees to think out of the box. Creativity is also hampered.

Conclusion

We all need planning for the future. So does the organization, need a plan for its survival in near future. The absenceof budgets means a journey without a destination. Budgets are the basic necessities for decision making. Different budgets are prepared for each different purpose. The basis of budget preparation varies according to the current financial standing of the organization.

Recommended Articles

This is a guide to What is Budgeting?. Here we also discuss the definition and purpose and process of budgeting along with advantages and disadvantages. You may also have a look at the following articles to learn more –

  1. Budgeting Career
  2. Project Budgeting Template
  3. Activity Based Budgeting
  4. Flexible Budget

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