The state university of Tula
An essay on
by Artur Tatarchukov,
In a market economy, an enterprise that enjoys a sustainable profit from its activities is considered to be prosperous. This task-maximum can be implemented on a stable basis through budgeting. As you know, the leading role in coordinating the activities of market entities belongs to prices; they determine the profitable volumes and methods of production for participants in economic relations. Every enterprise has to subordinate its actions to the price mechanism, the law of supply and demand, since no one is able to cancel their action. However, in the internal structure of each enterprise, the price mechanism is replaced by the conscious actions of the administration, managers and other specialists. Therefore, the activity of the enterprise is regulated through the adoption of planned decisions. From this position, planning should be considered as a mechanism that replaces prices and the market in the internal activities of the enterprise and is carried out by budgeting.
The concept of «budget» is used not only for the national economy, but also for a particular enterprise. At the same time, the budget is understood as the plan of economic activity of the enterprise for the current budget period — usually a quarter or a year. Distinctive features of budgeting at the enterprise level are: formalization, centralization, system.
Currently, most enterprises are experiencing difficulties associated with the process of budgeting. In this work I’ll try to describe the procedure for drawing up a consolidated budget for the enterprise, the methodology for monitoring and analyzing its implementation, and a set of measures to improve the effectiveness of budgeting in the enterprise.
- The essence, goals and tasks of budgeting
Usually the word «budget» is more associated with the development of economic policy on a national scale. It is less known that the budget can be developed and approved not only for the entire country, but also at the micro level, as part of the planning of the activities of an individual enterprise. We can say that in addition to «state budgeting» there is also «corporate budgeting» which refers to the system of «through» (complex) planning, control and analysis of the economic activities of the enterprise that has been put on a regular basis. It should be noted that the terms «budget» and «plan» are not identical. The budget is a quantitative expression of centrally established indicators of the enterprise plan for a certain period of:
— the use of capital, material and financial resources;
— attraction of sources of financing of current and investment activity;
— income and expenses;
— cash flow;
— investments (capital and financial investments).
When compiling the budget, the main characteristics are:
The term «formalization» means that the budget is, first of all, a set of figures. The plan, in addition to budget digital indicators, usually includes a list of specific activities to achieve these indicators. Another significant point is that the budget covers only centrally set by the management apparatus (directive) indicators for individual units (responsibility centers). The methodology of budgeting at individual enterprises may differ: there is a top-down planning (the budget drafts of departments are developed by the services of the management apparatus); «From the bottom up» (budget drafts are developed by the units themselves); counter-planning (budgeting projects are developed by departments with subsequent adjustment by the services of the management apparatus). However, in the end, the approval of budgetary indicators occurs through the line «management apparatus — a unit (the center of responsibility for the implementation of approved budget indicators).» Thus, budget indicators are always set «top-down» by the central body (management apparatus) of the enterprise and are compulsory for execution by structural subdivisions — the centers of responsibility. An exception is the drawing up of an indicative budget, which sets the targets for the enterprise development strategy for the long-term perspective and has a recommendatory character for the company’s divisions. It should be noted that the budget includes only the targets set by the central body (management apparatus) of the enterprise, which the object of budgeting (structural unit) is obliged to fulfill. «Systematic» means that in budgeting, the aggregate of the budgets of individual responsibility centers compulsorily forms the consolidated budget of the enterprise as a whole. Ultimately, the object of budgeting is the business of the enterprise as a whole, and the budget indicators for individual departments and for certain segments of economic activity are established based on the criterion of maximizing the final financial results of the enterprise as a whole, rather than improving the effectiveness of this particular segment. The budget of the enterprise, like the state budget, is always developed for a certain time interval, which is called the budget period. The enterprise can simultaneously make several budgets that differ in the duration of the budget period (current quarterly budget, medium-term annual budget, long-term «development budget» for 3 to 5 years, etc.). The correct choice of the duration of the budget period is one of the important prerequisites for the effectiveness of the budget planning system as a whole. It is also necessary to distinguish between the concepts of budget and budgeting. The budget, as already mentioned, is a document full of quantitative indicators, according to which the enterprise conducts its economic activities. Budgeting is the process of compiling and implementing this document in the practical activities of the company. The budgetary process is not limited to the stage of drawing up the consolidated budget. The stages of the budgetary process are shown in Fig. 1. Thus, the budget cycle is a period of time from the beginning of the first stage of the budgetary process, i.e. compilation of the consolidated budget, until the completion of the third stage — plan-fact analysis of the implementation of the consolidated budget. Ideally, the company’s budget process should be continuous, i.e. the completion of the analysis of the implementation of the budget of the reporting period should coincide with the development of the budget for the next period.
Fig. 1. The stages of budgeting process
The main condition for ensuring the continuity of the budgetary process is the correct methodology for conducting a «through» plan-fact analysis of budget implementation, on which basis the figures for budget indicators of the next period are formed, i.e. plan-fact analysis is both the starting and final stage of the budget cycle. Currently, budgeting is a time-consuming and inefficient process. Planning and economic services prepare a huge number of documents, while most of them are not suitable for financial analysis. Budgeting is time-consuming, which makes it unsuitable for management decisions. With the existing system of budgeting, it is impossible to conduct scenario analysis and analysis of a company’s financial stability to changing operating conditions. Proceeding from the above, it follows that the main objective in budgeting is the coordination of all aspects of the enterprise’s activities. The tasks that are supposed to solve budgeting can be formulated as follows:
— Budgeting is necessary for understanding where, when, how and for whom you are going to produce and sell products;
— Budgeting is necessary to determine the volume and amount of resources needed to achieve the goals;
— Budgeting is necessary for effective use of attracted resources.
- Analytical, accounting, organizational and program-technical aspects of budgeting
To introduce the budgeting system into the practice of enterprises, a number of mandatory conditions are necessary, without which this system simply cannot work. First, the enterprise should have the appropriate methodological base for the development, monitoring and analysis of the implementation of the consolidated budget, and the employees of management services must be sufficiently qualified to be able to apply this methodology to the plan-fact analysis of the implementation of the budget. The methodological basis for drawing up, monitoring and analyzing the implementation of the consolidated budget is the analytical block (or component) of the budget process. Secondly, in order to develop a budget, monitor and analyze its implementation, it is necessary to have adequate quantitative information on the activities of the enterprise, sufficient to visualize its real financial condition, the movement of commodity-material and financial flows, and basic economic operations. Consequently, the enterprise must have a management accounting system that records the facts of economic activity necessary to ensure the process of drawing up, monitoring and analyzing the consolidated budget. The management accounting system at the enterprise forms the basis of the accounting component of the budgetary process. Thirdly, the budget process is always implemented through the appropriate organizational structure and management system existing in the enterprise. The concept of organizational structure includes:
— the number and functions of the services of the management apparatus, whose responsibilities include the development, monitoring and analysis of the enterprise budget;
— a set of structural units that are objects of budgeting, i.e. those responsibility centers to which the budget plan is assigned and who are responsible for its implementation.
The budgeting management system is a procedure for interaction between the services of the management staff and structural divisions, which defines the responsibilities of each division in each of the stages of the budget process in the relevant internal regulations and instructions. Since the budget process is continuous and repetitive, in the same way regularly, at the appropriate time, the accounting information necessary to provide it must flow into the management apparatus from the structural units. On the other hand, structural subdivisions should receive in a timely manner from the administration of the budget task and adjustments made to it during the budget period. Consequently, the most important component of the budget process regulation is the internal document circulation — a set of regular information flows of the enterprise’s divisions fixed in the relevant internal regulations and instructions in the process of developing, monitoring and analyzing the implementation of the consolidated budget. The organizational structure and the management system constitute the organizational component of the budgetary process. Fourth, in medium and large enterprises, the process of developing, monitoring and analyzing budget execution involves the registration and processing of large amounts of information, which is difficult to do manually. In the budget process, the level of responsiveness and quality of accounting and analytical work is significantly increased, and the number of errors is reduced when using software and hardware (computer databases and software). Software and hardware used by enterprise structures involved in the budget process constitute the software and hardware component of the budgeting system. All four components of the budget process are closely related and constitute the infrastructure of the budgeting system in the enterprise.
Thus, for example, internal workflow is at the junction of the accounting and organizational blocks, since, on the one hand, it covers a set of information flows directly determined by the current management accounting system, on the other hand, it is rigidly fixed by internal regulations in the form of a number of internal regulations, and this is already part of the management system. It is also difficult to distinguish between the accounting and analytical blocks, because the processing of information for management purposes, including the calculation of coefficients, data structuring begins already at the stage of compiling accounting registers. Many enterprises do not receive the proper effect from the budgetary process, since they take for it a completely different process — the work of the accounting and accounting system. The result can be a systematic failure to fulfill plans. In particular, one of the important components of the infrastructure of the budgetary process is the planning methodology. There are no universal recommendations for compiling such techniques: often heuristic planning algorithms show more accurate results than classical ones. However, we can distinguish several typical problems. The first problem is the lack of methods themselves. Even if the financial service itself seems to think that all names in graphs should be read unambiguously, there will always be a subdivision that understands this in its own way. Accordingly, already at the stage of aggregation, there will be significant «assumptions». The second problem is the internal shortcomings of the techniques associated with their non-reflection of reality. The most significant difficulties are associated with the planning of cash flow: it is here that problems often arise that are caused by the fact that actual relationships with counterparties are not taken into account. Another problem related to the application of planning techniques is the lack of provisioning, i.e. «tight» planning . It is desirable that reserves exist at all responsibility centers. In order to understand how adequate the existing methods of planning are for the actual needs of the business, they must be analyzed not only from the point of view of the proper performance of «arithmetic» action, but also in terms of the actual results of their application, as well as from the point of view of the environment. Speaking about the requirements for the second component of the budget process — the accounting system, the following points should be distinguished :
- Ensuring the reliability of reporting in terms of mandatory requirements.
- Protection against unauthorized access.
- Single entry of data, i.e. a unified database of operations for all types of accounting (accounting, tax, management, IFRS).
- Providing the necessary analytics for the following purposes:
— the possibility of comparing the plan and the fact;
— the possibility of separating permanent and variable, direct and indirect costs;
— the possibility of conducting a margin analysis;
— the possibility of implementing additional internal control procedures.
One of the tasks of the accounting system is to ensure the reliability of the financial statements of the enterprise. It should be noted that any management reporting is desirable to approximate IFRS standards, because such reporting best reflects the real picture. Typical problems of ergonomic accountability are the following:
— An excessive amount of information in the reports;
— decrease in information content due to aggregation of information;
— lack of comparison with the planned indicators or indicators of the previous period;
— use of data «on payment» and «on shipment».
It should also be noted: within the budgeting system, special attention should be given to structuring, i.e. creation of process model of the enterprise. After all, it is necessary to budget the outputs of business processes, and more specifically those that represent the movement of material and financial flows. In this case, there is a contradiction between the existing organizational structure and the structure of the processes. The options for resolving this contradiction may be as follows:
- «Hard option» is a complete reform of the organizational structure, including re-subordination of departments and officials. Possible consequences of such a decision: the resistance of subordinates, the dismissal of valuable employees.
- «Soft option» is the formation of a financial structure on the basis of the organizational one, while the heads of services, in addition to their functional duties, are also responsible for the implementation of budget plans.
- «Compromise» — the adoption of the organizational structure with the subsequent modification of it to obtain a financial structure, for example, the unification of units that are homogeneous in terms of functionality in one Center of Financial Accountability.
Within the organizational block of the infrastructure of the budgeting system, special attention should be paid to the motivation component.
It is a common situation when those responsible for achieving specific indicators are not assigned, and their material incentive from these indicators is, at best, halved. This leads to the fact that most employees are indifferent to the achievement of results, especially if they are objectively overstated. It should be concluded that when developing a motivation system, it is necessary to determine which unit affects which result. And the motivation of each of the units should be based precisely on such indicators as strategic and tactical. Also an important problem of the motivation system is too much complexity. Regardless of the basis on which it was developed, the number of indicators will tend to increase. Therefore, it is necessary to strive for the adequacy of the motivation system: the average employee should be responsible for not more than 3 to 5 indicators, and the top manager — for 5 to 7 indicators.
When developing the fourth element of the infrastructure of the budgetary process — automated budgeting systems, it is necessary to pay attention to the following issues:
— training in the principles of building and operating a budget management system for future users;
— use of the same managerial analytics for planning, monitoring and analysis of activities;
— determination of responsibility for drawing up plans for their implementation, recording and registering results, as well as for subsequent analysis;
— a clear description of the rules of interaction between departments in the process of drawing up and executing budgets;
— Integration of the automated budgeting system with the existing accounting and analytical system.
- Types of budgets and their classification
The consolidated budget of the enterprise consists of three budgets of the 1st level — operational, investment and financial. Often in economic literature, the financial budget is defined as a «cash flow budget» or «monetary budget». This is not entirely correct, since the purpose of drawing up a financial budget is not only the planning of the company’s cash receipts and expenses, but also wider, of all current assets and short-term obligations as the main factors determining the current solvency of the company.
The operational budget focuses on modeling future expenses and revenues from current operations for the budget period. Consequently, the object of review of the operational budget is the financial cycle of the enterprise.
The investment budget considers issues of renewal and retirement of capital assets (fixed assets and investments, long-term financial investments), which is the basis of the investment cycle.
The purpose of the financial budget is the planning of the balance of cash receipts and expenditures, and in a broader sense — the balance of current assets and current liabilities to maintain the financial stability of the enterprise during the budget period.
The «output» results of the budget process are the plan forms of the consolidated financial statements:
- a statement of financial results (profits and losses) — the «output» form of the operating budget;
- a statement of cash flows and a statement of changes in the financial condition — the «output» forms of the financial budget;
- investment reports — «output» form of the investment budget;
- balance — an integral «output» form, combining the results of all three main budgets, which constitute the consolidated budget of the enterprise.
In turn, some Tier 2 budgets are made up of Tier 3 budgets, Tier 3 budgets can break up into 4th level budgets, etc., depending on the scale and variety of the company’s business operations.
In the budget process, the concepts of «costs», «expenses», «unplanned expenses» will be used as synonyms, because in the theory and practice of management accounting, a number of stable definitions have historically been developed with the inclusion of these terms.
On the levels of joining the consolidated budget of an enterprise, budgets can be classified as follows.
Master budget is a plan of the enterprise for a set period of time (budget period), expressed in a number of target (budget or planned) indicators covering all business segments of the enterprise and its organizational units. In economic literature there are often definitions of «core budget», «consolidated budget». The master budget consists of three sub-budgets of the 1st level: operational, investment and financial.
The operational budget is a sub-budget of the 1st level, which is part of the master budget of the enterprise and is a plan of revenues, costs and final financial results (profits) of the enterprise for the budget period. The operational budget consists of a number of sub-budgets of the second level: the budget of sales, the production budget, the budget of finished goods stocks, the budget of permanent (general and general commercial) expenditures, the procurement budget.
The investment budget is a sub-budget of the 1st level, which is part of the master budget of the enterprise and is a plan for capital expenditures and long-term financial investments of the enterprise for the budget period. In literature, there is also a definition of «capital budget».
The financial budget is a sub-budget of the 1st level, which is part of the master budget of the enterprise and is a plan of:
— Firstly, cash receipts and expenditures;
— Secondly, the movement of all marketable resources (working capital) and current liabilities of the enterprise for the budget period.
In the economic literature, there are also definitions of «monetary budget», «budget of cash flow.»
The sales budget is a sub-budget of the second level, which is part of the operational budget and is a plan of revenues from sales, physical volume and structure of sales, cost of sales and direct commercial sales costs of the enterprise for the budget period.
The production budget is a sub-budget of the second level, which is part of the operational budget and is a plan for the physical volume and structure of output (production program) and production costs of the enterprise for the budget period.
The budget of stocks (finished goods) is a sub-budget of the second level, which is part of the operational budget and is a plan for changing the cost and physical volume and structure of the finished goods stocks of the enterprise for the budget period.
The procurement budget is a sub-budget of the 2nd level, which is part of the operational budget and is a plan for the procurement of material current assets (raw materials, parts and components) and changes in the inventories of the company’s material circulating assets for the budget period. In the literature, there are also definitions «supply budget», «procurement budget».
The budget of constant expenses is a sub-budget of the second level, which is part of the operational budget and is a plan for permanent (general and general commercial) expenses of the enterprise for the budget period.
The budget of production costs is a third-level sub-budget, which is part of the production budget and is a plan for the size and structure of production costs for the budget period.
The budget of sales (direct commercial) expenses is a sub-budget of the third level, which is part of the sales budget and is a plan for direct commercial expenses in the context of marketing certain types of products for the budget period.
The budget of direct material costs is a sub-budget of the 4th level that is part of the production cost budget and is a plan for direct production costs in terms of spending material and financial turnover resources (raw materials, materials, components, subcontracting for outside organizations) for the budget period.
The budget of direct labor costs is a sub-budget of the 4th level, which is part of the production cost budget and is a plan for direct production costs in terms of direct labor costs for the budget period.
The budget of general production expenses is a sub-budget of the 4th level included in the budget of production costs and is a plan for all indirect production costs of the enterprise for the budget period.
The report on financial results and their use is the main planned reporting document of the operational budget, containing data on the size and structure of revenues, the cost of sales and non-operating expenses and final financial results (marginal revenue, balance and net profit). Another name is the profit and loss account.
The investment report is the main planned accounting document of the investment budget, containing data on the size and structure of investments (capital and long-term financial investments) of the enterprise for the budget period.
The cash flow statement is one of the two main planned accounting documents of the financial budget, containing data on the size and structure of the company’s cash receipts and expenditures for the budget period.
The report on the change in the financial condition is one of the two main planned accounting documents of the financial budget, containing data on changes in the size and structure of current assets and short-term liabilities of the enterprise for the budget period.
The management balance is the main planned and reporting document of the master budget, containing data on changes in the size and structure of assets and sources of financing of the enterprise for the budget period.
The development budget is one of the options for drawing up a long-term budget, in which the investment budget has not only a spending but also a revenue part, defined as income from investment for the investment cycle (useful life of investments).
The indicative budget is one of the options for drawing up a long-term budget, in which budget indicators are not mandatory for the responsibility centers (divisions) and serve as long-term business development guidelines when the units perform a budget assignment for the current (short-term) budget period.
In the budget process of the enterprise, the establishment of the budget period is very important. It is necessary to understand that the duration of the budget period is sufficiently determined by the industry and individual specifics of the company, as well as by the characteristics of the macroeconomic environment in which it operates. Usually, the key principle on the basis of which the duration of the budget period is determined is the excess of strategic planning over operational management. In other words, the current activity of an enterprise is determined by the strategic goals of its development, and not vice versa.
So, the basis for drawing up consolidated budgets is a strategic plan that defines the main priorities and development goals (including in quantitative terms) and outlines the mechanisms for achieving the set goals. Based on the strategic plan, three consolidated budgets are developed: one short-term budget and two long-term budgets (development budget and indicative «rolling» budget).
Budgets differ in regard to terms, functions, degree of mandatory execution, the possibility of adjustment.
Short-term budget (1-3 months). For many enterprises, the most optimal term for short-term (current) budgeting is 3 months (quarter). This coincides with the frequency of the compilation of fiscal reporting (quarterly consolidated financial reports submitted to the tax inspection), which largely facilitates the work of the accounting department of the enterprise, which is the main «information» center of the enterprise. The short-term budget is characterized by the following:
- Obligatory performance. Short-term budget is a law for the structural divisions of the enterprise and their managers. Non-fulfillment of budgetary indicators was seen as a disruption of the fulfillment of the plan in past times. Accordingly, the units were automatically deprived of bonuses, organizational conclusions were made.
- Lack of adjustment. Short-term budget is adjusted in exceptional cases with the sanction of the top management of the enterprise. Adjustment of the short-term budget can be caused only by force majeure (sudden change in market conditions, unexpected government decision, etc.). The results of the short-term budget are summed up on the basis of a comparison of the actual indicators with the planned ones established at the beginning of the budget period.
- The global character of the control and stimulating function of the budget. Based on the execution of the budget, all the personnel of the enterprise are awarded, or are depressed, certified, promoted or demoted in their posts and wages, up to the top management.
- High level of detail of budgetary indicators. So, for sales divisions not only the aggregate value of the planned volume of sales is established, but also its structure by types of products. Production units receive a budget, disaggregated by cost item in the context of individual production lines. Management services as an integral part of the budget assignment are required to comply with the rigidly established staffing schedule, the amount of travel and administrative expenses, etc.
Development budget (1 year). This budget is a long-term one. It is characterized by the following:
- Obligatory performance. At the beginning of the year, the company accepts a short-term budget (for a quarter) and a development budget (for 1 year), and further adoption of quarterly budgets goes within the development budget.
- Ability to adjust. Adjusting the indicators of the development budget is common, while the adjustment of the budget indicators of the current quarter, as a rule, is not allowed. This is due to the fact that for a period of 1 year, the uncertainty of the macroeconomic situation is very high and plays an important role in achieving the originally planned indicators. In this regard, the quarterly budget for the 4th quarter is the difference between the adjusted development budget and the overall planned indicators for the I-III quarters.
- Selective character of the control-stimulating function. For the achievement and overfulfilment of annual indicators, as a rule, managers of structural divisions (higher and middle management), rather than ordinary employees of subdivisions, are awarded. This is due to the fact that usually staff turnover is much higher among ordinary employees than managers. Therefore, ordinary staff is more interested in short-term remuneration for work, while managers look at their prospects within the framework of this enterprise.
- Fewer details of budgetary indicators. In the development budget, most often, only integral values are fixed, for example, the gross sales volume, the overall cost estimate of the unit, etc. This is quite reasonable, since the lower-level budget indicators are only a means of achieving aggregate cost targets, and not an end in itself.
- The availability of a revenue component in the investment budget (sub-budget level 1, included in the consolidated budget). When drawing up the investment budget for the current period (month or quarter), the planning for the disbursement of funds under long-term investment programs is made from the achieved level (at the beginning of the period) in accordance with the investment budget included in the development budget. In other words, the long-term investment program as a separate planning object (including the parameters of aggregate capital and operating costs, gross and net revenues, payback, etc.) appears only in the long-term development budget.
Indicative «rolling» budget (1 year). This is a special kind of budget. It is adopted at the beginning of the year and is completely analogous to the development budget (i.e. at the beginning of the year only two budgets are accepted: the development budget for 1 year and the short-term budget for the first quarter). After the end of the first quarter, another quarter is added to the «rolling» budget (the first quarter of next year), after the expiration of the second quarter — the second quarter of next year, etc. This ensures continuous 12-month planning.
The adjustment of the development budget and the adoption of the next quarterly budget during the year occur simultaneously and on the basis of the development of the next «rolling» annual budget. The indicative «rolling» budget is characterized by the following:
- This budget is not only discretionary, but by definition it is never fulfilled and serves for purely analytical purposes. There is no control-stimulating function in it.
- Details of budgetary indicators in the indicative budget are the same as in the development budget.
Thus, the combination of two long-term master budgets and a short-term one allows to implement a management policy in which the strategic and current goals of the enterprise are balanced and interrelated. This approach is advisable to use in large industrial enterprises, where additional costs for planning and analytical work are justified in the context of improving the quality of management decisions.
For medium-sized enterprises, planning can be recommended on the basis of two budgets (a short-term quarterly budget and an annual development budget).
For small businesses, as a rule, it is reasonable to practice only current planning with the compilation of only quarterly budgets. Small companies, at their core, are most dependent on external factors of market conditions and at the same time they can most flexibly adjust their resource potential to market changes.
- Herbert J. Davenport — The Economics of Enterprise, 3rd edition
- Arthur O’Sullivan, Steven M. Sheffrin — Economics: Principles in Action (2003)
- Martin Ricketts — The Economics of Business Enterprise (2002)
- Ram Mudambi, Martin Ricketts — The Organisation of the Firm (2002)