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23.1 Describe How and Why Managers Use Budgets

The Role of Budgets​

Budgets are management tools with multiple purposes:

  • Planning: Budgets define what the organization intends to achieve
  • Resource Allocation: Budgets determine where resources will be used
  • Coordination: Budgets align different parts of the organization
  • Communication: Budgets communicate priorities and expectations
  • Motivation: Budgets can motivate employees via performance targets
  • Control: Budgets provide benchmarks for evaluating actual results

Types of Budgets​

  • Strategic Budget: Long-term financial plan linked to strategy
  • Operating Budget: Short-term plan for revenues and expenses
  • Financial Budget: Focuses on cash flow, capital expenditures, balance sheet
  • Static Budget: Based on a single level of activity
  • Flexible Budget: Adjusts for different activity levels
  • Rolling Budget: Continuously updated (e.g., add a month when one ends)

Budgeting Process​

  1. Establish Objectives: Define goals
  2. Gather Information: Sales forecasts, cost estimates, historical data
  3. Develop Budget: Build revenue, expense, capital, and cash budgets
  4. Approve Budget: Management reviews and approves
  5. Communicate Budget: Share with responsible teams
  6. Implement Budget: Execute operations according to plan
  7. Monitor and Control: Compare actual results to budget
  8. Adjust and Evaluate: Update budgets based on performance and changes

Budget Responsibility​

Budget Responsibility means each manager is responsible for the budget items they control. Budgets should align with organizational structure so managers can be accountable for results they influence.

Participation in Budgeting​

  • Top-Down Budgeting: Senior management sets budgets

    • Pros: Fast, aligned with strategy
    • Cons: Less buy-in, may ignore local insights

  • Bottom-Up Budgeting: Lower-level managers prepare budgets

    • Pros: More accurate, better buy-in
    • Cons: Time-consuming, may need negotiation

  • Participative Budgeting: Combines both approaches

    • Balanced participation and strategic alignment

Behavioral Considerations​

Budgets influence behavior:

  • Goal Congruence: Align budget targets with company goals
  • Motivation vs. Pressure: Targets should be challenging but attainable
  • Budget Slack: Managers may pad budgets (build slack) to ensure they meet targets; must be managed through review and incentives

Budgeting Ethics​

Budget preparation and evaluation should follow ethical guidelines:

  • Honesty in estimates
  • Transparency in assumptions
  • Avoid manipulation for personal gain
  • Ethical treatment of employees regarding targets
  • Compliance with legal requirements

Luxembourg Compliance Note​

In Luxembourg, budgets support compliance with financial reporting and tax obligations. Banks often require budgets when assessing SME credit. Participative budgeting may be essential in multilingual teams to ensure understanding and buy-in.

Think It Through​

What happens if budgets are set without input from the people responsible for achieving them? How does participation affect motivation and accuracy?