Understanding Budgeting Process in Organizations
Budgeting is crucial for organizations to allocate financial resources effectively. In the public sector, it's a legal document requiring changes to go through political procedures. Private sector and NGOs use budgeting for planning, but frequent changes may indicate poor planning. Budgeting helps organizations achieve efficiency and control costs while implementing policies and missions.
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POSDCORB-BUDGETING By: Alberto D. Pena, PH.D Associate Professor, Ret., University of Connecticut (USA) Member of the Faculty, MDI, Illinois State University (USA)
POSDCORB-BUDGETING Budgeting is the process of allocating resources to various activities indicated in the plan. It is the financial version of the plan. In POSDCORB, budgeting refers to the allocations of money to the various activities and projects in the operation plan. Changes in the operational plan will change the budget. If the changes in the operational plan hits snags due to budget constraints the executives has to find new sources of funds or scale down the ambitions in the plan.
POSDCORB-BUDGETING.. A government budget is both planning and legal document. It is a law and that law cannot be change easily and the executives are enjoined to spend within the budget and in accordance with expenditures items allowed in the budget. Changes in the budget has to go through the legal and political procedures. New expenditures has to be deliberated again in Congress or Parliament and submit the approved changes to the President or Prime Minister for signature. This does not preclude the fact that budget changes does happen but it takes time.
POSDCORB-BUDGETING.. Budgeting in the private sector including NGOs are planning document. Technically it can be change without too much hassle compared to the government budget. However, frequent changes in the budget reflects poor planning. Remember that the operational plan is also based on strategic plan and frequent changes in the plan would indicate weak strategies. You do not just change the rules in the middle of the game as the saying goes.
POSDCORB-BUDGETING.. The Concept and Process of Budgeting: Budgeting is the process of allocating financial resources to different objects and subjects of expenditures. It articulates the objectives of the organization and provides the vehicle for implementing its policies. For the private sector organizations it is a means for achieving operational efficiencies and profitability. Budgeting in the public sector incorporates the administrative and political mandates and objectives of the organization. For both sectors, budgeting is a tool to implement organizational policies and mission. It is also a battleground for cost control. The budgeting process puts into motion the desire of the organization to attain certain levels of efficiency, effectiveness and economy in pursuing its administrative, political, and social objectives.
POSDCORB-BUDGETING.. The budget is the financial version of the plan. Allocations to different items of expenditures, activities, and programs give a picture of what the organization plans to do. It is also a monitoring and control mechanism for the implementation of the plan. The records of financial transactions through the accounting documents is actually the monitoring and control of budget and subsequently the plan. Changes in the plan will change the budget and changes in the budget will change the plan.
POSDCORB-BUDGETING.. The budgeting process is under the shadow of constraints. Scarcity of resources puts meaning to being efficient, effective, and economical. Organizations like to achieve their objectives at a lesser cost and gain more benefits per unit of cost. It is against this backdrop that cost effectiveness, cost accounting, cost control measures, benefit cost analysis, activity based budgeting, performance auditing, and other financial tools were developed in support of the budgeting process. Budgeting is the beginning and the end of the financial management system. By viewing the financial management system as a loop, one can see that the budget is the point of reference for all financial transactions during the accounting year and the budget for the next period is the culmination of all the experiences encountered in the previous year.
POSDCORB-BUDGETING.. The budget structure consists of two main parts: Sources of Funds and Allocation of Funds. For a corporation, the funds could come from various sources including operating revenues, investment income, sales of assets, and loans. For a public entity, funds may come from taxes, floatation of bonds, proceeds from endowments, fund raising, income from bank deposits and investments, sales of assets, loans, grants, and other sources. The largest source of funds for government agencies, such as a ministry or department, would be from government budgetary appropriation and special taxation. Funds from external development assistance may comprise a big portion of financing development projects in developing countries, in addition to government counterparts.
POSDCORB-BUDGETING.. The usual allocation for these funds would include salaries and fringe benefits, supplies, utilities, payment of liabilities, payment to outside vendors and service providers, repairs and maintenance, purchase of equipment, human resource development, etc. In addition to these recurrent allocations, the organization would add additional allocations for non-recurrent activities in a particular budgeting year such as estimated expenses for the new branding strategy (for corporations), expenses for additional fund raising (public agencies), and other allocations not included in the recurrent expenditures. The non-recurrent portion of the budget would also include allocations for capital investments such as acquisition of equipment, construction of new facilities, etc. which are called investment projects.
POSDCORB-BUDGETING.. The total amount to be raised from various sources should be equal the total amount for the allocation of funds. In practice however, the total amount raised should also cover various reserves such as a reserve for contingency. The reserve for contingency is meant to cover unforeseen minor expenses and price increases. In addition to covering unforeseen expenditures, the purpose of putting reserves is to avoid the bureaucracy of supplemental budgeting. It may not be too important for corporations but supplemental budgeting or request for additional fund is a very tedious process for government agencies. The budget of government entities is a legal document that cannot be changed easily. For a private corporation and NGOs, a budget is only a planning document.
POSDCORB-BUDGETING.. A budget is done at the present to be implemented in the future. Unlike accounting records that contain actual amounts, the amounts in the budget items are estimates. Because it will be implemented in the future, the estimates could be affected by future events. Since the budget is only the financial picture of a plan, the budget will change as the plan changes. Because of its nature, the budgeting process is dotted with cracks and pitfalls. It needs a careful analysis of the assumptions that were used as basis for estimating future revenues and future expenses.
POSDCORB-BUDGETING.. The reserve for contingency is not a sure way to patch things up. Significant deviations from the estimates would cause serious deficits or surplus. For corporate hospitals, it would be a case of misdiagnosis and misuse of funds. For manufacturing corporations, deficits are costly to patch because it may involve borrowing expensive funds on short notice. On the other hand, significant surplus means tying up valuable funds on-line instead of depositing it to higher earning accounts. For government entities, deficit means putting the budget in the emergency ward. Surplus would mean returning the money to the mother agency or to the government, which may affect future budget requests.
POSDCORB-BUDGETING.. At the national level, deficit would mean expensive short-term borrowing while surplus would translate to unnecessarily diverting financial resources from private investment to public allocations. For both private and public organizations, the term balanced budget is only an attempt to reconcile the actual funds being raised to actual funds being used. This balancing act happens towards the later part of the budget year. In most cases, it is the use of funds that will be subject to more scrutiny.
POSDCORB-BUDGETING.. There are important implications in the statements of budgeting objectives. One is the objective of maintaining fiscal discipline enjoining managers to abide by the budget as much as possible. Budgeting is a serious process and should not be taken lightly. It is not just an exercise in arithmetic. The budget is developed with an intention to follow it. A series of supplemental budgets and revisions, although necessary at times, are reflections of inability to forecast financial needs and economic events. Fiscal discipline also means that proper administrative procedures and fiscal policies have been followed.
POSDCORB-BUDGETING.. The second objective refers to setting or following organizational priorities. Priorities have been set in the planning phase of the financial management system and since the budget is the financial picture of the plan, allocations in the budget should be based on these priorities. The synchronization of the plan with the budget appears to be automatic following the flow of financial management system. In practice however, it is conceivable that actors and decision makers in making the plan and in making the final budget might be different. There are also cases where financial constraints may force the organization to change course. If for some reasons the priorities have to be changed in the operation budget, the priorities expressed in the plan should also be changed. There is a feedback mechanism between planning and budgeting as there is a feedback mechanism between and among the different elements in the financial management system.
POSDCORB-BUDGETING.. The third objective refers to achieving efficiencies in delivering services, mostly referring to the allocation portion of the operation budget. It implies that the allocated amounts to different input items are determined based on the most cost effective means of procurement and service delivery. It is not sufficient to ask the question how much would a budget item needs. The most important question to ask is how to achieve efficiency in delivering the service.
POSDCORB-BUDGETING.. The Operation Budget: The budget mentioned above is an operation budget. The operation budget contains the estimates of incoming funds from various sources as well as the allocation of these funds to different expenditure items. The array of these expenditure items is envisioned to carry out the operation of the organization for the calendar or fiscal year. It implies that the allocations in the operation budget are expendable items. In addition to the purely operational expenditure items, it may also contain the programmed expenses for capital projects intended for disbursement within the accounting year. The whole implementation budget for a large capital project encompassing a multi-year period would be separated.
POSDCORB-BUDGETING.. Procedural Sequence in the Budgeting Process: Operational budgeting follows two procedural sequences. One is to first estimate revenues and then makes the allocations within the estimated income. The other is to make the estimates of different allocations and develop strategies to raise revenues to cover the planned allocations. The first procedure is a common practice for business corporations, whose income comes mainly from the sale of their products. The second procedure is common to public organizations that depend on public fundraising (in case of NGOs), taxation (in case of national and local governments) and government support (in case of government ministries and other agencies). As a matter of fact, the so-called operational budget for government agencies is only a supplement for the general budget appropriation of the national government. The approval of the budget request is a tacit agreement that the government will appropriate and release the amounts requested by the agency.
POSDCORB-BUDGETING.. Budget Formats: The operational budget can be represented by using two formats. One format is called Line-Item Budget and the other Performance Budget. Referring to line item budget and performance budget as mere formats could be over simplified since both budget presentations have their own unique concepts and applications. For our immediate purpose, the line item budget format will be used as the basis for discussing significant issues in budget preparation and analysis such as cost centers, budget codes, and historical analysis. Line-item budgeting is the most common presentation for operation budget. Performance budget is most useful in programs, projects, and budgets of specific departments and units.
POSDCORB-BUDGETING.. Line Item Budgeting: Line items normally refer to the objects of expenditures in the allocation portion of the operation budget. It is called line item because the individual objects of proposed expenditures occupy a line in the budget presentation. Common examples of line item include salaries and wages, administrative supplies, purchase from outside vendors, human resource development, utilities, etc.
POSDCORB-BUDGETING.. Line item budgeting does not only refer to the objects of expenditures which indicate allocations to specific allocations. This is just the first illustration that an allocation intended for specific line expenditure could not be used for other purposes. In government budgets, the transfer of allocations from one line to another is governed by specific rules since the budget is a legal document. There are also instances where a source of fund is lined with specific allocation. This concept of line item budgeting is identified with public sector budgeting. Examples include specific tax revenues that could only be used for certain expenditures as in road user tax or property taxes. Another example is revenue from the issuance of bonds. Revenue from some bond issues could only be used for specific projects. This practice is most common to government agencies and non-government, non-profit organizations known as NGOs. It is the main reason why these organizations normally use fund accounting in recording financial transactions.
POSDCORB-BUDGETING.. The need for aggregation in the allocations for satellite units of a large organization may occupy specific lines in the budget. For example, the Ministry of Health may occupy just one line in the national budget. It simply means that such allocations can only be used by the Ministry. The budget at the level of the Ministry of Health may present a lump-sum appropriation for a government hospital as a separate line indicating the allocation for Hospital A could not be transferred to Hospital B. A lump-sum allocation to a project could occupy a line in the agency budget also indicating that the money could not be used for other purposes except for the implementation and operation of the project.
POSDCORB-BUDGETING.. Line Items in Aggregate Amounts: We already illustrated the need for aggregation according to organizational levels as in the case of national budget to ministry budget and further to a particular unit of the ministry. The amount of details follows the organizational ladder. More aggregation is needed as we go upward and more details are presented as we go downward. Aggregation is also evident in specific line items depending on the number of its components. In order not to clutter the presentation, the main budget contains aggregates of similar expenditures in one line item. This is especially true with large organizations. An example is a line item on utilities. This line item could be an aggregate amount for various expenditures such as electricity, water, oil and gasoline, etc. These sub-items would be presented in a separate list as an attachment to the budget.
POSDCORB-BUDGETING.. On the Sources of Funds side, the item on Sales Revenue is an aggregate amount representing sales of different products of the corporation. If the corporation has 6 products for sale, the Sales Revenue figure in the corporate operation budget represents the sales of these individual products. This is also true in other Sources of Funds items such as the Income from Short-Term Investments, Income from Long-Term Investments, and Income from Royalty Payments, and Other Income. This is done in order to present the operation budget in a simple and very readable document. Presenting the details of each Sources of Funds item would clutter the presentation of the operation budget. These details are presented as attachments to the operational budget for the purpose of reference and auditing.
POSDCORB-BUDGETING.. In the Allocation of Funds portion of the corporate operation budget, the amounts are also in aggregates. For example, the Salaries and Wages item might consist of different categories of personnel including allocations for consultants. The budget attachment for this item can be shown by categories of personnel such as permanent employees, contractual employees, and consultants. The attachment can also be presented by location of employees, i.e. by departments such as general administration employees (Office of the General Manager), administrative department, finance department, marketing department, maintenance department, etc. These attachments are important for referencing, auditing, and managerial and cost control analysis.
POSDCORB-BUDGETING.. Budget Analysis: After familiarizing with the format of the line item budget, managers could now focus on analyzing the budget. The understanding of the operational budget will put every manager in a very effective position to participate in the management of the organization. Budget analysis should focus on the following: 1) identification and analysis of revenue and cost centers; and 2) historical analysis. These budget analyses are based on determining the proportionate allocation to one item or to one department in relation to the total budget. This is the reason why they are lumped into the so-called ratio analysis.
POSDCORB-BUDGETING.. Ratio Analysis of Revenue and Expenditure Centers: Revenue and cost centers refer to the major sources of revenue and major items of expenditures. Comparing the percentage of each revenue source in relation to the total revenue can identify the revenue centers. For example, if the revenue from the in-patient department and diagnostic department of a hospital are 50% and 30% respectively, then these are revenue centers. If a business corporation is selling six products and 50% of the total revenue come from the sales of just two products, the production and marketing of these two products becomes revenue centers. For NGOs, the major revenue centers would be endowments and scheduled fundraising. The purpose of identifying revenue centers is to maintain or improve the effectiveness of raising revenues from these sources. In other words, management should pay more attention to these sources of funds. This is one important uses of operational budget as a planning document.
POSDCORB-BUDGETING.. Expenditure centers embrace many forms with one unifying concept: It is a place for controlling and containing costs. In other words, it is the place where efficiency battles are being fought. Cost containment can be done through major cost items or through departmental units or both. Major cost items: These items can be identified in the operational budget. This is done by computing the proportional percentage of each item from the total budget. For example, if salaries and wages contribute a significant portion of the total budget (say 50% of the total), then it is clearly a major item to watch. Similar analysis will apply to other items like cost of energy and utilities, travel, supplies, maintenance and repairs, etc. In some cases however salaries and wages for permanent employees are difficult to control compared to salaries and wages for temporary employees such as casual employees and consultants. This is mostly true in government budgeting. In corporation, salaries and wages are subject to continuous scrutiny and control.
POSDCORB-BUDGETING.. Departmental Units: Organizational units can also be cost centers. By following the established organizational chart, the organization can identify cost centers and their hierarchical relationships. For corporations, the departments that have the highest percentage of total budget allocation will be the cost centers. These could be the production department and the marketing department. This is also true for public agencies such as NGOs and government entities. In public agencies, the units that have the major portions of the total budget are cost centers. Management should pay more attention to these units for controlling cost.
POSDCORB-BUDGETING.. Some financial analysts would even distribute the value of shared human and material resources to different units for the purpose of determining cost centers. For example, the salary of the General Manager could be proportionately charged to different departments under his/her direct supervision. The cost of utilities shared by different departments would be distributed in similar fashion. This is usually done in case of fund management by NGOs and government agencies. For ordinary organizations not bound by legal requirements to separate funds, cost centers should be based on direct cost incurred by the department. The distribution of overhead would complicate the determination of cost centers.
POSDCORB-BUDGETING.. Historical Analysis of Budgets: Ratio analysis is a standard operating procedure for budget analysis. It is used in the identification of revenue and expenditure centers. The same ratios are used in the historical analysis of budgets. The main difference is time perspective. The former (analysis of revenue and expenditure centers) is based on the current budget while the later (historical analysis) is based on previous budgets in relation to the current budget. The former would establish a condition for the present while the later would establish a trend.
POSDCORB-BUDGETING.. Historical analysis of the operational budget will establish a trend of where the organization has been or where it is going. In addition to the ups and downs in the recurrent line items, the historical analysis would indicate major innovations or improvements that the organization has introduced through the years. Historical analysis would also trace the growth or reduction in different line items. These changes will show past realignment of the budget due to changes in priorities or whether cost- reduction measures are in place. It also serves as an input in the projection of the budget in the future. Historical analysis involves ratio analysis of line items in the context of time series, normally for the previous five years.
POSDCORB-BUDGETING.. The Financial Management System The financial management system consists of the following elements: Planning, Budgeting, Accounting, and Auditing. It starts with planning or the identification of activities to be done, normally within one fiscal or calendar year. This plan is known as the operational plan. The process of allocating financial resources to implement the activities in the operational plan is called budgeting. This type of budgeting will result to an operational budget commonly known as the financial version of the plan.
POSDCORB-BUDGETING.. The monitoring of financial transactions during the implementation of the operational budget is called accounting. The monitoring involves recording and reconciliation of financial flows. The verification and authentication of financial records is known as auditing. The auditor s opinion would point to whether the financial transactions were recorded following commonly accepted accounting rules or whether financial transactions are within the legal requirements of government, internal policies of the organization, or specific contractual requirements.
POSDCORB-BUDGETING.. The financial system is both structural and procedural. It is a structural system because it consists of elements that are dependent or structurally connected with each other and requires certain recording and reporting formats. Because of these standard formats, financial documents can be read and analyzed more easily. The financial system is also a procedural system because it follows specific steps or procedures in allocating financial resources as well as in recording and verifying financial transactions. The key to understanding financial documents is to be familiar with their purpose as well as the forms, formats, and procedures for developing them.
POSDCORB-BUDGETING.. Embedded within the elements of financial system (budgeting, accounting, and auditing) are specialized tools for making financial management more effective and useful. These include cash flow analysis, cost-effectiveness analysis, risk management, financial projections, financial engineering, cost control measures, capital budgeting, cost accounting, fund accounting, performance budgeting and auditing, project finance, and other improved financial management tools.
