In the programming phase of the management control cycle 1, an organization makes a variety of long-range decisions. Frequently these decisions involve investments in assets that senior management expects will be used over some future period of time (usually several years in duration), and that will result in a “payback” of some sort to the organization. Often, the result is a capital budget.
By contrast, the budget formulation phase of the cycle typically has a one-year focus and is concerned only with operating activities. Operating activities usually are assessed in two ways: (1) The operating budget, which focuses on revenues and expenses on an accrual basis; this budget is used to measure the performance of operating managers. (2) The cash budget, which analyzes cash inflows and outflows associated with ongoing operations; this budget is used by the controller’s office as a means of forecasting the organization’s cash needs.
In this note, we will look at operational budgeting only. Understanding operating budgets requires knowledge of both the technical aspects of preparing a budget, and the fit of the budgetary process with a variety of other aspects of the organization.
ORGANIZATION OF THE NOTE
The Note looks at operational budgeting through several lenses. The discussion begins by looking at the organizational and strategic context in which budgeting takes place, and distinguishes the mechanical aspects of budgeting from the behavioral ones. We then look at the mechanical aspects of building a budget. The Note concludes with a discussion of budgeting misfits—areas where the budgetary process does not work as well as it might because it does not fit well with other organizational systems or processes.
THE CONTEXT FOR BUDGETING
Operational budgeting is an important step in the management control process. It is during this phase of the process, that an organization sets out its plans for the upcoming year. Moreover, in many organizations, the budget is used as a central aspect of measuring managerial performance. As a result, operational budgeting has both mechanical and behavioral aspects.
One of the most fundamental problems in budgeting concerns the issue of what, in a budget measures. Indeed, while the budget may be the only concrete measure of a manager’s performance, it usually assesses only one side of a two-sided equation. The other side of the equation—the achievement of strategic and programmatic objectives—generally is not measured by the budget, and, some people would argue, is not measurable at all. For this reason, the budgetary process frequently is treated quite mechanically in many organizations.
Clearly budgeting has a mechanical aspect. Revenue forecasts must be made, the associated expenses must be estimated, and an overall budgeted surplus or deficit figure must be calculated. For organizations to use the budget as managerial tool, however, they must view it from a broader perspective than just its mechanics. We look first at this “contextual perspective,” and then use the resulting context as a basis for discussing the mechanical side of budgeting.
The Contextual Perspective
Operational budgeting has both a formulation and a monitoring phase. In this Note, most of our emphasis is on formulation. Nevertheless, to put operational budgeting in context, we need to look at both phases. Doing so allows us to view budgeting’s mechanical and a behavioral aspects in a strategic context.
The activities that comprise these two aspects are quite different in each of the two phases. Further, the whole process exists in an organizational context that gives it a contingent nature, thereby explaining why different organizations have different budgetary systems. This idea is shown schematically in Exhibit 1. To better understand it, let’s examine some of the key elements, beginning with the organizational context and the . . .
1 For a discussion of the management control cycle, see Anthony, Robert N., and David W. Young, Management Control in Nonprofit Organizations, 7th Edition, Burr Ridge, IL, Irwin-McGraw Hill, Inc., 2003.