Budgets are formal quantitative statements of the resources set aside for carrying out planned activities over given periods of time. As much, they are widely used means for planning and controlling activities at every level of the organization. There are a number of reasons for their wide usage.
First, budgets are stated in monetary terms, which are easily used as a common denominator for a wide variety of organizational activities – hiring and training personnel, purchasing equipment, manufacturing, advertising, and selling. Second, the monetary aspect of budgets means that they can directly convey information on a key organizational resource – capital – and on a key organizational goal – profit. They are, therefore, heavily favored by profit oriented companies.
Third, budgets establish clear and unambiguous standards of performance for a set time period – usually a year. At stated intervals during that time period, actual performance will be compared directly with the budget. Deviations can be detected quickly and acted upon.
In addition to being a major control device, budgets are one of the major means of coordinating the activities of the organization. The interaction between managers and subordinates that takes place during the budget development process will help define and integrate the activities of organization members.
In this article, we will describe the role of budgets in a control system and the budgeting process itself.
Control systems can be devised to monitor organizational functions or organizational projects. Controlling, a function involves making sure that a specified activity (such as production or sales) is properly carried out. Controlling a project involves making sure that a specified end result is achieved (such as the development of a new product or the completion of a building). Budgets can be used for both types of systems; our discussion will emphasize the use of budgets to control the functions.
Any organizational or functional unit headed by a manager who is responsible for the activities of that unit is called a responsibility center. All responsibility centers use resources (inputs or cost) to produce something (outputs or revenues). Typically is assigned to a revenue, expense, profit, and/or investment center. The decision usually depends on the activity performed by the organizational unit and on the manner in which inputs and outputs are measured by the control system. We will describe such centers briefly here.
Revenue Centers are those organizational units in which outputs are measured in monetary terms but are not directly compared to input costs. A sales department is an example of such a unit.
In Expenses Centers or cost centers, inputs are measured by the control system in monetary terms, but outputs are not. The reason is that these centers are not expected to produce revenues. Examples are maintenance, administration, service, and research departments. Budgets will be devised only for the input portion of these centers’ operations.
In Profit centers, performance is measured by the numerical difference between revenues (outputs) and expenditure (inputs). Such a measure is used to determine how well the center is doing economically and how well the manager in charge of the center is performing. A profit center is created whenever an organizational an organizational unit is given responsibility for earning a profit. In a divisional organization, in which each of a number of divisions is completely responsible for its own product line, the separate division are considered profit centers.
Investment centers: In an investment center, the control system again measures the monetary value of inputs and outputs, but it also assesses how those outputs compare with the assets employed in producing them. Assume, for example, that a new hospital requires a capital investment of $20 million in property, buildings, equipment and working capital. In its first year, the hospital has $2 million in labor and other input expenses and $4 million in revenue. For two reasons the hospital would not be considered to have earned a $2 million profit. First, an allowance must be made for the depreciation of building and equipment. Second, management must account for the interest that could have been earned from alternative investments. By assessing these factors as well, the company obtains a much more accurate picture of profitability. Managers can identify the return on an investment, not merely the actual inflow and outflow of dollars.