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BUDGETING IN BUSINESS

A budget is a financial plan. Specifically, a budget sets forth management's expectations for revenues and, based on those financial expectations, allocates the use of specific resources throughout the firm. You may live under a carefully constructed budget of your own. A business operates in the same way. A budget becomes the primary basis and guide for financial operations in the firm.

Budgeting is the principle activity in the planning function that all managers of successful firms must do in order to meet desired results. Just as managers use forecasts to approximate income from sales, they must also forecast the future availability of major resources, including people, raw materials, energy, and money. Techniques for forecasting resources are the same as those employed to forecast sales: hunches, market surveys, time-series analysis, and econometric models. The only difference is that the manger is seeking to know the quantities and prices of goods that can be purchased rather than those to be sold. A very close relationship exists between budgeting as a planning technique and budgeting as a control technique. During the planning phase of management, firms forecast future allocations of resources for business activities. After the organization bas been engaged in activities for a time, actual results are compared with the budgeted (planned) results and may lead to corrective action. This is the management function of controlling.

The budgeting process is complex in nature, derived from the management's objectives for the organization to the final financial budgeted balance sheet formulated. Sales forecasts play a key role in the budgeting process. It consists of a forecast of quantities sold and forecast of dollar income expected. All other budgets are related to it either directly or indirectly. The production budget, for example, must specify the materials. labour, and other manufacturing expenses required to support the projected sales level. Similarly, the marketing expense budget details the costs associated with the level of sales activity projected for each product in each sales region. Administrative expenses also must be related to the predicted sales volume. The projected sales and expenses are combined in the financial budgets, which consist of pro forma financial statements, inventory budgets, and the capital additions budget.

Most firms compile yearly budgets from short-term and long-term financial forecasts. There are usually several budgets established in a firm:

• An operating budget

• A capital budget

• A cash budget

• A master budget

Forecast data are based on assumptions about the future. If these assumptions prove wrong, the budgets are inadequate. So the usefulness of financial budgets depends mainly on the degree to which they are flexible to changes in conditions. Two principle means exist to provide flexibility: variable budgeting and moving budgeting. Variable budgeting provides for the possibility that actual output changes from planned output. It recognizes that variable costs are related to output, while fixed costs are unrelated to output. Thus, if actual output is 20 percent less than planned output, it does not follow that actual profit will be 20 percent less than that planned. Rather, the actual profit varies, depending on the complex relationship between costs and output. Furthermore. moving budgeting is the preparation of a budget for a fixed period (say, one year), with periodic updating at fixed intervals (such as one month). For example, a budget is prepared in December for the next 12 months, January through December. At the end of January, the budget is revised and projected for the next 12 months, February through January. In this manner, the most recent information is included in the budgeting process. Premises and assumptions are constantly being revised as management learns from experience.

In addition, budgets can sometimes lead companies to overlook critical variables such as quality and customer service. Often, their decision-making process is based solely on numbers and dollars, and wrong moves can turn into lost profit. To combat this companies set up guidelines that include the necessity to plan first, budget later: budget for managers, not accountants: measure output, not input; and design budgets to protect against dispute between departments.

Budgets are an important activity crucial to a managers’ success in maintaining the bottom line of a company. Without them, it would be the equivalent to walking through a mine field without sight. Eventually, you're going to be blown out of the way by competing firms.

QUESTIONS

1. What is a budget and what is it based on?

2. Why do sales forecasts play a key role in the budgeting process?

3. What are the components of the budgeting process?

4. How many kinds of budgets do you know? What are they?

5. Describe the two principle means providing flexibility: variable budgeting and moving budgeting.

6. Is there any difference between a budget and a financial plan?

7. What is the importance of making a budget?

to destock – to cut or use stocks to annualize – to calculate over a period of year to shrink – to become smaller in amount, size, or value to slide into recession – to gradually start to experience decrease in economy and employment economic slowdown – time or period when economic development gets slow

PROBLEMS OF EUROPEAN UNION

Almost single-handed, French consumers, who in the third quarter of this year spent an annualised 5% more than in the previous three months, kept the euro area's economy afloat. Among the three largest economies, which account for 70% of euro-area GDP, only France looked healthy, growing by 0.5%. Italy managed just 0.2%; Germany's economy, poorly for a year, actually shrank. As a whole, the euro area grew by a mere 0.1%.

Do not expect the French to keep it up, though. Consumption fell by 0.4% in October, and rising unemployment will probably keep spending in check. Nor is anybody else likely to take up the running. The European Commission reckons that, of the ten euro-area economies for which it forecasts quarterly GDP, only Spain and Finland will grow by more than 0.25% in the fourth quarter. The odd two out, Greece and Luxembourg, may well do better, but all four together make up less than one-seventh of the euro area's GDP.

The three biggest economies, and with them the euro area as a whole, are probably now shrinking, along with America and Japan. Whether the euro area's contraction will last for more than one quarter is unclear. Yet even optimists expect only slow growth in early 2002.

The best hope for revival lies in a reversal of the forces that have aggravated the euro area's slowdown. Rising prices, first of oil and then of food, ate into real incomes and depressed spending. The prices of oil and other commodities have since fallen fast, and the effects of foot-and-mouth disease and BSE are due to drop out of the inflation figures. Some economists think that inflation, now 2.4%, will fall to 1% or less in 2002. As well as boosting real incomes, falling inflation (or the expectation of it) ought to create more room for the European Central Bank (ECB) to cut interest rates below today's 3.25%.

In both France and Germany, inventories were run down in the third quarter, so there is not much more destocking to be done. Germany's construction industry, in decline for two years and a huge drag on growth at the start of 2001, almost stopped shrinking in the third quarter. The euro's weakness against the dollar and the yen should help exports.

That's the good news. Much else is amiss, notably America's slide into recession. This has hurt exports, but it has not reduced the euro area's trade surplus, since imports have been squeezed just as hard. Indeed, says Dieter Wermuth of Tokai Bank in Frankfurt, Germany is seeing a "trade miracle": exports actually rose in the third quarter, while imports fell. The trade balance had a big positive effect on Germany's GDP figure; feeble domestic demand clobbered the total.

America's recession is feeding through to GDP in other ways. Weakening exports are knocking domestic demand, through lower orders to suppliers and cuts in investment. Second, European companies have become more exposed to America through foreign direct investment: the American affiliates of European multinationals doubled their sales in the 1990s, which are now equivalent to almost 9% of euro-area GDP. An American slowdown means less profit, less investment and lower employment—in Europe as well as in the United States.

Third, America's troubles are sapping Europe's confidence. That has been much clearer since September 11th: Germany's IFO index of business confidence dipped again in October, after plummeting in September. The link between spirits in the two big economic regions is more than a couple of months old. The European Commission says that, between 1995 and 2001, the correlation between confidence indices in the euro area and America has been almost 0.9, with America just eight or nine months ahead. Where American businesses and consumers lead, Europeans seem to follow closely behind.

On top of this, there are domestic weaknesses to worry about. Unemployment, which kept falling in the early stages of the downturn, is now expected to rise. The ECB has so far been slow to cut interest rates, and may remain slow in future. The scope for loosening fiscal policy, especially in Germany, is small: next year's deficit will probably be close to the limits set by the euro area's stability and growth pact, which Germany's finance minister is determined not to violate. Salvation in an American recovery, then? Not only. If rising inflation dragged Europe down, falling inflation should help pull it up. With luck, the fourth quarter will be as bad as it gets for the old continent. But don't bet on it; and expect a slow climb back up.

QUESTIONS

1. What is the annual growth rate of the euro-area?

2. Which are the three biggest economies of the euro-area?

3. What dynamics of inflation is expected in the current year?

4. Are European companies becoming more exposed to America? In what way?

5. What are domestic weaknesses of the major European economies?

BRITAIN AND THE EURO

JUST as public opinion is apparently warming to the idea of joining the euro, relations between Gordon Brown and the European Commission have soured. The cause of the dispute is a ticking-off from Brussels about the chancellor's fiscal plans. This is no ordinary disagreement. It goes to the heart of whether Britain can both join the euro and maintain the drive to improve public services.

At first sight, the row between Mr Brown and the commission looks more theatrical than real. The commission says that Britain is failing to meet the rules of the stability pact by planning to run a budget deficit. This runs counter to the pact's stipulation that member states—both in and out of the euro area—should keep their budgets "close to balance or surplus over the medium term". For the moment, that does not much matter, since fines can be levied only on euro members.

But if Britain were to join the euro, say in 2004, the stability pact would become

highly relevant. Up till now the main focus of debate on whether Britain could make a success of euro membership has been about monetary policy. The principal question that the chancellor's five tests seek to answer is whether Britain could live with interest rates set by the European Central Bank. Underlying this is the worry that the British economy differs so much from the rest of the European Union (EU)-for example, through a housing market especially responsive to changes in interest rates that a one-size-fits-all monetary policy will prove harmful.

The latest row, however, highlights a different question—whether a one-size-fits-all fiscal policy set in Brussels will prove damaging. One criticism of the pact is that it makes little sense for countries to limit their fiscal freedom now that they have surrendered control over interest rates and exchange rates within the euro area. That applies to any euro member state. But there are two particular reasons why Europe's stability pact could prove especially problematic for Britain.

The first is that Britain's public infrastructure is exceptionally run-down compared with the rest of Europe. Government investment is much lower as a proportion of GDP than in most European countries. After a long period of neglect, culminating in Labour's first term of office, there is an urgent need to remedy matters. That is why Mr Brown plans to double net public investment's share of GDP to 1.7% by 2003-04 and then to sustain this level of spending. He wants to finance most of the investment by borrowing, arguing that this is fairer than funding through taxation since it spreads the cost of works that will benefit people for many years to come. With debt now very low in relation to GDP, he maintains that borrowing to invest is also fiscally responsible.

But the European Commission is anxious to ensure that the EU as a whole reduces debt in relation to GDP by running balanced budgets or surpluses. A particular reason for this is concern about the future impact of Europe's ageing populations. This will lead to big increases in spending on pensions and health, resulting in likely deficits and higher debt. This could in turn undermine monetary union as the more heavily indebted countries lobby for inflationary policies to erode their debts. Hence the need to use the next ten or so years, before population ageing gathers momentum, to lower the public debt burden.

That policy may be legitimate for the EU as a whole, but not for Britain. This is the second way in which a one-size-fits-all fiscal policy creates a particular problem because of British exceptionalism. For one thing, Britain's debt is the third lowest in the EU as a share of GDP. More important, Britain does not face the same pressures to raise public pensions as other European countries, partly because population ageing will be less intense but also because big private schemes bear much more of the strain of pension provision, and they, unlike state pensions, are funded. Worries about the adequacy of pensions have led the British government to boost poorer pensioners' income, but this will not change the broad picture.

Over the next few years, then, there is a mismatch between Britain's need for higher investment and the euro area's need for lower debt. One way round this would be to interpret the stability pact more flexibly to meet the interests of individual member states. Treasury sources say that the commission has no monopoly of wisdom in interpreting the pact and criticise the commission for a narrow, legalistic approach. The chancellor will press Britain's case at the next meeting of finance ministers on February 12th, arguing that his budgetary projections are consistent with a prudent interpretation of the stability pact. The commission does not want a confrontation but fears that allowing one exception will open the door to special pleading by other countries.

If the stability pact were to become binding—as early membership of the euro would entail—then this will create real problems for Mr Brown as he tries to find the money to pay for improvements in the public services. He has already been preparing the ground for tax increases in this year's budget. But these would have to be a lot bigger—possibly as much as £10 billion—for Britain to comply with the pact.

Tony Blair wants Britain to join the euro. He also wants to rebuild the public services without upsetting taxpayers. Those two aims may be incompatible.

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