Budgetary control

Preface

Although much has been written of budgetary control as applied to particular phases of a business, this is the first attempt, so far as the author is aware, to present the subject as a whole, and cover the entire budgetary program. It is to be regarded as an effort to state clearly the problems involved, rather than to offer full solutions. It is hoped that the discussion will stimulate thought, and constructive criticism will be gladly received. ^ i>

One obvious difficulty has been the problem of what to "^ include and what to omit. The budgetary procedure involves administrative policies on the one hand, and administrative routine on the other. The discussion might easily cover the whole field of business administration, ranging over a wide variety of topics about which no one individual can be expected to have expert knowledge. In the present work, however, the reader is addressed throughout, not as a technical expert, but rather as a student of the broad problem of administration. The advertising man, for example, may be aided in handling his own problems through understanding the method of applying budgetary control to the operations of all other departments of the business, as explained in the other chapters of the book. So with the other departmental executives ; it is hoped that each of them will . be helped by a comprehensive picture of the problem as a whole. The discussion has been kept sufficiently elementary, it is believed, to be easily understandable by those who are not experts on the technical subjects discussed.

With this thought in mind, there has been no effort to prescribe an arbitrary procedure. In some cases, assumptions have been made and definite procedures discussed, but

iii

IV PREFACE

only for the purpose of making the treatment concrete ; the definite procedures given are intended to be suggestive only. Similarly, the various forms given are merely indicative. All of them have been used by the author at some time in his professional practice, but he by no means regards them as standard forms. He has found it necessary to design forms to meet each particular case.

Finally, no attempt has been made to discuss in detail the many problems which may arise in the installation and operation of budgetary control. To do so would be to make the volume less useful to those for whom it is primarily intended. It is thought that the reader who has a comprehensive picture of the entire problem will be able to make his own applications and to work out the special adjustments required for his own situation.

The text is based primarily on the rather wide experience of the author in professional work, but material assistance has been received from various business men, accountants, and instructors. Particular acknowledgment is due to the following: Mr. W. V. Lindblom, executive in charge of the budgetary procedure of the Walworth Manufacturing Company, and Mr. Albert S. Keister, Lecturer on Business Finance, University of Chicago, who have read all the manuscript and given many useful suggestions; Mr. N. L. McCully, executive in charge of the budgetary procedure of the Lewis Manufacturing Company, who prepared the chart on budgetary procedure given in Chapter XXIII ; and Mr. George E. Frazer, C.P.A., the author's partner, to whose counsel and assistance the author is especially indebted.

James O. McKinsey Chicago, Illinois,

Contents

Chapter Page

I The Meaning of Budgetary Control ....... 3

II The Need for Budgetary Control 12

CHAPTER I THE MEANING OF BUDGETARY CONTROL Planning of Business Operations

That comprehensive planning is necessary for efficient administration may be regarded as an axiom of the present-day philosophy of business administration. Business executives have come to realize that they can perform properly the tasks of today only if they have already planned those tasks yesterday, and planned also the tasks of tomorrow. There are many who do not yet plan scientifically, but there are few who will deny the merits of the system.

The planning which may be done in connection with any particular business may be classified into three broad overlapping groups :

1. That which deals with the operations of the separate depart-

ments, such as production, sales, and finance. Such planning has been described loosely in the past, as "industrial engineermg.

2. That which deals with the coordination of the operations of the

several departments to the end that a well-formulated program may be made, for the business as a whole. Such planning may well be termed "budgetary control."

3. That which deals with the determination of future conditions as

reflected in the business cycle and the shaping of the plans of the business to meet these conditions. Such planning is known as "forecasting" or "business predicting."

While the discussion in the following pages is restricted primarily to a consideration of planning of the second kind, it must be realized of course that these various kinds of plans are all very closely related and must be coordinated if

1/ proper results are to be obtained. The budgetary plans are vitally affected by the business cycle, and the departmental plans are equally affected by the budgetary plan. The reader will notice that in the following pages it will be necessary to discuss to some extent all three kinds of planning.

Popular Conception of Budgetary Control

In the past, budgetary control has been considered primarily in connection with governmental units. There has been much discussion of the "budgets" of cities and states, and during recent years much interest has been manifested in the budget of the national government. This interest has been greatly increased by the passage of the National Budget Act and the submission to Congress of the first budget prepared under this act. The budgets of governmental units are discussed frequently in the daily press and by aspirants for political office, and are thus called constantly to the attention of the public. As a consequence many people have come to think of budgetary control as an instrument for governmental administration. Not only is this the popular view but practically all the literature on budgetary control is confined to a discussion of governmental budgets.

Although practically all people who have given thought to the subject will admit that there should be budgetary control of public finances, very few have thought of budgetary control with reference to the individual business unit. It is the purpose of these chapters to show that the principles of budgetary control are as applicable to the individual business unit as to the governmental unit, and to explain the method by which these principles may be applied. As a first step it is necessary to see (i) what budgetary control is, and (2) why it is needed in business administration. The present chapter and the chapter immediately following will be devoted to a consideration of these topics.

THE MEANING OF BUDGETARY CONTROL 5

Procedure for Budgetary Control

Probably the best way to show "what budgetary control is" is to outline how it operates. The procedure to be followed by a business firm in the installation and operation of budgetary control will of necessity vary, depending primarily on the organization of the business and the nature of its operations. A possible procedure, stated briefly and in outline form, is as follows:

1. Each department prepares an estimate of its activities for the budget period. The method of stating these activities depends on the nature of the operations of the department, the sales department stating the sales it expects to make and the estimated expenses it will incur in making these sales ; the production department stating the estimated production for the period and the estimated requirements in materials, labor, and manufacturing expenses to meet this estimate; the service departments, such as the personnel department, the traffic department, the accounting department, and the office raanager's department, stating the estimated expenditures of their departments. Because of the interdependence of these departments, some will need to use the estimates of other departments in making their own estimates. For instance, the production department must know the estimated sales before it can estimate the production necessary to meet the sales demands; the treasurer must know the plans of all the departments before he can estimate his cash receipts and cash disbursements. Consequently a procedure must be set up which provides for a proper scheduling of the estimates with reference to preparation and distribution.

2. The departmental heads will transmit the departmental estimates to an executive who has supervision of the budgetary procedure. Sometimes the controller acts in this capacity, while in many cases the duty is delegated to a member of the staff of the general manager or president. Since many businesses do not have a controller, it will be assumed during the present discussion that an assistant to the president acts in this capacity. This official combines the estimates of all the departments into a proposed financial budget for the business. In preparing this estimate he will be assisted by the treasurer, though in some cases this budget is prepared by the treasurer alone. The proposed financial budget should show the estimated receipts from all sources and the estimated expenditures by all departments of the business.

3. The executive in charge of the budget procedure makes a comparison between the estimated receipts and the estimated expenditures as shown by the proposed budget. If the estimated expenditures exceed the estimated receipts, one of the following courses of action must be taken :

(a) The departmental expenditures may be reduced. In making such reductions a problem arises due to the fact that the reduction of expenditures may result in a reduction of receipts. For instance, if the expenditures of the advertising department are reduced, this may result in a reduction of sales, with a consequent reduction of receipts from collections. In the same manner, a reduction of the expenditures of the production department may result in a reduction of production, with a consequent lack of goods to meet sales demands which will result in a reduction of receipts from sales. Care must be taken, therefore, in the reduction of expenditures to see that receipts are not reduced more than proportionately.

(b) Additional receipts may be secured. It may be possible by speeding up operations and securing more efficient administration to secure additional receipts without incurring a proportionate increase of expenditures.

(c) Additional capital may be secured. If it is not

THE MEANING OF BUDGETARY CONTROL 7

deemed wise to reduce expenditures, plans must be made to secure additional capital with which to finance the excess of expenditures over receipts. It is understood, of course, that this condition cannot continue for long, otherwise the business will find it necessary to liquidate.

The executive in charge of the budgetary procedure may make recommendations with reference to possible procedures, but he is usually not invested with authority to determine the plans to be followed.

4. The executive in charge of the budgetary procedure prepares from the departmental estimates an estimated balance sheet and an estimated statement of profit and loss, showing respectively the anticipated financial condition at the end of the budget period and the anticipated result of the operations of the period.

5. The departmental estimates, together with the proposed financial budget, and the estimated financial statements, are submitted by the executive in charge of the budgetary procedure to a budget committee, composed of the principal executives of the company and presided over by the president. This committee considers the proposed estimates and makes such revisions as it thinks necessary. In case the proposed budgets involve important changes in the company's policy, or require the securing of additional capital for a material amount, it may be necessary to submit them to the board of directors for consideration. Indeed, in some businesses all budgetary plans are submitted to the board of directors for approval. After the proposed estimates have been approved, they constitute the working program for the budget period. The budgets as adopted set limits upon the expenditures of all the departments, and these limits cannot be exceeded without the permission of the budget committee. The budgets also set up standards of performance for certain departments. For instance, the sales budget states the sales that are to be made by the sales department, and the production budget states the estimated production of the production department.

6. Each department makes plans which will enable it to carry out its program as outlined by its budget. For instance, the advertising department makes contracts for advertising space; the sales department sets quotas for its salesmen; the production department sets up schedules of production.

7. Records are established so that the performance of each department may be properly recorded and comparisons made between the estimated and the actual performance. Periodic reports, showing a comparison between the estimated and the actual performance of each department for the budget period, are made to the executive in charge of the budgetary procedure and are by him transmitted to the budget committee and in some cases to the board of directors. On the basis of these reports the budget committee or board of directors may make such revisions of the budgetary program as it may deem desirable.

Essential Features

The foregoing procedure is intended to be suggestive only. Each organization must adopt a procedure which is fitted to its particular needs. The purpose of the foregoing outline is to indicate what budgetary control is by suggesting how it operates. From this outline it can be seen that budgetary control involves the following:

1. The statement of the plans of all the departments of the business

for a certain period of time in the form of estimates.

2. The coordination of these estimates into a well-balanced pro-

gram for the business as a whole.

3. The preparation of reports showing a comparison between the

actual and the estimated performance, and the revision of the original plans when these reports show that such a revision is necessary.

THE MEANING OF BUDGETARY CONTROL 9

Budgetary Control Not a New Idea

All businesses practice budgetary control to a greater or lesser degree although many of them do not realize the fact. The newsboy estimates his probable sales before making his purchases, and every business man must do likewise if he is to continue to operate long. Even the farmer, who usually scorns the use of formal methods of control, estimates the probable returns from land used for various kinds of crops and the cost of producing each, and on this basis decides upon the crop which he will plant. During the war the Red Cross, the Y.M.C.A., and Liberty Loan committees used the budgetary idea in their ''drives" by setting up quotas for each territory. These quotas were based on estiraates of the sales possibilities in these territories. Budgets for governmental units have been in use for many years, and the "family budget" has long been a matter of discussion.

Many business firms which deny that they operate a budgetary program will be found to make and use estimates. In this connection the author recalls a visit he made to the merchandise manager of a large wholesale store several years ago. This executive derided the idea of preparing a sales estimate and stated that he did not care to discuss such an academic question. A few minutes later the author inquired if the merchandise manager permitted his buyers to use their own judgment in deciding on the quantity of goods to purchase. He emphatically replied that to permit the buyers to purchase all they desired would bankrupt the firm in six months. In response to the request to explain how the buyers' purchases were controlled, he stated that the executives of the firm first obtained the average sales for the past three years and added to this average the percentage of increase which they expected during the next year. After they determined in this manner their ''exlO BUDGETARY CONTROL

pected" sales, they "calculated" the purchases necessary to meet these sales and instructed the buyers accordingly. It took the author some minutes to show the manager that his firm was preparing both a sales estimate and a purchases estimate. Further investigation showed that it was the practice of the treasurer of the company to obtain a copy of the sales estimate and purchase estimate and to use these as a means of making estimates of cash receipts and disbursements. In other words, the company had an informal and imperfect system of budgetary control.

Similar investigations will show that all other profitable businesses make plans for future operations, and however informal these plans may be, they are in essence budgetary control.

Modern Tendency Towards Budgetary Control

Modern business administration tends more and more to become a standardized routine. In a large organization such standardization is essential to the maintenance of a unified business policy and to the coordination of the activities of the several departments ; and coordination means subordination to a common head. Business men are gradually coming to realize that this can best be accomplished by the formulation of plans submitted for approval in black and white, if indeed coordination can ever be accomplished in any other way for a great length of time. Not that plans have not always been made, but they have commonly been carried around in someone's head. Becauseof the increase, however, in the volume of business performed by the typical industrial unit, with the corresponding complexity in business organization, it is coming to be less and less possible to maintain a business organization that depends upon the intuitive faculties of a single individual developed by years of experience, faculties which perish with the individual.

THE MEANING OF BUDGETARY CONTROL II

The organization must be independent of any single individual in it. All of which goes to show that there should be some systematic method of gathering information from the past and formulating on this basis plans for the future, and of subsequently reporting how these plans have been carried out. Such an accounting and statistical organization we may call a budget system.

CHAPTER II THE NEED FOR BUDGETARY CONTROL Why Budgetary Control Is Needed

In the preceding chapter it has been explained that budgetary control has long been practiced in an informal way but that only in recent years has it been introduced as a formal and comprehensive procedure. In fact the firms are largely in the minority which have formally adopted budgetary control at the present time. It is the belief of the author that the delay of business firms to adopt budgetary control as a definite part of their administrative methods is due to one of two causes : Either they do not fully realize its need, or they do not understand how to install and operate it.

It is the purpose of the present chapter to explain its need as an instrument of administration, while the remaining chapters of this book are devoted to an explanation of its installation and operation.

Budgetary control is urgently needed in administrative control for two purposes:

1 . As a means of coordinating the activities of the various functional

departments.

2. As a basis for centralized executive control.

Perhaps its use for these purposes can best be shown by sketching the method by which administrative control is exercised in the modern type of business organization, the problems which arise therefrom, and the need for a comprehensive method of planning ahead as a basis for solving these problems. Much that is said in the remainder of this chapter, though perhaps more or less familiar to the reader, is

THE NEED FOR BUDGETARY CONTROL I3

stated here in order to present a comprehensive picture of the problems which give rise to a need of budgetary control.

Interdependence of Business Activities

It is the author's experience that executives often become so engrossed with what they regard as the larger administrative policies of their business, that they fail to give sufficient attention to many of the administrative problems to realize their significance. They are easily Impressed with the value of a sales campaign which will result in a large Increase In the volume of sales, but they may fail to realize the importance of working out methods by which to coordinate the sales campaign with the production program so that the goods sold will be ready for delivery at the proper time. They are keenly Interested in the enlargement of manufacturing facilities and the increase of production, but may fail to realize the significance of maintaining a careful check on inventory to avoid the accumulation of unsalable merchandise.

It is worth while for the executive to make a comprehensive survey of the whole problem of administrative control from time to time to see that he Is not overemphasizing some phases of the problem at the expense of others. If this chapter serves to Impress upon the reader the interdependence of all the activities of a business, it will have served a useful purpose regardless of his reaction to the argument presented in behalf of the need for budgetary control as a means of coordinating these activities.

Functional Activities — ^Their Coordination

The operations of businesses vary widely and the variations in operations produce a divergence In organization, but in every business there are certain functional groups of activities which must be performed. These functions are:

1 . The sales function

2. The production or purchasing function

3. The personnel function

4. The finance function

5. The standard and record function

Since these functions are found combined in a single business unit, it is fair to suppose that there must be a close relationship between them. A very brief study will show that there is such a close interrelation that it is impossible to perform one of them unless the others are also being properly performed. It is true that some businesses emphasize one of these functions and other businesses emphasize another, but in no business can any of these functions be safely neglected. A few illustrations of the interrelationship will make this clear.

Balancing Production and Sales

Goods are purchased or produced in order to be sold. It is unwise and unprofitable to purchase or produce more goods than can be sold within a reasonable time after their purchase or production. To do so results in tying up capital in a non-income producing investment, for excess inventories yield no profit. A second danger arising from this procedure is the deterioration which may take place in the surplus stock due to time or obsolescence. It is obvious, therefore, that wise administration will take into consideration sales expectancies in planning purchases or production. The failure to limit purchases and production to correspond with sales possibilities has caused many firms heavy losses during recent years.

On the other hand, it is unwise to sell goods in excess of the possibilities of supply. To sell more than can be purchased or produced leads to an unnecessary expense both in securing the sale and in handling the inevitable complaints which arise from failure to fill orders. An additional loss may arise from the ill-will of the disappointed customer. It is better to refuse an order in the beginning than to accept j^' the order and fail to satisfy it. Many firms lost prestige by such actions during the years 1 9 1 8 and 1 9 1 9. It is necessary, ^ therefore, to consider production or purchasing possibilities in planning the sales campaign. In other words, the sales function and the production v^r purchasing function are so closely interrelated and interdependent that they must be considered jointly in planning executive policies.

Planning for Equipment and Personnel

Not only must sales and production be correlated, but this correlation must be planned sufficiently in advance of the time when it is to be effected to make possible the securing of the necessary equipment and personnel to produce the goods required. In a manufacturing business plant and equipment are essential to the production of goods, and in considering increased production the possible increase in plant and equipment requirements resulting thereform must be taken into account. But the quantity of production is determined by the volume of sales; so in the end the sales campaign determines the plant and equipment program. The relation between these two functions can be easily seen. Loss will result from the sale of more goods than the present equipment can produce or than it is possible or profitable to purchase equipment to produce. In this connection three questions must be asked :

1. Can the desired amount of goods be produced with the present

plant and equipment?

2. If not, can additional plant and equipment be secured in time to

produce goods to supply the present demand?

3. If so, can such plant and equipment be secured and operated

profitably?

It is equally unwise to secure plant and equipment beyond that needed to satisfy the present or the anticipated demands of customers. Consequently the plant and equipment program is closely related to both the sales and production programs.

But equipment cannot be operated without workers and it is necessary to know the production requirements sufficiently in advance of the time of their fulfilment to make possible the securing of the necessary amount of personnel. Where skilled labor is employed the securing of the proper personnel is a problem of major importance.

Planning of Finances

The making of sales, the producing of goods, and the securing of equipment and personnel, all involve an expenditure of funds. All these operations must be financed and they can be carried on only to the extent to which the financial resources of the business will permit. It is unwise indeed for, a business to plan a sales campaign with the consequent production requirements without considering the financial possibilities of the business. A lack of coordination of the sales and production programs may lead to loss, but a lack of coordination of the various departmental programs of the business with its financial program will lead to bankruptcy.

Coordination — Special Problems

The foregoing illustrations point out the interrelationship of the primary functions of the business and show the necessity for their correlation. But in the securing of this correlation many things must be considered. For instance, emphasis has been placed upon the desirability of not producing beyond sales requirements because of the consequent loss arising from the capital invested and the possible deterioratlon of the goods. There may be other factors, however, which make it desirable to produce beyond sales capacity for a certain period of time. For instance, if the sales fluctuate from period to period, it may not be desirable to have the production fluctuate accordingly. There are several reasons for this, one of the principal being the problem of maintaining a proper labor supply if wide fluctuations in production take place. If production fluctuates it is necessary to discharge laborers whom it may be difficult to replace later, especially in the case of skilled labor, or it is necessary to retain laborers not employed for full time, which is undesirable and uneconomical. It may be preferable to maintain a uniform production and thereby accumulate in a period of slack sales an inventory which may be used to meet the excess demands during the rush period. The loss of the excess capital tied up in the inventory may be less than the loss which would result from fluctuating production. This is but one illustration of the many problems which arise in planning coordination of the operations of the functional departments. Many more will undoubtedly occur to the reader.

Cooperation among Functional Officers

From the few illustrations given, the interrelation of the various functions of the business should be evident and the necessity for the coordination of these functions should be apparent. But business administration can be discussed only in terms of business organization, and ''functions" of the business can be discussed only in terms of the "functionaries " who are responsible for them. The discussion of the coordination of functions, therefore, resolves itself into a discussion of the coordination of functionaries, and a brief study of the prevailing conditions in large business establishments will show that such coordination is the most s/ urgent need for effective business organization at the present time. A conservative estimate would attribute a majority of the business failures of the present time to a lack of coordination of the functions of the business due to a lack of cooperation on the part of the functional officers. That this lack of cooperation is not intentional and is due primarily to a lack of information which would make such cooperation possible, does not change the situation.

Reason for Present Lack of Coordination

It is quite easy to see how the present situation came about. When the business enterprise was small, with a simple organization and its activities local, the owner, who was also the manager, was able to exercise direct control of all the functions of the business. He acted as the executive head of each of the functional departments; he was sales manager, production manager, treasurer, and controller, all in one. Because of this condition he was able to bring about the proper correlation without difficulty. In his capacity of sales manager he knew the sales which he estimated possible, so that he knew what purchases to make when he was acting as merchandise manager or purchasing agent. As treasurer he knew the funds which were available so that he could make his sales and purchasing plans accordingly.

When the business unit increased in size and its organization became more complex, the executive was forced to delegate certain of his duties to assistants, and the present plan of functional organization developed, with a separate executive in charge of each function. The change in conditions is apparent. The sales manager devotes his entire time, thought, and energy to the securing of sales, and he has no direct contact with the production department. The production manager has become engrossed in the problems of production and has little or no means of becoming