Profit Planning


Profit Planning:

Learning Objectives:

  1. Define and explain the terms “profit planning” and “budgeting”.
  2. What is the difference between planning and control?
  3. What are the advantages and disadvantages of budgeting?

Contents:

  1. Definition and Explanation of Profit Planning and Budgeting
  2. Difference Between Planning and Control
  3. Advantages and Disadvantages of Budgeting
  4. Responsibility Accounting
  5. Budget Period

Definition and Explanation of Profit Planning and Budgeting:

Profit planning:

Profit planning can be defined as the set of steps that are taken by firms to achieve the desired level of profit. Planning is accomplished through the preparation of a number of budgets, which, when brought through, from an integrated business plan known as master budget. The master budget is an essential management tool that communicates management’s plan throughout the organization, allocates resources, and coordinates activities.

Budgeting:

A budget is a detailed plan for acquiring and using financial and other resources over a specified period of time. It represents a plan for the future expressed in formal quantitative terms. The act of preparing a budget is called budgeting. The use of budgeting to control a firm’s activities is called budgetary control. Master budget is a summary of a company’s plan that sets specific targets for sales, production, distribution, and financing activities. It generally culminates in cash budget, a budgeted income statement, and a budgeted balance sheet. In short, it represents a comprehensive expression of management’s plans for the future and how these plans are to be accomplished.

Difference Between Planning and Control:

The term planning and control are often confused, and occasionally these terms are used in such a way as to suggest that they mean the same thing. Actually, planning and control are two quite different concepts. Planning involves developing objects and preparing various budgets to achieve those budgets. Control involves the steps taken by management to increase the likelihood that the objectives set down at the planning stage are attained and that all parts of the organization are working together toward that goal. To be completely effective, a good budgeting system must provide for both planning a control. Good planning without control is time wasting.

Advantages and Disadvantages of Budgeting:

Companies realize many advantages / Benefits from a budgeting program. Among these benefits are the following:

  1. Budgets provide a means of communicating management’s plans through the organization.
  2. Budgets force managers to think about and plan for the future. In the absence of the necessity to prepare a budget, many mangers would spend all of their time dealing with daily emergencies.
  3. The budgeting process provides a means of allocating resources to those parts of the organization where they can be used most effectively
  4. The budgeting process can uncover many potential bottlenecks before they occur .
  5. Budgets coordinates the activities of the entire organization by integrating the plans of the various parts of the organization. Budgeting helps to ensure that everyone in the organization is pulling in the same direction.
  6. Budgets provide goals and objectives that can serve as benchmark for evaluating subsequent performance.

Disadvantages / Limitations of Budgeting: Whilst budgets may be an essential part of any marketing activity they do have a number of disadvantages, particularly in perception terms.

Budgets can be seen as pressure devices imposed by management, thus resulting in:

a) bad labor relations b) inaccurate record-keeping.

 Departmental conflict arises due to:

a) disputes over resource allocation b) departments blaming each other if targets are not attained.

It is difficult to reconcile personal/individual and corporate goals. Waste may arise as managers adopt the view, “we had better spend it or we will lose it”. This is often coupled with “empire building” in order to enhance the prestige of a department. Responsibility versus controlling, i.e. some costs are under the influence of more than one person, e.g. power costs. Managers may overestimate costs so that they will not be blamed in the future should they overspend.

In Business| Bringing Order Out of Chaos:Consider the following situation encountered by one of the authors at a mortgage banking firm: For years, the company operated with virtually no system of budgets whatever. Management contented that budgeting was not well suited to the firm’s type of operation. Moreover, management pointed out that the firm was already profitable. Indeed, outward the company gave every appearance of being a well managed, smoothly operating organization. A careful look within, however, disclosed that day to day operation were far from smooth, and often approached chaos. The average day was nothing more than an exercise in putting out one brush fire after another. The cash account was always at crisis levels. At the end of a day, no one ever knew whether enough cash would be available the next day to cover required loan closings. Departments were uncoordinated, and it was not uncommon to find that one department was pursuing a course that conflicted with the course pursued by another department. Employee morale was low, and turnover was high. Employees complained bitterly that when a job was well done, nobody ever knew about it. The company was bought out by a new group of stockholders who required that an integrated budgeting system be established to control operations. Within one year’s time, significant changes were evident. Brush fires were rare. Careful planning virtually eliminated the problems that had been experienced with cash, and departmental efforts were coordinated and directed toward predetermined overall company goals. Although the employees were wary of the new budgeting program initially, they became” converted” when they saw the positive effects that it brought about. The more efficient operations caused profits to jump dramatically. Communication increased throughout the organization. When a job was well done, every body was knew about it. As one employee stated,” For the first time, we know what the company expects of us”

Responsibility Accounting:

The concept of responsibility accounting is very important in profit planning. The basic idea behind responsibility accounting is that a manager should be responsible for those items that the managers can actually control to a significant extent. Each line item (i.e., revenue or cost) in the budget is made the responsibility of a manager, and that manager is held responsible for subsequent deviations between budgeted goals and actual results. Someone must be held responsible for each cost or else no one will be responsible, and the cost will inevitably grow out of control. Being held responsible for costs does not mean that the manager is penalized if the actual results do not measure up to the budgeted goals. However, the manager should take the initiative to correct any unfavorable discrepancies, should understand the source of significant favorable or unfavorable discrepancies, and should be prepared to explain the reasons for discrepancies to higher management. The point of an effective responsibility system is to make sure that nothing “falls through the cracks” that the organization reacts quickly and appropriately to deviations from its plans, and that the organization learns from the feedback it gets by comparing budgeted goals to actual results. The point is not to penalize individuals for missing targets.

In Business | A Little Coordination Please!Budgeting plays and important role in coordinating activities in large organizations. Jerome York, the chief financial officer at IBM, discovered at one budget meeting that “the division that makes As/400 workstations planned to churn out 10,000 more machines than the marketing division was promising to sell. He asked nicely that the two divisions agree on how many they would sell for the sake of consistency (and to cut down on the inventory problem). The rival executives said it could not be done. Mr. York got tougher, saying it could. Ultimately, it was.” Source: Laurie Hays, “Blue Blood: IBM’s finance chief, Ax in Hand, Scours Empire for Costs to Cut,” The wall Street Journal, January 26, 1994, pp. A1, A6

Choosing a Budget Period:

Operating budgets ordinarily cover one year period corresponding to the company’s fiscal year. Many companies divide their budget year into four quarters. The first quarter is then divided into months, and normally budgets are developed. These near term figures can often be established with considerable accuracy. The last three quarters may be carried in the budget at quarterly totals only. As the year progress, the figures of the second quarter is broken down into monthly amounts, then the third quarter figures are broken down, and so forth. This approach has the advantage of requiring periodic review and reappraisal of budget data through out the year. Continuous or perpetual budgets are used by a significant number of organizations. A continuous or perpetual budget is a 12 month budget that rolls forward one month (or quarter) as the current month (or quarter) is completed. In other words, one month (or quarter) is added to the end of the budget as each month (or quarter) comes to a close. This approach keeps managers focus at least one year ahead. This approach keeps managers focused on the future at least one year ahead. Advocates of continuous budgets argue that with this approach there is less danger that managers will become too narrowly focused on short-term results.

You may also be interested in other articles from “Budgeting and planning” chapter:

  1. Profit Planning
  2. Participative or Self Imposed budgeting
  3. Human Factors in Budgeting
  4. Zero Based Budgeting (ZBB)
  5. Budget Committee
  6. Master Budget
  7. Sales Budget
  8. Production Budget
  9. Inventory Purchases Budget for a Merchandising Firm
  10. Material Budgeting | Direct Materials Budget
  11. Labor Budget
  12. Manufacturing Overhead Budget
  13. Ending Finished Goods Inventory Budget
  14. Selling and Administrative Expense Budget
  15. Cash Budget
  16. Budgeted Income Statement
  17. Budgeted Balance Sheet
  18. International Aspects of Budgeting

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