Budgeting

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Budgeting

I. Government BudgetingArthur Smithies

BIBLIOGRAPHY

II. Budgeting as a Political ProcessAaron b. wildavsky

BIBLIOGRAPHY

I GOVERNMENT BUDGETING

Budgeting may be described as the art of living within an economic constraint. Virtually every organization or individual has economic limits imposed on what it wants to do; exceptions are the professional ascetic or the sailor shipwrecked on an abundant island. Budgeting, however, may be passive or active. A traditional subsistence farmer will undertake the same production program year after year and always wants to consume more than he has of everything he produces. On the other hand, a modern commercial farmer has a number of alternative ways of employing his resources and actively chooses among them. In an organization, the process of budgeting is almost necessarily active and explicit, since the very nature of an organization is that its decisions result from the interaction of a number of individuals or groups. This article is concerned with government budgeting, but it is useful to recall that, in their budgetary processes, governments are reflecting the pervasive need to allocate scarce economic resources. [For consumer budgeting, seeConsumers, article onConsumption levels and standards.]

A government’s budget is usually, and almost necessarily, its only comprehensive program of action for the period to which it relates. This is so because a program cannot be crystallized until the question of cost is taken into account, and virtually everything a government does costs money. The character of the administration of justice, for instance, depends critically on the amount of money spent on judges, prosecutions, and policemen. In the United States, varying political attitudes toward the antitrust laws find concrete expression in the appropriations made to the Department of Justice. The importance of the budget is clearly recognized in countries with the parliamentary system of government. The invariable British tradition is that the government (executive) resigns if its budget is defeated in Parliament.

The process of decision making that results in a budget, whatever its complexities, contains three necessary ingredients: (1) determination of the variety of policy objectives the government intends to pursue, such as defense, education, or law enforcement; (2) estimation of the cost of pursuing each of these objectives in varying degrees; and (3) an assessment of the willingness and ability of the public to pay for the government’s program as a whole [seePublic expenditures; Taxation].

No government can exist without a policy, even though that policy may be largely passive. In the world contemplated by the English classical economists, government should restrict itself to “essential functions” in order to give maximum scope to private enterprise. Its budgetary problem would then be to determine the minimum cost of performing those necessary functions and to raise the taxes necessary to pay for them, while interfering to the minimum extent with private capital accumulation.

The task of modern governments is far less simple. Although classical considerations impose restraints on their action, governments are concerned with the active pursuit of goals that require expenditures for their attainment. Governments of today are preoccupied, in different degrees, with defense, development, and improving the economic welfare of their citizens. The way in which these objectives become formulated varies widely among countries, depending on their form of government. An authoritarian government can select its objectives and assess their relative importance with minimum reliance on the consent of the public. In a democratic society, the process is far more complicated. Consent to government policies is given or withheld in free elections, and the goals established by government result largely from ideas and opinions that emerge from the whole society and are impressed on government by the groups actively interested. But, one way or another, a government does acquire a set of objectives and some idea of the relative weight to be given to each.

The extent to which an objective should be pursued, or whether one should be preferred to another, will depend on their costs. In a “classical” world, where governments were supposed to perform minimum functions, the question of costs could be approached by fairly crude methods. Finance ministers and officials won their reputations by frustrating the operation of Parkinson’s Law. Treasuries acquired their reputation for saying “no.” In a world of nuclear weapons, space flight, and economic development, the question of cost estimation becomes vastly more important and difficult.

Finally, governments must assess the willingness of the public to pay for government programs—to provide money, in the form of taxes or loans, that could have been used for something else. To win acceptance for its budget the government must persuade the legislature or the electorate that what it proposes is worth the cost.

The essential ingredients of the process of budgeting under “ideal” conditions can then be summarized :

(1) If the relative importance of spending money in pursuit, to varying degrees, of the different objectives can be ascertained, the government can prepare a series of “optimal budgets.” For any level of total expenditures it can determine the best mix of its various programs. The mix, say between defense and social welfare, will normally vary with the size of the hypothetical budget. It will also vary materially among countries.

(2) The government can determine the method of paying for budgets of any given size that is least burdensome from economic and political points of view. It can thus estimate the cost of any of its hypothetical budgets in terms of private goods.

(3) The information provided under (1) and (2) provides the government with a basis for weighing the benefits to be derived from expenditures against the costs of expenditures, and hence for selecting a particular budget.

Traditional approach

In practice, governments have attempted to organize themselves for budgetary purposes by attempting to make a basic distinction between “policy making” and “finance.” Policy makers decide what ought to be done. Financial agencies assert their views on how much the government can afford. There remains the task of achieving a compromise between the two views and producing a budget. In most governments, this third function is also considered to be within the province of finance. The budget is usually the immediate responsibility of the chancellor of the exchequer, the minister of finance, or the treasurer, as the case may be.

In countries with the parliamentary system of government, particularly in countries whose institutions are of British origin, policies are decided on by the cabinet in the general political context that obtains and are endorsed by parliament in legislation. Budget requests are submitted by the departments to the treasury, which produces a budget that allocates the total among the various activities. That total is arrived at in the light of the difficulties of financing it. The budget, prepared by the treasury, is then discussed to varying extents by the policy makers in the cabinet, which may accept or revise the treasury’s budget as an adequate expression of the government’s policy. The outcome depends on the relative strengths of the treasurer and other members of the cabinet in a collective bargaining process. It is fair to say, however, that the cards are stacked in favor of the treasury. Not only is the treasurer the authority on revenues, but he is more completely informed on the entire expenditure program of the government than is any other member of the cabinet. When the budget has been approved by the cabinet, it is submitted to the parliament, which must virtually accept the budget or dismiss the government.

In the United States Congress, the three steps in the process are explicitly recognized in the parallel committee structure of the House and Senate. Authorizing committees recommend legislation that both declares policy and authorizes expenditure. Moreover, committee hearings and reports constitute “legislative history” that establishes policy in more informal ways.

The Committee on Ways and Means of the House and the Senate Finance Committee are the bodies concerned with recommending tax measures. The traditional rule in the United States is that the entire budget be covered by taxation.

The task of budget making is assigned to the appropriations committees, which review estimates received from the executive branch in the light of the objectives declared by Congress and the availability of revenues. In practice, however, revenue considerations are implicit rather than explicit in the work of the committees.

Before 1921, the Congress was the main budgetmaking body in the United States. The executive departments submitted their estimates to Congress with very little coordination by the executive branch. In that year, however, legislation required a single executive budget to be submitted by the president and set up a Bureau of the Budget to prepare it. In line with tradition, the Bureau of the Budget was to be located in the Treasury. In 1939, however, this ambiguity was removed, and the Bureau of the Budget was transferred to the executive office of the president. His personal responsibility for the executive budget was thus unequivocally established.

The Bureau of the Budget has no independent authority; it is a staff agency of the president. Under this system, the Treasury is concerned with the revenue side of the budget. The president, in making his budget, weighs the claims of the departments against the reluctance of the Treasury. However, both the claimant departments and the Treasury are supposed to reflect the policy of the president. He is thus policy maker and budget maker. In principle at least, the distinction between policy making and finance has been blurred. Practice has been steadily catching up with principle. The Bureau of the Budget is slowly becoming increasingly concerned with policy as well as finance.

The distinction drawn between policy making and finance is unfortunate. It conveys the impression, reflected in practice, that a financial agency is concerned not with policy but merely with costs and revenues. In fact, the statement has frequently been made in the United States that the Congress determines what ought to be done, and the budgetary problem is to translate that policy into financial terms. In this view, the budget should be a document that merely expresses the minimum cost of doing the government’s business and gives explicit directions to the executive agencies with respect to the personnel they can employ, the automobiles and typewriters they can purchase, and the buildings they can construct. Its preoccupation is with the means to be employed rather than the ends to be accomplished.

That view of the problem might be adequate in a simple society in which each agency of government performed well-defined functions to some specified extent. For instance, it might be firmly established policy that the post office make two mail deliveries per day or that there be a prescribed number of policemen on the beat. In the defense area, planning was long dominated by the concept of absolute requirements. Military men by military methods were supposed to be able, by applying planning factors, to determine the number of men, weapons, and ships and the amount of food and clothing needed for the “defense of the country.” If all this were possible, policy throughout the government could be definitely determined. Budget makers would then review cost estimates submitted by the departments, cut out those costs that they deemed unnecessary, and then raise the revenues needed to finance the resulting budget. The process thus becomes a highly simplified special case of the more general theory of budgeting set out above.

Problems

This simplified view of the matter has never been more than a rough approximation, although it still underlies much budgetary practice. Treasuries have never accepted a military view of absolute requirements. Sometimes to the benefit and sometimes to the detriment of the country, they have cut military strength below the level deemed necessary. They have also cut the number of mail deliveries or the number of policemen in order to relieve the burdensomeness of taxation. In these activities they have, in the guise of a financial operation, assessed the relative merits of defense, postal service, and law enforcement, and at the same time compared the absolute merits of these programs with the burdensomeness of taxation.

Nevertheless, much of the distinction between policy making and finance could be preserved if the policy makers could give adequate instructions to treasuries with respect to the policy decisions the latter have to make. This could be done if it were possible to measure government programs like defense or welfare in precise quantitative terms. If, in addition, the policy makers could follow the economics textbook and draw up social utility curves of their programs, they could give precise instructions to the financial officials. If the latter could determine the costs of carrying out the different programs to varying extents, they could draw up the array of optimal budgets referred to above as a reflection of policy already determined. There would remain, however, the policy question of which optimal budget to select. That would require a policy decision.

The task of physical measurement of major programs, to say nothing of measuring social importance, is out of the question in any precise sense. Consider education as an example. At first sight it might appear that the numbers of students taught might serve as useful indicators of the quantities of school and college education provided. But although the numbers of students are an important dimension of the problem, it has other dimensions, such as the number and quality of teachers, buildings, and equipment. Even if all measurable information were assembled, the educational value of it all would have to depend on an exercise of human judgment. Nevertheless, some unit of measurement is needed, and for major programs or program subdivisions, there seems to be no unit of measurement as satisfactory as money cost. In considering education, for instance, the question to be asked is not, How can a given amount of education be achieved at minimum cost? It is, rather, How can a given sum be spent on education in order to give the best educational results, under conditions in which education itself is not precisely defined? Although all available quantitative and qualitative information should be brought to bear on the decision, uncertainties concerning educational values render an element of human judgment necessary. The process of decision making should be organized so as to make this judgment as informed as possible.

What policy makers should do is conduct intellectual and practical experiments to determine the benefits of spending money in alternative ways. Can expenditures be shifted beneficially from social welfare to defense or vice versa, or can they be shifted usefully to alternative uses within the areas of defense and social welfare. Difficult though such comparisons may be, they would be intellectually impossible without using the common denominator, money. Thus, policy making penetrates far into the area traditionally assigned to finance.

Proposed solutions

The world survived for a long time with traditional views of the distinction between budgeting and policy making. But modern governments, preoccupied as they are with defense, development, and welfare, are coming to recognize that budgeting and policy making are part of the same process.

In the United States, in particular, efforts are being made to adapt budgetary methods to modern requirements. In consequence, conventional methods, particularly in the defense area, are being replaced or supplemented by “program budgeting.”

In view of the world-wide interest and concern with economic development, investment budgeting, too, calls for special attention. In one respect investment is different from other government programs: the ends to be accomplished as well as the means employed can be expressed in economic terms. The problem of investment criteria has evoked extensive discussion. All that can be done here is to indicate the main principles involved and the relation of a government’s investment program to other components of its budget.

A further important contemporary problem is the assessment of the economic impact of the budget. When budgets were small in relation to national revenue, the problem of financing them could be regarded as largely the political one of overcoming the reluctance of the public to pay taxes and ensuring reasonable standards of equity. In the United States in the latter part of the nineteenth century the problem was even easier than that. Customs revenues were so plentiful that the problem of the federal government was to avoid a surplus, which, if allowed to occur, might have led to a reduction of the tariff. At the present time budgets are so large that the methods of financing can have marked effects on levels of employment, income distribution, or economic growth. Consequently, simple rules of finance are gradually being replaced by analysis of the economic impact of the budget.

Program budgeting. For the budget to serve its purpose as a policy-making instrument, it must be prepared and considered in terms that relate directly to the policy objectives to be furthered. This means a reversal of traditional practice whereby budgets are designed to allocate money to responsible administrative agencies. In some cases there need be no conflict between program and administrative objectives. For instance, the money appropriated to the post office is, or should be, the same thing as the cost to the government of the postal program. (Even this statement, to be true, requires that the post office pay what may be other government agencies, such as airlines or railways, for carrying mail. This is not universal practice.) In other cases there is a clear conflict. Tradition and administrative effectiveness require that the army, the navy, and the air force be maintained as separate services; yet important defense programs require the cooperation of the three services. Budgets for the separate services clearly fail to indicate the capacity of the services to perform a combined operation.

At first sight, it might appear that program budgets could be extracted from administrative budgets. But this practice would fail to do justice to the central problem of obtaining maximum program advantage from a given cost. Administrative budgets are necessary, but they should be derived from program budgets. Governments are only slowly coming to realize this point.

Progress toward a program budget has been most noticeable in connection with the defense budget of the United States in the early 1960s. The conventional defense budget has been submitted for each of the services and for the Defense Department as a whole, in the following categories: military personnel, operation and maintenance, procurement, research and development, military construction, and civil defense. These categories are designed essentially from the point of view of effective administration of the Department of Defense, and they tell very little about the relation of the defense program to the various missions it is supposed to accomplish. Military personnel of the air force, for instance, includes airmen on missile sites in Colorado and airmen in Laos, and the same holds for the other categories. The information contained in the conventional budget does not permit the reader, including members of Congress who have to review it, to form any adequate idea of the program for the defense of the United States itself. Reviewers therefore have to take the word of officials concerning the strategic adequacy of the budget and confine their specific review to small details that are likely to be irrelevant to the major issues. Yet their decisions have a vital bearing on strategy.

The Department of Defense has met these difficulties by preparing an alternative budget in terms of major “budget programs.” These include strategic retaliatory forces, continental air and missile defense forces, general purpose forces (the army, the bulk of the navy, and the tactical air force), sealift and airlift forces, reserves and guard forces, research and development, general support, and civil defense. These programs, in turn, are built up from “program elements,” which consist of complete weapons systems that contribute to the program objective.

The reforms, however, have not been able to accomplish a complete program budget at this time. The objectives of general purpose forces cannot be indicated with the same clarity as those of retaliatory forces. Transport and reserve and guard forces represent administrative rather than program categories. With respect to research and development, especially research, budgeting in terms of particular programs would presumably cause needless duplication.

The program budget permits the Congress and the president to address themselves to the important questions of strategy when they review the budget. Moreover, knowledge of the costs of these programs and program elements is an important aid in the original process of strategic planning. Defense in the modern world has multiple objectives: to prevent general war, to prevent or win limited war, and to prevent or eliminate internal subversions—so-called sublimited wars. Because resources are limited, substitutions among programs and program elements must be considered by the strategic planners. It is exceedingly difficult to think in terms of shifting a “unit” of general purpose forces to strategic retaliatory forces, or vice versa. It is easier, although still difficult, to consider the “cost effectiveness” of shifting a billion dollars of expenditure from one program to another. As Assistant Secretary of Defense C. J. Hitch observed (in a statement before the Military Operations Subcommittee of the House Committee on Government Operations, July 25, 1962): “The job of economizing … cannot be distinguished from the whole task of making military decisions.”

The practical need to measure programs in terms of their cost has led to the new concept “cost effectiveness.” Studies of cost effectiveness attempt to answer the question whether the purposes of a program will be better served if a given sum is spent in one way rather than another. To study cost effectiveness in simple situations may mean nothing more than to determine the cheapest way of performing some specific and well-defined operation. The more interesting cases, however, are those in which expenditures in different directions contribute in different ways to general and imprecisely defined program objectives. Here a study of cost effectiveness organizes the information on the basis of which the decision maker must make a judgment. Examples, arranged in order of the increasing importance of the judgment factor, are: Will expenditure of an additional sum on sea-based or land-based missiles more effectively contribute to the retaliatory forces? Will expenditure on the retaliatory forces or on air defense more effectively protect the United States from attack? Will expenditure on strategic forces or on general purpose forces more effectively contribute to the whole defense program? Will expenditure on defense or on social welfare more effectively serve the interests of the country? In the area of research, the problem becomes vastly more difficult, if not insoluble. Expenditures undertaken now yield unpredictable results in an unpredictable future. Estimates of their cost effectiveness may have to rely almost entirely on experienced judgment.

Defense budgeting in the United States has been selected for discussion because in that country and that area of government activity, the intellectual problems have been most extensively examined and faced. But the problems are pervasive, for budgeting is essentially concerned with the task of achieving a rational allocation of resources under conditions in which the objectives are imperfectly defined.

Program budgeting calls not only for new concepts and methods but for the application of human skills infrequently found in traditional ministries of finance or departmental budget offices. Budgetary staffs, wherever they are located, should include men of the highest professional competence, with respect both to the ends of policy and the economic analysis of costs.

Investment budgeting. Budgeting for economic development projects falls in a separate category because the objectives of the projects can be defined in economic terms. The problem also engages particular attention, not only because of the world-wide interest in development, but because it seems to be soluble by objective economic calculation.

From the point of view of the whole economy, the benefits of a development project consist of the contributions to the national income of the country that the project will make during the course of its life, which may be very long. In this respect, a public project is no different from a private project if the latter is considered from the social point of view: if the indirect benefits and costs to the economy are taken into account in addition to the direct returns from it. On the other hand, if as is sometimes appropriate, the public project is considered purely in terms of the direct monetary returns from it, the problem is similar in principle to that faced by the private investor. In either case, forecasting the distant economic future is notoriously difficult. Although there is no escape from making the attempt, the great uncertainty surrounding any estimates should be explicitly recognized. The evaluation of a project can be attempted by estimating what may be termed its economic “efficiency.” Following Keynes, the efficiency of a project may be defined as the rate of discount which, when applied to future returns and future costs, will equate the present value of returns with that of costs [seeInvestment].

If the government assumes control over the entire investment program of the economy, both public and private projects can be ordered in terms of their efficiency and priority granted to projects in that order. (This statement assumes that the efficiencies of various projects are independent of one another. This assumption may be a fair approximation in a developed economy with free access to foreign supplies. It may be far from adequate in an underdeveloped economy in which the efficiency of an automobile factory depends on the existence of a steel mill.)

If the total supply of saving is known, the total investment program should be such as to absorb that supply; and the “rate of interest” will correspond to the efficiency of the lowest priority project undertaken.

This account of the matter, however, ignores the critical factor of uncertainty of the estimates of future yields and costs. Allowance for uncertainty must be made either as a deduction from the measure of efficiency or as an increase in the rate of interest to be compared with the efficiency of particular projects. The latter is the more common approach, and it is sometimes argued that differences in the structure of rates that appear in the market are an adequate assessment of the risks and uncertainties that surround the investment projects of particular classes of borrowers. This point of view is not generally shared by private business. The rates of return that are used for internal planning purposes are normally much higher than the rates at which firms can borrow in the market. In government, however, there is a persistent tendency to regard the rate at which the government can borrow as that which should be applied in assessing particular investment projects. That rate is thoroughly inappropriate for the purpose; it is normally lower than other rates, mainly because the entire creditworthiness of the government is behind its loans, but also partly because governments are able to adjust the loan market in their favor. It is safe to say that the rate with which the efficiency of a public investment project should be compared is normally higher than the rate at which the government can borrow.

If it were true that the flow of saving available for investment in public and private projects were fixed, budgeting for public investment could be separated from the rest of the budget and dealt with as a matter of allocating investment among public and private projects in the manner suggested above. In fact, this assumption is the basis of the common practice of regarding public loans as the normal source of finance for public investment and taxation as the normal way to finance current expenditures.

That assumption, however, is unwarranted. The flow of saving is affected by the government’s policies with respect to current expenditure and taxation. The flow of saving is increased or decreased if taxation exceeds or falls short of expenditures. Furthermore, a balanced increase of current expenditures and taxation will reduce saving, for taxation inevitably reduces private saving. An increase or decrease in total saving will lower or raise the structure of interest rates, including internal planning rates, which affects the rate of investment, public or private, or both. Hence, investment budgeting cannot be regarded as a separate operation. Current government expenditures compete with public investment expenditures, and both compete with private consumption and investment expenditures. The government must make a political choice between its desire for future development and its desire for benefits of defense, welfare, and law and order.

As a further complication, the government’s contribution to economic development cannot be identified with public investment. As governments are coming to realize, expenditures on current items such as education or public health are equally relevant. Defense programs can yield important by-products in the form of technological knowledge that can be applied throughout the economy. They can also withdraw technical skills from employment elsewhere.

Economic impact of the budget. Governments, traditionally, have applied some simple rule of thumb to decide whether the budget as a whole is worth its cost. In the United States the rule has been that total expenditures should be covered by taxation. Other governments use the rule that current expenditure should be so covered, while capital expenditures should be financed by borrowing from the public. These rules are honored by their breach as well as their observance. They are inevitably broken in times of depression or war, when governments borrow for current purposes; but the rules persist as guides for normal prudent governmental conduct and, indeed, may serve some useful purpose in a complex political organism. Nevertheless, governments are gradually recognizing the need for a more comprehensive and rational approach to the question of economic impact. Reflections of modern economic theory are gradually appearing in budget documents, and many governments issue statements of the national accounts together with their budgets. These statements imply that the government sector of the economy should be considered in its relation to the entire national economy. This, indeed, is inevitable if large development expenditures are involved.

In financing a budget of given size, the government should decide on the method of withdrawing resources from the rest of the economy that will least impede the attainment of other economic objectives; or it may seek to further other objectives, such as distribution of income, through its method of financing. In deciding on the size of the budget, it must seek a satisfactory compromise between the ends to be attained by the budget itself and those other objectives.

The government can finance the budget by taxation or borrowing. Whether taxation or borrowing is used should depend not on the character of government expenditures—whether they can be classified as consumption or investment—but on the effects the government desires to produce, broadly speaking, on private consumption and investment.

In a fully employed economy, the government withdraws resources from private use when it applies them to public use. Whether it withdraws them from private investment or private consumption depends on how it compares the present with the future. Borrowing mainly affects private investment; and finance by borrowing means that the budget is being provided for at the expense of the growth of the private economy. Finance by taxation, on the other hand, normally means that both private consumption and investment are curtailed, although the relative degrees by which they are curtailed will depend on the nature of the taxation imposed. The appropriate combination of borrowing and various kinds of taxation can be determined only by explicit recognition of the objectives of government policy with respect to the private economy. The government may go further and, in the guise of financing the budget, may actively promote other objectives. For instance, it may levy taxes in excess of total expenditures and thus increase savings that may be made available for the private economy. Such action, in conjunction with an appropriate monetary policy, can increase the rate of growth of the private economy.

In a situation where resources are generally unemployed and likely to remain so, the immediate task of the government is not to withdraw resources from private use to make way for the budget, but to use the budget to increase both public and private expenditures. This it can do by borrowing and spending funds that would otherwise remain unused. So long as resources remain generally idle, budgeting ceases to be a matter of allocating scarce resources. Indeed, under such conditions budgeting and economic life as well lose their rationality. The objective of government through its budget or other measures should always be to ensure that a condition of scarcity prevails. Economic activity should always be increased to the point where it is limited by some scarce factors. Such factors may be labor, particular kinds of labor, capacity in critical industries, or foreign exchange. In a condition of scarcity, rational conduct is possible and the allocative principles of budgeting apply.

Technical summary

The foregoing argument represents an attempt to apply the principles of economic theory to the problem of budgeting, with minimum use of the language of economics. It may be useful to summarize the central argument in economic terms. If government activities can be expressed in quantitative terms, the government can draw up a preference map showing rates of substitution among its various activities. If it knows the relative costs of these activities, it can then draw up its series of hypothetical budgets. If it can produce from this information index numbers of public goods, and also of private goods, it can draw up another preference map, consisting of a family of indifference curves relating public to private goods. With its cost information it knows the rate at which private goods can be transformed into public goods. It can thus find its optimum budget. Under these circumstances there could be a clear division of labor between policy makers who determine the indifference curves and budget makers who determine the cost curves and make the computations.

In practice, the construction of index numbers for various programs would involve enormous difficulties. Initial weights of the various components would have to be determined, and the problem of the changing mix of optimal programs would have to be wrestled with. The relation of any index number to what it was supposed to indicate would be subject to change. The significance of the defense index would be affected by the capabilities of the enemy, and of the health index by the prevalence of disease. At all these points the construction of an index would depend heavily on judgment. But the construction of an index might give the impression that objective methods were possible and that the exercise of judgment was not necessary.

The same difficulties occur, in magnified form, if an index of all public goods is attempted. On the other side of the question, no index of private goods foregone would convey an adequate impression of the economic impact of budgets of varying size.

Because a large element of judgment must be exercised in any case and because the construction of aggregate indexes for programs would not facilitate that process, it seems clearly preferable to work with the more familiar notion of money optimally spent in various directions, with particular stress on the need for optimizing. (The standard index approach, however, may be feasible in many cases in solving problems at the “program elements” level, just as it is in many other economic problems.)

Consequently, the indifference curves should be established in terms of given amounts of money optimally spent on various programs, on the total government program, and on private goods. The transformation curves then simply become 45° lines. The processes of budgeting and policy making are thoroughly intermingled.

These conclusions concerning government budgeting suggest that the standard theory of consumer behavior might be usefully modified along similar lines. Although a consumer, planning his breakfast, may be able to establish preferences between bacon and eggs, the purchase of a house may be a different matter. A consumer with a limited budget may employ an architect to draw up a number of plans within his budget constraint. The purchaser then selects the plan he likes most; he may not know what kind of house he wants until he has inspected the alternatives available to him. Economics should be concerned not only with the allocation of scarce resources among alternative uses but also with the discovery of the alternative uses to which scarce resources can be put.

Arthur Smithies

[See alsoEconomics of defense.]

BIBLIOGRAPHY

Burkhead, Jesse 1956 Government Budgeting. New York: Wiley.

Colm, Gerhard 1955 Essays in Public Finance and Fiscal Policy. Oxford Univ. Press.

Eckstein, Otto 1958 Water-resource Development: The Economics of Project Evaluation. Harvard Economic Studies, Vol. 104. Cambridge, Mass.: Harvard Univ. Press.

Hicks, Ursula K. 1954 British Public Finances: Their Structure and Development, 1880–1952. Oxford Univ. Press.

Hitch, Charles J.; and McKean, R. N. 1960 The Economics of Defense in the Nuclear Age. Cambridge, Mass.: Harvard Univ. Press.

Moor, Roy E. 1962 The Federal Budget as an Economic Document. Prepared for the Subcommittee on Economic Statistics, 87th Congress, Joint Economic Committee Print. Washington: Government Printing Office.

National Bureau of Economic Research 1961 Public Finances: Needs, Sources, and Utilization. Special Conference Series, No. 12; Universities–National Bureau Committee. Princeton Univ. Press.

Novick, David 1961 New Tools for Planners and Programmers. Santa Monica, Calif.: RAND Corp.

Smithies, Arthur 1955 The Budgetary Process in the United States. New York: McGraw-Hill.

UN Department of Economic Affairs 1951 Budgetary Structure and Classification of Government Accounts. New York: United Nations.

II BUDGETING AS A POLITICAL PROCESS

Budgets are predictions. They attempt to specify connections between words and numbers on the budget documents and future human behavior. Whether or not the behavior intended by the authors of the budget actually takes place is a question of empirical observation rather than one of definition. The budget of the Brazilian government, for example, has long been known as “a great lie” (Alionar Baleeiro, reported by Frank Sherwood), with little if any connection between what is spent for various purposes and what is contained in the formal document. Nor is there any necessary connection between the budgets of Soviet (Berliner 1957) and American (Argyris 1952; Sord & Welsch 1958) industrial firms and the expenditures they make or the actions they take.

Budgeting is concerned with the translation of financial resources into human purposes. Since funds are limited, a budget may become a mechanism for allocating resources. If emphasis is placed on receiving the largest returns for a given sum of money, or on obtaining the desired objectives at the lowest cost, a budget may become an instrument for pursuing efficiency (Smithies 1955). A proposed budget may represent an organization’s expectations; it may contain the amounts which the organization expects to spend. A budget may also reflect organizational aspirations; it may contain figures the organization hopes to receive under favorable conditions. Since the amounts requested often have an effect on the amounts received, budget proposals are often strategies. The total sum of money and its distribution among various activities may be designed to have a favorable impact in support of an organization’s goals. As each participant acts on the budget he receives information on the preferences of others and communicates his own desires through the choices he makes. Here a budget emerges as a network of communications in which information is being continuously generated and fed back to the participants. Once enacted a budget becomes a precedent; the fact that something has been done before vastly increases the chances that it will be done again (Wildavsky 1964).

For our purposes we shall conceive of budgets as attempts to allocate financial resources through political processes. If politics is regarded as conflict over whose preferences are to prevail in the determination of policy, then the budget records the outcomes of this struggle. If one asks who gets what the (public or private) organization has to give, then the answers for a moment in time are recorded in the budget. If organizations are viewed as political coalitions (Cyert & March 1963), budgets are mechanisms through which subunits bargain over conflicting goals, make side-payments, and try to motivate one another to accomplish their objectives.

Viewed in this light, the study of budgeting offers a useful perspective from which to analyze the making of policy. The opportunities for comparison are ample, the outcomes are specific and quantifiable, and the troublesome problem of a unit of analysis with which to test hypotheses— there is no real agreement on what a decision consists of—is solved by the very nature of the transactions in budgeting. Although a major effort has been made to collect budgetary material from many different countries, levels of government, and private firms, the results have only been fragmentary at best. Very little is available in any language on how budgeting is actually carried on. From Stourm’s classic work on the budget (1889) to the present day, virtually the entire literature on budgeting has been normative in tone and content (Smithies 1955; Burkhead 1956; Buck 1929; 1934; Willoughby 1918; 1927). Yet the glimpses we do get of budgetary behavior in different systems suggest that there may be profound uniformities underlying the seeming diversities of form and structure.

Budgetary calculations

Decisions depend upon calculation of which alternatives to consider and to choose. Calculation involves determination of how problems are identified, get broken down into manageable dimensions, and are related to one another, and how choices are made as to what is relevant and who shall be taken into account. A major clue toward understanding budgeting is the extraordinary complexity of the calculations involved. In any large organization there are a huge number of items to be considered, many of which are of considerable technical difficulty. Yet there is little or no theory in most areas of policy which would enable practitioners to predict the consequences of alternative moves and the probability of their occurring (Braybrooke & Lindblom 1963). Man’s ability to calculate is severely limited; time is always in short supply; and the number of matters which can be encompassed in one mind at the same time is quite small (Simon 1947–1956). Nor has anyone solved the imposing problem of the interpersonal comparison of utilities. Outside of the political process, there is no agreed upon way of comparing and evaluating the merits of different programs for different people whose preferences vary in kind and in intensity.

Simplification

Participants in budgeting deal with their overwhelming burdens by adopting aids to calculation. They simplify in order to get by. They make small moves, let experience accumulate, and use the feedback from their decisions to gauge the consequences. They use actions on simpler matters they understand as indices to complex concerns. They attempt to judge the capacity of the men in charge of programs even if they cannot appraise the policies directly. They may institute across-the-board (“meat axe”) cuts to reduce expenditures, relying on outcries from affected agencies and interest groups to let them know if they have gone too far (Wildavsky 1964, pp. 1–13). Hospital boards in Great Britain, unable to determine what costs should be in an absolute sense, rely on comparisons with comparable institutions. County councils keep close track of expenditures in only a few major areas to cut down on the bulk of overspending. The timing of new starts on projects is used as a simplifying device for regulating total expenditures. Another way local authorities keep spending within limits is through the practice of “rate rationing,” or allowing committees so many pence or shillings of each pound of income (Royal Institute … 1959). Industrial firms use the percentage of total industry sales or some percentage of earnings on assets employed before taxes in setting budgetary goals. Many organizations use the number of personnel as strategic control points in limiting expenditures (Sord & Welsch 1958). Constraints are actively sought as in the common practice of isolating “prunable” items when looking for places to cut the budget (Royal Institute … 1959, pp. 115–116).

Incremental method

By far the most important aid to calculation is the incremental method. Budgets are almost never actively reviewed as a whole in the sense of considering at once the value of all existing programs as compared with all possible alternatives. Instead, this year’s budget is based on last year’s budget, with special attention given to a narrow range of increases or decreases. The greatest part of any budget is a product of previous decisions. Longrange commitments have been made. There are mandatory programs whose expenses must be met. Powerful political support makes the inclusion of other activities inevitable. Consequently, officials concerned with budgeting restrict their attention to items and programs they can do something about—a few new programs and possible cuts in old ones.

When a British Treasury official warns in 1911 against “the habit of regarding each year’s estimate as the starting-point for the next …,” (Higgs 1914, pp. 135–136) one can be sure that the practice has become well established. Both the practice and the complaints continue unabated in Great Britain (Mitchell 1935; Royal Institute … 1959). Incremental budgetary calculations can be found in such different places as Canadian provinces (McLeod 1953) and Michigan cities (where a sample budgetary guideline to department heads reads, “Budgets should be for the same level of service as the current year unless a variation is previously approved …” [Kressbach 1962, p. 41]).

Expectations of participants

Incremental calculations proceed from an existing base. By “base” we refer to commonly held expectations among participants in budgeting that programs will be carried out at close to the going level of expenditures. The base of a budget, therefore, refers to accepted parts of programs that will not normally be subjected to intensive scrutiny. Since many organizational units compete for funds, there is a tendency for the central authority to include all of them in the benefits or deprivations to be distributed. Participants in budgeting often refer to expectations regarding their fair share of increases and decreases (Wildavsky 1964, pp. 16–18). Argyris (1952, p. 16) quotes a supervisor as observing that employees had a well-developed notion of a fair output. In talking about the Philadelphia capital budget, Brown and Gilbert (1961) observe that every department got a share because projects were considered partly as contributions toward keeping the departments going. The widespread sharing of deeply held expectations concerning the organization’s base and its fair share of funds provides a powerful (though informal) means of co-ordination and stability in budgetary systems which appear to lack comprehensive calculations proceeding from a hierarchical center.

Coordination and supervision

The most powerful coordinating mechanisms in budgeting undoubtedly stem from the role orientations adopted by the major participants. Roles (the expectations of behavior attached to institutional positions) are parts of the division of labor. They are calculating mechanisms. In American national government, the administrative agencies act as advocates of increased expenditure, the Bureau of the Budget acts as presidential servant with a cutting bias, the House Appropriations Committee functions as a guardian of the Treasury, and the Senate Appropriations Committee serves as an appeals court to which agencies carry their disagreement with House action. The roles fit in with one another and set up a stable pattern of mutual expectations, which markedly reduces the burden of calculation for the participants. The agencies need not consider in great detail how their requests will affect the president’s over-all program; they know that such criteria will be introduced by the Budget Bureau. Since the agencies can be depended upon to advance all the programs for which there is prospect of support, the Budget Bureau and the appropriations committees can concentrate respectively on fitting them into the president’s program or paring them down. If the agencies suddenly reversed roles and sold themselves short, the entire pattern of mutual expectations would be upset, leaving the participants without a firm anchor in a sea of complexity. For if agencies refuse to be advocates, congressmen would not only have to choose among the margins of the best programs placed before them, they would also have to discover what these good programs might be. Indeed, the Senate Appropriations Committee depends upon agency advocacy to cut its burden of calculation; if the agencies refused to carry appeals from House cuts, the senators would have to do much more work than their busy schedules permit (Wildavsky 1964).

A writer on Canadian budgeting (Ward 1962, p. 165) refers to the tendency for an administrator to become “an enthusiastic advocate” of increased funds for his policies. When disagreements over departmental budgets arise, as they frequently do in private firms, the controller and the departmental representatives come to a meeting armed to the teeth to defend their respective positions (Argyris 1952, p. 9). The same interministerial battles go on in Great Britain (Brittain 1959, pp. 216–217), the Netherlands (Drees 1955, pp. 61–71), and the Soviet Union, where “serious clashes” arise when ministries and republics ask for greater funds to fulfill their plans (Davies 1958, p. 184).

In a discussion which deserves to be better known, W. Drees (1955, pp. 61–71) points out that agency heads can defend the interests of their sectors because it is so difficult for them to relate their modest part in total expenditures to the over-all budgetary situation. Anything they could save through a spirit of forbearance would be too small a portion of the total to make the sacrifice worthwhile. From their point of view, total expenditures are irrelevant.

The role of guardian or defender of the treasury apparently did not come naturally. In the early days of public finance in France, “Financiers appropriated to themselves without restraint the spoils of the nation, and used for their own profit the funds intended for the Treasury; the only restraint lay in the fact that when their plundering exceeded the measure of tolerance they were hanged. It was a summary procedure of control a posteriori …” (Stourm [1889] 1917, p. 536). It took centuries to develop a finance minister like Louis Thiers, whose definition of his role included that “ferocity … needed to defend the Treasury” (Stourm [1889] 1917, p. 69). The members of the U.S. House Appropriations Committee consider themselves guardians of the Treasury who take pride in the high degree of frequency with which they reduce estimates (Fenno 1962). They reconcile this role with the defense of constituency interests by cutting estimates to satisfy one role and generally increasing amounts over the previous year to satisfy the other.

Among the legislatures of the world, however, guardianship appears to be quite rare. Drees (1955) reports that in the Netherlands the legislative specialists concerned with finance, by advocating higher appropriations, defend the interests of the policy areas over which they have jurisdiction to a degree overriding party lines. Much the same thing happened in France during the Fourth Republic (Williams 1954). It may be that guardianship depends, first, on appropriations committees that have continuing power to affect outcomes— a rare occurrence in the modern world—and, second, on the development of cultural values and legislative mores that support an insistent financial check on the bureaucracy. Legislative committees in nations like Mexico, where virtually complete budgetary power is in the hands of the president, who heads the single great party (Scott 1955), or Great Britain, where party responsibility overwhelms parliamentary initiative (Brittain 1959), are hardly in a position to develop a role of guardianship.

Budgetary goals

Possessing the greatest expertise and the largest numbers, working in the closest proximity to their policy problems and clientele groups, desirous of expanding their horizons, administrative agencies generate action through advocacy. But how much shall they ask for? Life would be simple if they could just estimate the costs of their ever-expanding needs and submit the total as their request. But if they ask for amounts much larger than the appropriating bodies believe are reasonable, the credibility of the agencies will suffer a drastic decline. In such circumstances, the reviewing organs are likely to apply a “measure of unrealism” (Royal Institute … 1959, p. 245), with the result that the agency gets much less than it might have with a more moderate request. So the first decision rule is: Do not come in too high. Yet the agencies must also not come in too low, for the assumption is that if agency advocates do not ask for funds they do not need them. Since the budgetary situation is always tight, terribly tight, or impossibly tight, reviewing bodies are likely to accept a low request with thanks and not inquire too closely into the rationale. Given the distribution of roles, cuts must be expected and allowances made.

The agency decision rule might therefore read: Come in a little high (padding), but not too high (loss of confidence). But how high is too high? What agency heads do is to evaluate signals from the environment—last year’s experience, legislative votes, executive policy statements, actions of clientele groups, reports from the field—and come up with an asking price somewhat higher than they expect to get (Wildavsky 1964, pp. 21–32). In Michigan cities, for example, city managers sound out councilmen to determine what will go or get by in their budgets (Kressbach 1962, p. 5). Departments and local authorities in Great Britain commonly make assessments “of how much spending is likely to be acceptable to the governing body” (Royal Institute … 1959, p. 57). After first determining what the mayor, finance director, councilmen, and other key participants will “die for,” together with other projects which “cannot be moved,” the men in charge of Philadelphia’s capital budget let other projects by if they seem sound and if the request is not too far out of line (Brown & Gilbert 1961, pp. 71–88).

The Bureau of the Budget in the United States takes on the assigned role of helping the president realize his goals when it can discover what they are supposed to be. This role is performed with a cutting bias, however, simply because the agencies normally push so hard in asking for funds. The bureau helps the president by making his preferences more widely known throughout the executive branch so that those who would like to go along have a chance to find out what is required of them. Since Congress usually cuts the president’s budget, Bureau figures tend to be the most the agencies can get, especially when the items are not of such paramount importance as to justify intensive scrutiny by Congress. Yet the power of the purse remains actively with Congress. If the Budget Bureau continually recommended figures which were blatantly disregarded by Congress, the agencies would soon learn to pay less and less attention to the president’s budget. As a result, the Bureau follows consistent congressional action (Wildavsky 1964, pp. 4–42); it can be shown empirically that Bureau recommendations tend to follow congressional actions over a large number of cases.

In deciding how much money to recommend for specific purposes, the House Appropriations Committee breaks down into largely autonomous subcommittees in which the norm of reciprocity is carefully followed (Fenno 1962). Specialization is carried further as subcommittee members develop limited areas of competence and jurisdiction. Budgeting is both incremental and fragmented as the committees deal with adjustments to the historical base of each agency. Sequential decision making is the rule as problems are first attacked in the jurisdiction in which they appear and then followed step-by-step as they manifest themselves elsewhere (Wildavsky 1964, pp. 56–64). The subcommittee members treat budgeting as a process of making marginal monetary adjustments to existing programs, rather than as a mechanism for reconsidering basic policy choices every year (Fenno 1962). Fragmentation and specialization are further increased through the appeals functions of the Senate Appropriations Committee, which deals with what has become (through House action) a fragment of a fragment. When the actions of subcommittees conflict, coordination may be achieved by repeated attacks on the problem or through reference to the House and Senate as a whole when the appropriations committees go beyond the informal zone of indifference set up by the more intense preferences of the membership. When one thinks of all the participants who are continually engaged in taking others into account, it is clear that a great many adjustments are made in the light of what others are likely to do.

Budgetary strategies

Having decided how much to ask for, agencies engage in strategic planning to secure their budgetary goals. Strategies are the links between the goals of the agencies and their perceptions of the kinds of actions which their political environment will make efficacious. Budget officers in the U.S. national government uniformly believe that being a good politician—cultivating an active clientele, developing the confidence of other officials (particularly of the appropriations subcommittees), and using skill in following strategies that exploit opportunities—is more important in obtaining funds than demonstration of efficiency. Agencies seek to cultivate a clientele that will help them to expand and that will express satisfaction to other public officials. Top agency officials soon come to learn that the appropriations committees are very powerful; their recommendations are accepted approximately 90 per cent of the time (Fenno 1962). Since budgetary calculations are so complex, the legislators must take a good deal on faith. Hence their demand that agency budget officers demonstrate a high degree of integrity. If the appropriations committees believe that they have been misled, they can do grave damage to the career of the offending budgeting officer and to the prospects of the agency he represents. While doing a decent job may be a necessary condition for success, the importance of clientele and confidence are so great that all agencies employ these strategies (Wildavsky 1964, pp. 65–98).

In addition to these ubiquitous strategies there are contingent strategies which depend upon time, circumstance, and place. In defending the base, for example, cuts may be made in the most popular programs so that a public outcry results in restoration of the funds. The base may be increased within existing programs by shifting funds between categories (Kressbach 1962, p. 51; Stourm [1889] 1917, p. 348). Substantial additions to the base may come about through proposing new programs to meet crises and through campaigns involving large doses of advertising and salesmanship (Wildavsky 1964, pp. 101–123). The dependence of these strategies on the incremental, increase-decrease type of budgetary calculation is evident. By helping determine the ways in which programs are perceived and evaluated, the forms of budgetary presentation may assume considerable importance.

One major strategy deserves separate attention —the division of expenditures into capital and expense budgets. In practice, as Mosher says, “The Capital budget is a catalogue of prospective budgets for which money may be borrowed …” (1956, p. 69). The attempted distinction between capital assets with future returns and ordinary expenditures soon breaks down under the pressure of avoiding tax increases or the appearance of deficits by borrowing for items designated in the capital budget (Burkhead 1956, pp. 182ff.; Mosher 1956, p. 70; Sundelson 1938, pp. 146–198). The ideological emphasis on the size and growth of the deficit in the United States makes it likely that the introduction of a capital budget would permit substantially greater expenditures as apparent deficits become converted into formal surpluses.

Organizations wish to maintain themselves in their environment. For governmental agencies this can be taken to mean maintenance of political support from clientele groups and other governmental participants. We expect that policies are chosen not only because of any intrinsic merit but also because they add to, or at least do not seriously detract from, the necessary political support. The heads of agencies can expect to lose internal control, to be fired, to see their policies overturned, or even to find their organization dismembered if their recommendations are continually disapproved. They therefore seek to maintain a reasonable record of success (to guard their professional reputation, as Richard Neustadt puts it) in order to maintain the confidence of the key people in and out of their agency. Thus, they are compelled to consider the probable actions of others differently situated who have a say in determining their income. These notions may be tested by observing how agency requests vary with the treatment they receive from the Budget Bureau and Congress.

Suppose that we wish to explain the level of appropriations which agencies request of Congress through the Bureau of the Budget and the amounts which Congress provides through appropriations laws. The goals of the participants may be conceived of as constraints which are represented by the role orientations adopted by members of the appropriations committees and by top agency officials. Moreover, we know that budgetary calculations are incremental. Thus, it becomes possible to create in symbolic form, as linear, stochastic differences equations, a series of simple decision rules embodying the relationships we expect to find. Given the availability of appropriations laws and of Budget Bureau requests for individual agencies, the decision rules can be tested for their fit in accommodating the times series comprising fifteen or twenty years’ figures.

In the simplest form, for example, a decision rule might be that the funds requested by an agency in a particular year are a direct function of its appropriation in the previous year up to a normally distributed random error. A second decision rule might make allowance for the difference between what the agency asked for and actually received from Congress in the previous year. Should an agency decide to pad its request to make up for a cut, should it decide to insist on the worth of its programs despite congressional action— strategies such as these can be represented as separate decision rules. Davis, Dempster, and Wildavsky (1966) are now able to show that basic parts of the federal budgetary process can be precisely described by a small number of relatively simple decision rules.

Budgets of firms

Treatment of budgets as political instruments is justified not only in governmental activities but also in industrial enterprises. A more political phenomenon than budgeting in Soviet industrial firms has not been invented. Rewards to managers depend on meeting production quotas assigned in economic plans. But the supplies, skilled labor, and financial resources are often lacking. The first consequence is that the quota is not set from above but becomes the subject of bargaining as the managers seek to convince the ministries that quotas should be as low as possible. The managers find it prudent not to exceed their quota hugely, for in that case next year’s quota will be raised beyond attainment. The second consequence is that production is not rationalized to yield the greatest output at the lowest cost but is geared instead to meeting specific incentives. Heavy nails, for example, are overproduced because quotas are figured by weight. Maintenance may be slighted in favor of huge effort for a short period in order to meet the quota. Funds are hidden in order to provide slack that can be used to pay “pushers” to expedite the arrival of supplies. The list of essentially deceitful practices to give the appearance of fulfilling the quota is seemingly endless: producing the wrong assortment of products, transferring current costs to capital accounts, shuffling accounts to pay for one item with funds designated for another, declaring unfinished goods finished, lowering the quality of goods, and so on (Berliner 1957). The point is that the budgetary system arranges incentives so that managers cannot succeed with lawful practices. Communist China reveals the same pattern (Hsia 1953; Li 1959). When similar incentives are set up in American industrial firms similar practices result, from running machines into the ground, to “bleeding the line,” to meeting a monthly quota by doctoring the accounts (Jasinsky 1956, p. 107).

As in the Soviet Union, American firms often use budgets not to reflect or project reality but to drive managers and workers toward increased production. Indeed, some firms base their budgets on historical experience plus an added factor for increased performance (Axelson 1963). Budgets are conceived of as forms of pressure on inherently lazy people so that (to paraphrase Mao Tse-tung) the more the pressure, the better the budget. Inevitably, managers and workers begin to perceive budgets as “perpetual needlers.” In some cases this type of budget leads to discouragement because it is apparent that whatever the effort, the budget quota will be increased. Since accounting takes place by subunits in the firm, it is not surprising that fierce negotiations occur to assign costs among them. As a result, top officials find it necessary to engage in campaigns to sell budgets to the units. Otherwise, sabotage is likely (Sord & Welsch 1958, pp. 140–150). While some attention has been given to human relations in budgeting (Bebling 1961, p. 16), only Stedry (1960) has attempted to explore the essential motivational problems of budgeting within a political, institutional framework. Yet without an understanding of the impact of different goals and incentive systems on human activity, reliable statements about the likely consequences of budget documents can hardly be made.

Intensive study of budgetary behavior has just begun. Despite the relative paucity of comparative data, patterns of behavior appear to be remarkably consistent across private and public organizations (Wildavsky 1965) and national and state boundaries. After the appearance of monographs on different budgetary systems in various environments, it should be possible to create a small number of budgetary models specifying the elements of the organization coalition, the distribution of roles among the principal actors, the most prevalent aids to calculation, the strategies which appear as responses to types of incentives, and the outcomes to be expected in terms of amounts requested and received. Computer simulation may be used to test the effect of shocks to the budgetary systems. The study of budgeting as a political phenomenon in an organizational context may then become a major aid in the comparative analysis of governmental policy.

Aaron B. Wildavsky

[See alsoDecision making; Organizations; Political process.]

BIBLIOGRAPHY

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Budgets and Budgeting

views updated May 17 2018

Budgets and Budgeting

In the broadest sense, a budget is an allocation of money for some purpose. The word once used to mean "pouch" or "purse"; a budget therefore is "what's in the pouch." Budgeting as an activity ranges in extent from managing household finances on up to the preparation of the Budget of the United States, undertaken yearly by Congress; that document is rarely less than 1,000 pages in length. This article will focus principally on "formal budgeting" as practiced in corporations, sometimes called the "budget process."

Budgeting has always been part of the activities of any business organization of any size, but formal budgeting in its present form, using modern budgeting disciplines, emerged in the 1950s as the numerical underpinning of corporate planning. Modern corporate planning owes much to operations research and systems theory. A pioneer in that field, Russell L. Ackoff, worked closely with General Electric, Anheuser-Busch, and other major corporations. His first book on the subject, the first of four, A Concept of Corporate Planning, had a major impact.

Modern formal budgets not only limit expenditures; they also predict income, profits, and returns on investment a year ahead. They have evolved into tools of control and are also used as a means of determining such rewards as profit-sharing and bonuses. Unless the budgetary process is managed with extreme skill and care, the very virtues of budgeting can turn into negativesand have, of late, emerged into a movement actively working to change this process.

BUDGETING AS A PROCESS

In large corporations, budgeting is a collective process in which operating units prepare their plans in conformity with corporate goals published by top management. Each unit plan is intended to contribute to the achievement of the corporate goals. Unit managers prepare projections of sales, operating costs, overhead costs, and capital requirements. They calculate operating profits and returns on the investment they intend to use. The budget itself is the projection of these values for the next calendar or fiscal year. As part of this process, each unit presents its plans and budget to a reviewing upper management panel and may, thereafter, make whatever changes result from instructions from or negotiations with the higher level. Texts presenting, documenting, and defending the rationales underlying the numbers are usually part of the planning document. Approved budgets then become the road-map for operations in the coming year. Ideally monthly or quarterly budget reviews track performance against the budget. As part of such reviews, changes to the budget may be approved. At year-end managers are judged by their performance against the budget.

While budgets are developed bottom up, managers must strive to meet top-down corporate goals (e.g., "Annual growth in after-tax profits of 39 percent."). Because performance is measured based on meeting or exceeding positive projections (of sales, returns, and profits) and meeting or coming in below negative projections (fixed and variable costs and capital expenditures) managers have strong incentives for projecting the lowest possible "positive" and the highest possible "negative" results. The more successful they are in understating sales and profits and overestimating costs, the higher the likelihood of "meeting the budget." Top management's incentives, by contrast, are to do the opposite. Therefore the budgeting process is inherently marked by potential conflict.

Such difficulties can be, and usually are, mitigated by rational policies, good will on both sides, and straight forward implementation. Projections should be as realistic and quantifiable as possible. If projections are out of line with historical patterns, up or down, management must question the planning. Thus, for instance, a sharply rising projection of costs must have some real-world justification. Overly ambitious revenue projections must also be questioned. Conversely, managers must resist pressures sharply to raise revenue targets unless tangible changes in the market or compensating raises in sales expenditures are present. If the negotiating levels are honest and realistic, the right projections will result. Ideally, operating units should not be measured on activities over which they lack full control. An operation which does not operate its own debt collection, for example, should not be measured on how rapidly invoices are collected. Since budgets are often at least 50 percent guess-work, formal budgetary review at reasonable intervals and realistic adjustments based on actual events must be part of a well-functioning process. All too often, the spring budgeting event is rapidly forgotten.

BENEFITS AND COSTS

The single-most potential benefit of formal budgeting lies in ensuring that responsible managers take time each year (and then at fixed intervals throughout the year) in thinking about their operation by looking at all of its aspects. Budgeting creates a comprehensive picture of the future and makes both opportunities and barriers conscious. This foreknowledge then helps guide day-to-day activities.

The chief cost of the budget process is time. In some corporations the process takes on a life of its own and becomes a convoluted exercise of excessive complexity which, moreover, prevents unit managers from doing any thinking: their time is consumed in efforts to comply with a vast array of requirements dictated from above. Much of the negative attitude that has developed concerning this activity has its roots in unnecessary bureaucratic impositions on the one hand and unreliability because of rapid change a few months out.

TYPES OF BUDGETS

The two dominant forms of budgeting are traditional and zero-based. Business planning is usually a combination of the two. Traditional budgeting is based on a review of historical performance and then the projection of such findings to the future with modifications. If inflation is high, for instance, cost trends of the last several years are projected forward but with adjustments both for inflation and for projected growth or decline in business activity. Historical sales patterns, using established trends in sales growth, are projected; new sales from planned new product introductions are then added. Zero-based budgeting is the creation of a completely new budget from the ground upas if no history existed. When using this method, the operation must justify and document every item of expenditure and income anew. Brand-new operations will utilize zero-based methods.

In government planning, but only very rarely in business, performance budgeting is used as a third alternative. Under this method, the budget is fixed at the outset. The planning activity is to determine exactly what activities will be carried out using the allocated funds. Performance budgeting is sometimes used in the corporate setting when the advertising budget is arbitrarily set as such-and-such a percent to projected sales. The advertising function then uses performance budgeting to allocate the budget to various products and media.

CRITIQUES OF THE PROCESS

As early as 1992, the famous guru of management, Peter Drucker, wrote in The Wall Street Journal: "Uncertaintyin the economy, society, politicshas become so great as to render futile, if not counterproductive, the kind of planning most companies still practice: forecasting based on probabilities."

Uncertainty has, if anything, grown since 1992 with the expansion of the Internet, the reality of terrorism, pressures on hydrocarbon fuels, the threat of global warming, and worldwide epidemics. In addition to uncertainty, formal budgeting has also come under fire for impeding trust and empowerment, two new concepts in the evolving corporate culture, as well as for stifling innovation. As David Marginson and Stuart Ogden recently wrote in Financial Management (UK), "Budgets have long had a bad press, but they have attracted even more flak recently for being at best inappropriate to modern business practice and at worst potentially harmful. The Beyond Budgeting Round Table (BBRT) has been one of their most vociferous critics. It argues, for example, that the necessary conditions of trust and empowerment in today's organizations are not possible with budgets still in place, because the entire system perpetuates central command and control." Innovation is vital for economic survival. But "budgeting stifles trust and empowerment, according to its critics, which in turn stifles innovation."

The BBRT is an element of The Player Group, a management advisory firm; the Round Table has 29 major corporate members. On its homepage, BBRT advocates a set of principles which include, among others, continuous planning and controls (rather than an annual budget process), resource allocation as needed (rather than based on annual allocations and plans), high performance standards (rather than detailed rules and budgets), and freedom of action by small front-line teams (rather than direct control of operations from the center).

The high costs of the budget process and its poor adaptability to stock market perceptions is another force working to bring about change in the budgetary process as it has been practiced over the last 50 years or so. An article in The Practical Accountant put the matter as follows, citing Herman Heyns of Accenture/Cranfield School of Management: "[T]the budget process is obsolete given today's economy, resulting in documents that are time-consuming to produce, of little predictive value, subject to gamesmanship and, quite frankly, out of date by the time they're implemented." Among the new approaches advocated by Heyns is the rolling budget. Under a rolling budget, performance of the operation over the last 12 months is evaluated on an on-going basis; projections for the next three months are generated every month.

Budgeting appears to be on the cusp of a change. How long it will take to transform itself is difficult to predict. In a new book titled Beyond Budgeting, Jeremy Hope and Robert Fraser start off by sketching the ambivalence felt by top and middle management toward formal, traditional budgeting. Then they go on: "Though this ambivalence toward budgeting has existed for decades, the balance of opinion has swung decidedly in favor of the 'very dissatisfied.' Even within the financial management community, nine of ten have expressed their dissatisfaction, finding the budgeting process too 'unreliable' and 'cumbersome.'"

The changes, as they evolve, will impact large corporations first and foremost. For the small business owner, budgeting in the traditional sense will continue to be a sensible, necessary, and valuable tool practiced, in essence, by examining current resources, eyeing the future, and making rational allocations for the immediate future.

see also Business Planning

BIBLIOGRAPHY

Ackoff, R. L. A Concept of Corporate Planning. Wiley-Interscience, 1969.

Drucker, Peter. "Planning for Uncertainty." Wall Street Journal. 22 July 1992.

Fearon, Craig. "The Budgeting Nightmare." CMA Management. May 2000.

Hope, Jeremy, and Robin Fraser. Beyond Budgeting. Harvard Business School Press, 11 April 2003.

Marginson, David and Stuart Ogden. "Budgeting and Innovation: Do budgets stifle creativity?" Financial Management (UK). April 2005.

Reason, Tim. "Building Better Budgets." CFO. December 2000.

"Throwing Out the Annual Budget." The Practical Accountant. February 2002.

                                 Hillstrom, Northern Lights

                                 updated by Magee, ECDI

Budgets and Budgeting

views updated May 29 2018

BUDGETS AND BUDGETING

A budget is a financial plan for the upcoming period. A capital budget, on the other hand, involves an organization's proposed long-range major projects. The focus of this section is on budget. Public and private entities both engage in the budgetary process. A government budget starts with the projection of sources and amounts of revenue and allocates the potential receipts among projects and legislatively mandated programs based on projected needs and public pressure. Government entities actually record budgets in the accounting records against which expenditures can be made.

A budget is a quantitative plan of operations that identifies the resources needed to fulfill the organization's goals and objectives. It includes both financial and nonfinancial aspects. Budgeting is the process of preparing a plan, commonly called a budget. A master budget is comprised of operating budgets and financial budgets. Operating budgets identify the use of resources in operating activities. They include production budgets, purchase budgets, human resources budgets, and sales budgets. Financial budgets identify sources and outflows of funds for the budgeted operations and the expected operating results for the period. Some variations of budgets are continuous budgets and continuously updated budgets. Rather than preparing one budget for the upcoming year, in a continuous budget one updates the budget for the following twelve months at the end of each month or each quarter. Such a budget remains more current and relevant. A good budget uses historical data as a base and for reference but at the same time incorporates anticipated costs and volumes based on a comprehensive knowledge and understanding of both internal and external factors that affect the business.

COMPONENTS OF THE MASTER BUDGET

The master budget includes a sales budget, which shows expected sales in units and in dollars. A merchandising firm needs to budget for the goods it needs to purchase for resale; these purchases become its cost of sales. A manufacturing organization's master budget includes a production budget, which uses the sales budget and inventory levels anticipated at the beginning and end of the period to determine how much to produce.

The production budget needs to be exploded into budgets for direct material, direct labor, and manufacturing overhead. Direct material and direct labor are items clearly identifiable in the finished product. Manufacturing overhead includes all costs of manufacturing except direct material and direct labor, such as machine depreciation, utilities, and supervision. The direct material budget explodes the production into basic ingredients; quantities to be purchased are anticipated based on expected inventory levels at the beginning and end of the period. With the help of the purchasing department, the prices for the needed materials are computed to arrive at the material purchases budget. The direct labor budget uses industrial engineering guidelines and production needs to estimate labor requirements. The human resources department provides the labor rates for the skill levels required. Overhead costs are estimated based on production level and appropriate cost drivers (i.e., the factors that cause costs to vary). Some overhead costs are considered variable because they vary with the level of output. Others are considered fixed because the level of output does not affect the amount of those costs. For example, the production supervision cost is assumed to be the same regardless of how much is produced within a shift in a plant. One can, then, estimate production costs and cost per unit for goods to be produced. Cost of goods sold can be determined based on the inventory levels of finished goods. Selling and general administration costs are then estimated, taking into consideration those costs that vary with sales, such as sales commission, as well as fixed costs that remain the same regardless of the level of sales, such as office rent. The information put together so far gives one all one needs to prepare a forecasted income statement.

At this point, the cash budget is developed. This item starts with cash at the beginning of the period plus cash that will be generated through collection of receivables, cash sales, and other sources minus anticipated minus cash disbursements, which include payroll disbursements, payment for taxes, and accounts payable depending on the terms for payment. The resulting cash balance may be negative if there are more disbursements than receipts, in which case borrowing needs are determined. A positive cash balance may be more than needed for operating expense. Such excess cash may be deposited in a temporary investment account. The final part of master budget preparation is the forecasted balance sheet, where the anticipated cash balance, investments, accounts receivable, inventory, fixed assets, accounts payable, wages payable, taxes payable, long-term liabilities, and equity accounts are recorded to assure that the two sides of the equation balance; that is, assets = liabilities + equity.

THE BUDGETING PROCESS

Budgeting is, or should be, the result of teamwork. A top-down budget is a budget that is essentially imposed on the organization by top management. This may be an efficient way to prepare a budget but because of lack of participation by the employees, such budgets often bring with them a level of employee resentment and resistance that leads to problems in implementation of what is proposed. Employees do not feel a sense of ownership in a budget in which they have not been participants. A participatory, or bottom-up budget, on the other hand, starts with the employees in each department determining their needs and requirements in order to achieve the company goals. Because employees feel a sense of ownership in such budgets, they attempt to meet or exceed those expectations. A balance between the two extremes can often be achieved. Top management should be involved in setting the tone and providing the guidelines and parameters within which the budget will be set. Incentives should be put into place so that those who achieve or exceed the budgetary expectations will receive suitable rewards for their efforts.

There must also be guidelines to discourage budgetary slacks and abuses whereby the requested budget amounts are in excess of anticipated needs in order for the department to look better and reap some rewards. A very tight budget, on the other hand, may prove discouraging and unattainable. No matter what approach is taken, it is important to realize that the budget should serve as a map and guideline in anticipating the future. Top management must take it seriously in order for the employees to take it seriously as well. At the same time, the budget should not be seen as a strict and unchangeable document. If opportunities arise, circumstances change, and unforeseen situations develop, there is no reason why the budget should be an impediment to exploring and taking advantage of such opportunities. Many companies form a budget committee to oversee the preparation and execution of the budget. The budget can also be seen as a tool that helps in bridging the communications gap between various parts of the organization. Sales, production, purchasing, receiving, industrial relations, sales promotion, warehousing, computing, treasury, quality control, and all other departments see their roles and understand the roles of the other players in achieving the goals of the organization. Such participation also necessitates budget negotiation among the various parties to the budgetary process until the budget is finalized. Goal congruence occurs when the goals of the employees and the goals of the company become intertwined and meshed together. A budget that does not consider the goals of the employees often fails. The finalization of the budget requires acceptance by the affected departments and approval and sign-off by top management. If circumstances change due to factors such as change in product mix, costs, selling prices, negotiated labor rates, or engineering specifications, there may be a need for budget revision.

OTHER BUDGETING TECHNIQUES

An incremental budget is a budget that is prepared based on prior-year figures, allowing for factors such as inflation. Although such an approach is used by some government entities, most people frown upon such a practice because it is contrary to the whole notion of a budget, which is supposed to be a calculated and wise anticipation of the future course of events with due consideration of all potential factors. A zero-based budget, on the other hand, is a budget that does not take anything for granted. It starts from point zero for each budgetary element and department each year and attempts to justify every dollar of expenditure. Although some industries had implemented such a method earlier, it was first used in preparing the state of Georgia's budget in the early 1970s and was later used to prepare the federal budget in late 1970s during President Carter's administration. However, it was soon abandoned because the paperwork generated and timeframe necessary to do this task proved to be too cumbersome for the federal government. Kaisen budgeting, a term borrowed from Japanese, is a budgeting approach that explicitly demands continuous improvement and incorporates all the expected improvements in the budget that results from such a process. Activity-based budgeting is a technique that focuses on costs of activities or cost drivers necessary for production and sales. Such an approach facilitates continuous improvement. An easily attainable budget often fails to bring out the employees' best efforts. A budget target that is very difficult to achieve can discourage managers from even trying to attain it. So budget targets should be challenging and at the same time attainable.

MONITORING THE BUDGET

A flexible budget modifies the budget to the actual level of performance. Obviously, if the original budget is prepared for say, 1,000 units of a product, but 2,000 units are produced, comparing the original budget to the actual volume of output does not provide meaningful information. Accordingly, the budgeted costs per unit for all variable costs can be used and multiplied by the actual volume of output to arrive at the flexible change proportionately to the level of output for the former and to the level of sales for the latter cost. Fixed costs, such as rent, however, do not normally change with the level of production or sales. These budgeted costs, therefore, are not adjusted and left intact even though the volume of sales and output may be different from the originally budgeted levels.

Ultimately, a good budget is one that not only uses good budgeting techniques but is also based on a sound knowledge of the business as well as the external factors that affect it. The budget serves as a planning tool for the organization as a whole as well as its subunits. It provides a frame of reference against which actual performance can be compared. It provides a means to determine and investigate variances. It also assists the company in planning again based on the feedback received considering the changing conditions. An attainable, fair, and participatory budget is also a good tool for communication, employee involvement, and motivation.

see also Financial Forecasts and Projections

bibliography

Blocher, Edward J. et al. (2005). Cost Management: A Strategic Emphasis (3rd ed.). Boston, MA: McGraw-Hill/Irwin.

Horngren, Charles T., Foster, Datar, and Foster, George (2005). Cost Accounting: A Managerial Emphasis (12th ed.). Upper Saddle River, NJ: Prentice Hall.

Raiborn, Cecily A., Barfield, Jesse T., and Kinney, Michael R. (1999). Managerial Accounting, (3rd ed.) Cincinnati: South-Western College Pub.

Schick, Allen, ed. (1980). Perspectives on Budgeting. Washington, DC: American Society for Public Administration.

Willson, James D. (1995). Budgeting and Profit Planning Manual. Boston, MA: Warren, Gorham, Lamont.

Young, S. Mark (1997). Readings in Management Accounting (2nd ed.). Upper Saddle River, NJ: Prentice Hall.

Roger K. Doost

Budgeting

views updated Jun 27 2018

Budgeting

What It Means

Budgeting is a form of fiscal planning that enables individuals or other entities to make informed financial decisions. Budgeting focuses on two principal aspects of a financial situation: income or revenue (in other words the amount of money that is earned over a set period of time) and expenditures (the amount of money that is spent). Through budgeting individuals keep track of how much money they spend on certain aspects of their lives and try to figure out ways to cut their regular expenses to free up money for other expenditures they might like to make. The actual financial plan created by the process of budgeting is called a budget.

There are many types of budgets. Governments create budgets to ensure that they take in enough revenue (generally through the collection of taxes) to pay for social programs, such as schools, police and fire departments, public parks, financial assistance programs for low-income families, and various other projects having to do with the effective management of a community. Corporations use budgets to calculate methods of minimizing overhead (expenditures relating to running a company, such as purchasing supplies, paying employees, renting office space, and so on) in order to maximize profits.

Individuals and families also use budgets, as a means of managing their personal finances. In creating a personal budget an individual or a family must consider a number of factors, relating to both their financial resources and their financial goals. In certain respects the first step to creating a budget involves establishing priorities concerning how money is spent. All families have a certain number of expenses, relating to food, shelter, rent or a home mortgage, clothing, and utilities (everyday services, such as electricity, water, sewer, and waste disposal), that are essential to maintaining a healthy and safe existence. For some families, particularly those with low incomes and/or a large number of children, these necessary expenditures account for most if not all of their monthly earnings. In these instances a budget might prove vital to making certain that these necessary payments are made in a timely way, thereby ensuring the family’s continued financial security.

For families or individuals with larger incomes, a budget can help maximize financial resources to increase overall quality of life. Having additional income above and beyond the payment of necessary expenses gives an individual or a family a wider range of choices regarding how much money to spend on particular aspects of their lives. The amount of money that an individual or a family sets aside for a specific purpose will generally depend on what activities or consumer products they regard as important to their happiness. A young man in his 20s, for example, with few financial responsibilities beyond paying rent and utilities, putting gas in the car, and eating, might create a budget that allows him to set aside money for recreational pursuits, such as taking exotic vacations or purchasing a motorcycle. As people grow older and start families, their financial priorities often change, both because their personal interests evolve over time and because their financial responsibilities increase as they assume responsibility for the care and upbringing of children. For these families a budget might enable them to save money for their children’s education or to begin investing a certain portion of their monthly income in an individual retirement account, or IRA (an investment savings account that individuals set aside to use as income in the future, after they retire from their jobs).

When Did It Begin

Some form of budgeting has undoubtedly played a central role in financial management since approximately 3100 bc , when people in ancient Mesopotamia (a region roughly consisting of what is now Iraq) first began keeping written records of crop production on clay tablets. In English usage the word budget traces its origins to the fifteenth century. Originally a term designating a leather wallet or pouch, it eventually came to refer to the contents of such a pouch; by the first half of the eighteenth century, the term budget had come to refer to the English government’s statement of annual expenditures. In nineteenth-century America the increased practice of household budgeting roughly corresponded to the emergence of home economics (the science of running or managing a household) as an educational discipline. In the twentieth century the concept of household budgeting became a subject of economic study. In his landmark books Human Capital (1964) and A Treatise on the Family (1981), Nobel prize-winning economist Gary S. Becker (b. 1930) analyzed the importance of budgeting in determining how modern families function.

More Detailed Information

According to many experts one of the keys to creating a workable budget is simplicity. For most people income is the most predictable aspect of their financial lives; their paycheck comes from a single source and remains constant from pay period to pay period, whether it is calculated by the week, month, or year. When it comes to expenses, however, a person’s financial picture becomes more complicated. Some expenses, such as housing, cable television, and car payments, remain fixed from month to month and are therefore easy to anticipate when drawing up a budget. Other monthly expenses, on the other hand, are variable: heating costs rise and fall depending on the season, gasoline prices fluctuate constantly, phone bills are typically calculated according to the calls that are made, and so on. At the same time, irregular expenses (for example, paying to get a computer repaired or purchasing a new couch) arise constantly and often cannot be predicted. Thus to try to create a budget that accounts for all expenditures would be extremely complicated if not outright impossible.

By dividing a budget into broad categories, however, a person can allow for more flexibility in monitoring expenditures. Typical budget categories might include housing (rent or mortgage payments), food (including meals that are prepared at home, snacks purchased from a vending machine or corner store, and so on), car (such as monthly car loan payments, auto insurance, gas, and minor maintenance), basic utilities (including phone, Internet, and cable television), clothing, entertainment (movies, going out to restaurants, buying beer or wine, visiting a museum, and the like), and general household items, ranging from laundry detergent to toothpaste.

In essence budgeting is a means of controlling monthly expenses. Monthly spending habits vary widely, depending on the life situation of the person. For example, the expenses of a single young man will typically be less complicated than those of a large family. Say a young man earns a net income (the amount of personal income remaining after taxes) of $2,800 a month working as a computer programmer in a major city. His obligatory monthly expenses include rent ($1,200), utilities ($150 on average), clothing ($50 on average), public transportation ($100), laundry ($25), and groceries ($275). Theoretically at the end of the month he will have an additional $1,000 of his monthly earnings, a considerable surplus.

In all likelihood, however, the young man’s monthly spending will greatly exceed these necessary expenses. For example, he might stop by a local pub every Friday after work to drink pitchers of beer and shoot pool with his friends ($200 a month), go to the movies once a week ($50 a month, with popcorn), purchase various magazines at the corner newsstand ($30), purchase a latte each morning at the coffee shop ($100 a month), rent videos a couple evenings a week ($40 a month), eat some form of takeout three nights a week ($180 a month), and download 50 to 100 songs off the Internet ($49.50 to $99). In addition he might buy pizza slices on his way home from the pub ($25), buy candy bars or other snacks whenever the mood strikes him ($25), and purchase at least two expensive items a month, such as running sneakers, stereo equipment, or a handheld gaming device ($200).

After all these additional expenses the young man might find himself with somewhere between $50 and $100 remaining each month. When other, irregular expenses occur (for example, flights home to visit family twice a year, $1,000; taxis home from the pub when it is too cold to walk, $100 each winter; a visit to the dentist, $150; laptop repair, $250) the young man might find that he does not have enough money to cover them and must charge some of the expenses to his credit card. Rather than having a sizable surplus at the end of the year (money that could have gone toward taking a trip to Europe, investing in an IRA, or putting a down payment on a home), the young man has a gradually increasing debt.

This situation could easily be avoided if the young man were to draw up and follow a basic monthly budget, allowing him to regulate his expenses to ensure that he lives within his means. In creating a budget the young man would start by keeping track of everything he spends over the course of a single month. The initial totals might look like the following: $1,200 for rent, $150 for utilities, $50 for clothing, $100 for subway cards, $25 for laundry, $275 for groceries, $475 for entertainment (including pub night, movies, and takeout), $300 for “large” purchases (sneakers, song downloads, and so on), and $150 on miscellaneous items (such as magazines and coffee). After adding up all his expenses the young man will see that he spends roughly $2,725 of his $2,800 salary every month, leaving him only $75 left over for additional expenses. As the young man begins to consider his future and develop long-term financial goals for himself, some of these expenditures might seem frivolous. He might find ways to reduce his spending, some of which might be easy for him to do; he might decide that he can make his own coffee in the morning ($30, as opposed to $100), read magazines at the public library (free, instead of $30), or start going to movies only once a month ($12, rather than $50). Others (such as giving up the sneakers and the electronic games and cutting back on his Friday nights at the pub) might seem more difficult to sacrifice. Still, even if the young man can cut his unnecessary expenditures by 50 percent, he will find himself with an extra $500 a month, or $6,000 a year.

Recent Trends

Traditionally many people have written budgets by hand on pieces of paper, which they subsequently keep stored in folders or file cabinets. With the advent of the personal computer, budgeting has become a far more simple process for most consumers. A number of products allow individuals to use electronic spreadsheets (an accounting method that organizes different categories of income and expenditures into individual columns), and money management software is available for people to keep track of their financial activities. Many of these software programs generate monthly reports, allowing consumers to identify general trends in their spending habits.

Budgeting

views updated May 17 2018

Budgeting

Organizations develop specific plans for saving and spending income. These plans, or budgets, are essential for developing spending and saving priorities. A properly prepared budget also serves as a reference to check how well money is being managed, by allowing managers to see actual revenues and expenses compared to budgeted revenues and expenses during a period. Managers can identify revenue shortfalls or expense excesses and take corrective action earlier.

The term budget can be dated back to medieval England, where it meant leather purse or wallet. A budget allows businesses to meet specific goals by creating a system of saving and spending money efficiently. Simply defined, a budget is a plan for using corporate funds in a way that best meets the firm's wants and needs. The plan

includes a recorded entry of expected income, expenses, and savings over a defined period of time.

A wide range of budgeting techniques exist and although the fundamental purposes are similar, the specifics among various organizations are often different. One important aspect of budgeting is how organizations increase cash to finance ongoing operations and new opportunities. Large corporations, for example, may have the option of increasing cash by selling treasury stock, previously authorized shares of ownership that have never been offered for sale on the stock market. The liquidity of equity (stock) markets allows managers to implement these equity decisions fairly quickly to budget for projected needs.

Several independent organizations rate the debt-paying ability of large corporations. This creates a market for corporate debt, more commonly referred to as bonds. Corporations with favorable debt ratings have the ability to borrow money, that is, issue bonds, at lower interest rates than those with unfavorable debt ratings.

Small businesses, in contrast, often do not have publicly traded shares of stock. Although these businesses can sell stock to investors, the process is more uncertain because the market for this type of stock is less liquid. Venture capital is also an option, but the number of small businesses seeking venture capital nearly always exceeds the amount of venture capital available. Also, debt-rating agencies do not rate the debt-paying ability of many small businesses, limiting the extent to which these businesses can raise cash through bond issues. Without a ready market for debt, small businesses must often turn to the less liquid forms of debt financing such as bank loans, in some cases at higher interest rates than would be available from established credit markets available to larger corporations.

Budgets allow businesses to better utilize the financial resources available to them. To begin with, budgets help businesses operate within their means. Over the long term, budgets assist businesses in spending less money than they earn. Next, budgets help businesses achieve their financial goals by planning for the future and organizing money into categories such as income, expenses, and savings. In short, budgets help a business avoid credit problems, better prepare for financial emergencies, and build better money management skills by creating a structured plan.

Businesses should follow several steps to successfully implement a budget. These include setting financial goals, planning budget categories, maintaining financial records, and balancing and adjusting the budget. Setting financial goals is the starting point in the budgeting process. Questions managers should ask include:

  • What do we want accomplished within one month, one year, or ten years?
  • What new products or services do we want to offer in the short- and long-term, and how can we finance these?
  • Will my operating expenses increase with inflation, and how will we increase revenue to meet these additional expenses?

These questions provide a starting point to spur additional questions. The answers to these questions should help determine how income should be spent and saved. Managers should ask dozens of additional questions to cover all the categories of revenue, expense, and debt and equity financing.

In general, budgeting questions should revolve around estimates of income and expenses. Categories include fixed expenses such as rent, insurance premiums, and taxes; estimates of variable expenses such as utilities and wages; and estimates that allow for uncertainties.

One way to budget is by comparing estimated financial figures created before a budgeting period with actual experience at the end of the budgeting period. The initial estimates are called pro forma financial statements. The three primary types of financial statements are a balance sheet, income statement, and statement of cash flows. The balance sheet shows assets owned, liabilities owed, and owners' equity (owners' financial stake in the businesses). The income statement details profit and loss for a given period. The statement of cash flows helps managers see where cash came from and where it went. By comparing pro forma financial statements to end-of-period financial statements, managers can judge whether or not their budgets are in line with estimates. Adjustments can then be made for future budgeting periods.

Companies often experience a budget variance, the difference between a budgeted figure and an actual figure. There are two kinds of budget variance. A quantity variance is due to an increase or decrease in the quantity of the resource used. A cost variance is due to a difference in the cost of a resource. For example, a company may have a fuel budget based on an estimated consumption of 100 gallons at $3 per gallon. If the company uses more than 100 gallons of fuel, a quantity budget variance has occurred. Likewise, if the cost of the fuel increases to $3.50, the company is facing a cost variance. The variance tells companies that something is out of line.

A budget must meet certain characteristics to help businesses successfully manage money. The budget should be realistic as well as flexible. When a budget variance occurs, the budget should be specific enough to provide information that shows what costs are out of budget. When unexpected expenses arise, the spending plan should be able

to handle these costs. A budget is not a permanent plan and should be realigned when circumstances occur that alter budget categories. The budget should be carefully planned and organized, yet clear enough to be communicated to organizational stakeholders such as lenders and owners.

Companies create budgets for a mixture of reasons. They can serve a variety of functions, and many techniques can be implemented to develop them. Budgets can be used as a means of forecasting and planning for the future. Their creation can also be used as a motivational tool. The plan can be used as a means of evaluation and control as well as a resource for information and decision-making.

In addition to preparation or pro forma financial statements and comparison to actual financial statements, many different approaches to the budgeting process can be used depending on the desired function of the company. Breakeven analysis, for instance, estimates the amount of sales required to cover the expenses of a new product or service. Payback periods are similar, but increase the focus of breakeven analysis on needed sales by adding the length of time needed to achieve those sales. This tells managers how long it will take to recoup initial expenses. Another type of budgeting is capital budgeting, in which the estimated revenue from capital projects such as purchase of property, plants, and equipment is projected. Additional techniques include parametric, partial, zero-based, and equity budgeting. Each of these may be applied to organizations' financial situations depending on the needs of the individual businesses.

Each department within a corporation plays a key role in the overall budget process. Regardless of the approach, those working on the budget must know the corporation's goals and initiatives for the coming year. By considering corporate strategy, all departments within the corporation create their budget in a way that helps enable the company to hit its key initiatives for the coming fiscal year, and to meet short- and long-term corporate goals.

Budgeting is essential. Businesses without budgets can quickly find themselves short of cash not only for new products and services, growth and expansion, and improvements in capital projects, but also in simply meeting short-term needs such as payroll, insurance, and tax expenses. Budgeting is thus a key element in all business planning.

SEE ALSO Break-even Point; Financial Issues for Managers; Zero-Based Budgeting

BIBLIOGRAPHY

Henry, David. Loading Up on Junk. Business Week, 31 Jan. 2005, 7880.

Orlando, John. Budgeting for IT: Four Pitfalls to Avoid. SearchCIO.com, 19 Sep. 2007. Available from: http://searchcio.techtarget.com/news/column/0,294698,sid182_gci1273064,00.html

Schick, Allen. Twenty-Five Years of Budgeting Reform. OECD Journal on Budgeting 1, no. 4 (2004): 102124.

U.S. Small Business Administration. Small Business Startup Guide. 2005. Available from: http://www.sba.gov/starting_business/startup/guide.html.

Vorster, Mike. How to Manage Fixed-Cost Budgets.Construction Equipment, 1 Oct. 2006. Available from: http://www.allbusiness.com/economy-economic-indicators/economic/6292572-1.html.

budget

views updated Jun 27 2018

budg·et / ˈbəjit/ • n. an estimate of income and expenditure for a set period of time: keep within the household budget. [as adj.] a budget deficit. ∎  an annual or other regular estimate of national revenue and expenditure put forward by the government, often including details of changes in taxation. ∎  the amount of money needed or available for a purpose: they have a limited budget.• v. (budg·et·ed, budg·et·ing) [intr.] allow or provide for in a budget: the university is budgeting for a deficit [as adj.] (budgeted) a budgeted figure of $31,000 [as n.] (budgeting) corporate planning and budgeting. ∎  [tr.] provide (a sum of money) for a particular purpose from a budget: the council proposes to budget $100,000 to provide grants.• adj. inexpensive: a budget guitar.PHRASES: on a budget with a restricted amount of money: we're traveling on a budget.DERIVATIVES: budg·et·ar·y / -ˌterē/ adj.ORIGIN: late Middle English: from Old French bougette, diminutive of bouge ‘leather bag,’ from Latin bulga ‘leather bag, knapsack,’ of Gaulish origin. The word originally meant a pouch or wallet, and later its contents. In the mid 18th cent., the Chancellor of the Exchequer in the UK, in presenting his annual statement, was said “to open the budget.” In the late 19th cent. the use of the term was extended from governmental to private or commercial finances.

Budget

views updated May 14 2018

BUDGET

The federal budget is the comprehensive annual program of income and expenditure of the federal government. The budget is not a constitutional requirement, nor does it answer to either the "appopriations made by law" or the "regular statement of account" of Article I, section 9, of the Constitution. Rather the budget is a legislatively created device to regularize the exercise of the taxing and spending power.

In the nineteenth century there was no overall annual spending program. Appropriations bills were formulated by various congressional committees, which thereby exercised considerable control over the executive departments. A national budget process was first recommended by the Commission on Economy and Efficiency, appointed by President william howard taft in 1908; and the budget and accounting act, which governed the budget process for over half a century, was enacted in 1921.

Because expenditure is an executive function, the President, as chief executive, was given authority to prepare and submit the budget. This represented a major shift of power within the government in favor of the executive branch. President franklin d. roosevelt further consolidated presidential authority in 1939 by transferring the Bureau of the Budget (created by the 1921 act) from the Treasury Department to the Executive Office of the President. In 1969, President richard m. nixon restyled the bureau office of management and budget and increased its control over the operations of executive departments and agencies.

Congress reasserted its role in fiscal policymaking by the congressional budget and impoundment control act (1974). The act created a permanent budget committee in each house of Congress, established the Congressional Budget Office to provide independent evaluation of executive economic planning, and prescribed a timetable for each phase of the budget and appropriations process. Even after passage of this act, however, the budget process is necessarily dominated by the chief executive.

Dennis J. Mahoney
(1986)

(see also: Balanced-Budget Amendment; Budget Process.)

Bibliography

Borcherding, Thomas E., ed. 1977 Budgets and Bureaucrats: The Sources of Government Growth. Durham, N.C.: Duke University Press.

Marini, John 1978 The Politics of Budget Control: An Analysis of the Impact of Centralized Administration on the Separation of Powers. Unpublished Ph.D. dissertation, Claremont Graduate School.

budget

views updated May 18 2018

budget. The practice of devising an annual programme for financial legislation has been attributed to William Lowndes, an official in the Treasury throughout the half-century after 1675. The term dates from the 1730s and is derived from the wallet or ‘bougette’ in which the chancellor of the Exchequer carried his proposals. Early in the 18th cent. the principle was established that funding and expenditure proposals should be the preserve of the House of Commons, and that financial initiatives within the Commons should be the preserve of the Treasury ministers. In the 19th cent. the practice developed by which the annual budget comprised an assessment of Exchequer income and expenditures for the past financial year, together with estimates of expected spending needs in the forthcoming year and the fiscal steps required to provide for them. Since the Second World War, when economic management has become a more important part of the political process, the budget has become a means of indicating government economic strategies to other economic agencies, a statement of the state of the economy, and a means of political and media manipulation. As the range of economic instruments at the disposal of the state has increased, together with the need to respond far more frequently to changing events, the budget has lost some of its importance.

Clive H. Lee

Budget

views updated May 23 2018

Budget

a bag or sack with its contents; a stock or accumulation; an estimate of expenses; a leather or skin bottle.

Examples: budget of freshwater [leather bottleful], 1580; of general knowledge, 1822; of inventions, 1692; of nails [a bag], 1677; of news; of olives, 1653; of paper, 1729; of paradoxes, 1867; of tools [a bag], 1879.

budget

views updated May 29 2018

budget Plan for the financial expenditure of an individual, corporation or government, matching it against expected income. National budgets determine the level of direct and indirect taxation against projected expenditure and economic growth. The complexity of modern trade and finance has sometimes forced governments to make two or more budgets in a single year.

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