A budget uses numbers to express thoughts which can be done broadly, narrowly, or both. How thoughts are expressed is important in a budget. If a budget is not impressed properly, it becomes irrelevant in many ways.
The Purpose of a Budget
The purpose of a budget is to provide guidance. Guidance is a necessary part of our lives, most notably in helping us reach destinations. For companies, the destination is the improvement of stakeholder well-being. The effectiveness of improving stakeholder well-being can be determined by the effectiveness of expressing thoughts in a budget.
Thinking within a Budget
How can we think within a budget? The answer is financial statements.
Financial statements organize thinking through their elements. Each financial statement has distinct elements that can improve guidance inside companies:
- Income statement expresses delivery of products or services.
- Balance sheet expresses the acquisition of resources.
- Cash flow statement expresses how companies receive and spend money.
Thinking broadly is about the categories of financial statements. Each financial statement has categories that allow flexibility i.e. an ability to adapt to changes in environment.
The broadest thought in an income statement is net income, the difference between revenues and expenses.
Thinking broadly about net income requires flexibility in both revenues and expenses:
- Will revenues be earned from products or services or both?
- Will expenses be incurred from cost of goods sold, selling expenses, or administrative expenses?
The broadest thought in a balance sheet is the accounting equation: assets = liabilities + stockholders’ equity.
- Will the acquisition of assets focus on current or long-term resources?
- Will liabilities used to acquire assets focus on short-term or long-term obligations?
- Will stockholders’ equity used to acquire assets focus on contributed capital or retained earnings?
Cash flow statement
The broadest thought in a statement of cash flows is the ending cash balance. A company’s ending cash balance can be affected by different types of activities:
- an emphasis on conducting relationships (operating activity),
- acquiring long-term assets (investing activity),
- and/or raising money (financing activity).
The emphasis on these tasks is where the premise of a budget, the expression of thoughts with numbers, comes into play.
The priority is to think broadly about the combination of effort and reward, the combination of liabilities and stockholders’ equity and the ending cash balance that will improve stakeholder well-being.
Thinking narrowly is about precision. Precision is about specific elements in the process of creating, promoting, distributing, and supporting what companies sell.
Specific elements are familiar to accountants because of their work with a chart of accounts. It is a database containing numbers as well as names that help people identify, record, and communicate transactions:
A chart of accounts can both help and hinder the financial reporting process. The hindrance is minimizing flexibility which is necessary in the financial planning process.
How useful is your company’s 2020 budget?
Thinking about a Budget
So what must one do in regard to thinking about a budget?
First, remember Kern Rule #2: nothing can be perfect but everything can be better. One must incorporate a process that makes a budget better and yet accept some type of error will come from the process. In this article, the error is whether a budget will be thought about broadly or narrowly. If one is going to err, one should err on the side of thinking broadly.
Remember, a budget should guide people in their company’s effort to improve the well-being of its stakeholders. Guidance should not restrict action, it should encourage experimentation. Experimentation in the process of creating, promoting, distributing, and supporting what a company sells will occur when changes in the environment occur. Next month’s article will expand on this mindset.
The process of improving stakeholder well-being can change over time. Changes over time require changes in action and they must be done after thoughts are expressed. How thoughts are expressed affect the relevance of a budget and its ability to guide action in an environment of change. The way to connect relevance to action is to express thoughts broadly.