Once a firm’s general goals for the planning period have been established, the next step is to set up a detailed plan of operation—the budget. A complete budget system encompasses all aspects of the firm’s operations over the planning period. It may even allow for changes in plans as required by factors outside the firm’s control.
Budgeting is a part of the total planning activity of the firm, so it must begin with a statement of the firm’s long-range plan. This plan includes a long-range sales forecast, which requires a determination of the number and types of products to be manufactured in the years encompassed by the long-range plan. Short-term budgets are formulated within the framework of the long-range plan. Normally, there is a budget for every individual product and for every significant activity of the firm.
Establishing budgetary controls requires a realistic understanding of the firm’s activities. For example, a small firm purchases more parts and uses more labour and less machinery; a larger firm will buy raw materials and use machinery to manufacture end items. In consequence, the smaller firm should budget higher parts and labour cost ratios, while the larger firm should budget higher overhead cost ratios and larger investments in fixed assets. If standards are unrealistically high, frustrations and resentment will develop. If standards are unduly lax, costs will be out of control, profits will suffer, and employee morale will drop.
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