BUDGET DEFICIT



A budget deficit is the amount by which an individual, business, or government's income falls short of the expectations set forth in its budget over a given time period. In most cases, those who experience a budget deficit must borrow funds to make up the difference between projected and actual income and expenses. The borrower must pay interest on this amount, known as its debt, which further increases expenses for the following time period. In this way, budget deficits tend to grow over time with the accumulation of loans and interest payments. If a business fails to take action to correct a budget deficit and restore the balance of cash inflows and outflows, bankruptcy can result.

THE BUDGETING PROCESS

A budget is a plan for the expenditure and receipt of funds to support a business, agency, program, or project. A master budget is a formal overall plan for a company. It consists of specific plans for business operations, capital expenditures, and the projected financial results of those activities. The budgeting process can begin with preparing a sales budget. Based on expected sales volume, merchandisers can budget purchases, selling expenses, and administrative expenses. Next, the capital expenditures budget is prepared, which includes all budgeted purchases and direct labor.

Budgets are no longer strictly the domain of corporate finance, but are important at all levels of management. The most typical budget of concern to both large and small businesses is the cash budget used in short-term financial planning. Its purpose is to identify financial needs in the immediate to near future. The cash budget records estimates of cash receipts and cash disbursements. The result is an estimate of the cash surplus or deficit. Other budgets can include the capital budget, or the budget associated with acquisition or construction of major capital items, including land, buildings and structures, and equipment. Funds for these capital projects are usually appropriated from surpluses, earmarked revenues, bond sales, or the operating budget. The operating budget for a state agency or program is typically based on legislative appropriation.

When expenses in the relevant time period (which may be a year, quarter, month, week, or day) exceed the budgeted cash available to cover the expenses, the organization (or division or unit under consideration) is said to have a deficit. Sometimes the deficit is also termed a shortfall. In technical terms, the budget process can develop, over time, into a number of substantial parts: operating budgets, capital budgets, debt management practices, tax expenditure budgets, forecasting processes for both revenues and expenditures, and inflation adjustments. To the uninitiated, the budget can easily be mistaken for an expenditure plan.

WHY DO DEFICITS OCCUR?

Deficits occur because cash is not available to cover expenses. Sources of cash might include collections, the sale of assets, investment income, or receipts from planned long-term financing. Expenses or cash disbursements/payments exceed incoming cash during a budget deficit. These cash disbursements may be greater than budgeted amounts in accounts payable for supplies and materials, wages and taxes, purchases of capital equipment, interest payments on long-term debt outstanding, or dividend payments to shareholders.

Without some outside financing, a deficit will carry over into the next period. Often the deficit may be the result of delays in collections on sales or a capital expenditure that was not planned, like the purchase of a new piece of equipment. Deficits could also result when sales are worse than the forecast due to a downturn in the economy or lost sales to competitors. Since budgets are based on prior forecasts, it is common for the actual amounts to differ from the forecasted or budgeted amounts. When deficits occur, management should attempt to determine the reason for the inconsistencies.

USING BUDGETS TO AVOID DEFICITS

Without clearly outlined budgets, corporations are unable to predict profits or losses or create plans for the future. Managers should work to understand how the budget is related to the other functional areas of strategic planning and to the general economic environment. Within the company, the budget is an element of internal control and can help set cost behavior and policies in the organization. From a human resources perspective, performance compensation can even be tied to budgets, particularly in the functional areas. For example, companies might pay on the basis of performance as compared to the sales and marketing budget, the manufacturing budget, the research and development budget, the administrative-expense budget, the payroll budget, etc.

Budgeting is important for managing cash so an organization can avoid deficits. Because deficits are often detrimental in any environment, budgeting is necessary in all types of businesses—and not just in the for-profit arena, but also in non-profit organizations, higher education, the health-care industry, and any type of organization that must manage expenses and revenues.

Planning is a management responsibility of crucial importance to business success. Budgeting is the process used by management to formalize its plans. Budgeting promotes analysis by management and focuses its attention on the future. Budgeting also provides a basis for evaluating performance, serves as a source of motivation, acts as a means of coordinating business activities, and communicates management's plans and instructions to employees.

FURTHER READING:

Banham, Russ. "Better Budgets." Journal of Accountancy. February 2000.

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

Hornyak, Steve. "Budgeting Made Easy." Management Accounting. October 1998.

Rachlin, Robert, ed. Handbook of Budgeting. 4th ed. McGraw-Hill, 1998.

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



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