A budget is a comprehensive financial plan setting forth the expected route for achieving the financial and operational goals of your business. Budgeting is an essential step in effective financial planning. Even the smallest business will benefit from preparing a formal written plan for its future operations. However, there are some advantages and disadvantages to consider:
The advantages of budgeting include:
- Planning orientation. The process of creating a budget takes management away from its short-term, day-to-day management of the business and forces it to think longer-term. This is the chief goal of budgeting, even if management does not succeed in meeting its goals as outlined in the budget - at least it is thinking about the company's competitive and financial position and how to improve it.
- Profitability review. It is easy to lose sight of where a company is making most of its money, during the scramble of day-to-day management. A properly structured budget points out what aspects of the business produce money and which ones use it, which forces management to consider whether it should drop some parts of the business or expand in others.
- Assumptions review. The budgeting process forces management to think about why the company is in business, as well as its key assumptions about its business environment. A periodic re-evaluation of these issues may result in altered assumptions, which may in turn alter the way in which management decides to operate the business.
- Performance evaluations. You can work with employees to set up their goals for a budgeting period, and possibly also tie bonuses or other incentives to how they perform. You can then create budget versus actual reports to give employees feedback regarding how they are progressing toward their goals. This approach is most common with financial goals, though operational goals (such as reducing the product rework rate) can also be added to the budget for performance appraisal purposes. This system of evaluation is called responsibility accounting.
- Funding planning. A properly structured budget should derive the amount of cash that will be spun off or which will be needed to support operations. This information is used by the treasurer to plan for the company's funding needs. • Cash allocation. There is only a limited amount of cash available to invest in fixed assets and working capital, and the budgeting process forces management to decide which assets are most worth investing in.
- Bottleneck analysis. Nearly every company has a bottleneck somewhere, and the budgeting process can be used to concentrate on what can be done to either expand the capacity of that bottleneck or to shift work around it.
The disadvantages of budgeting include the following:
- Time required. It can be very time-consuming to create a budget, especially in a poorly-organized environment where many iterations of the budget may be required. The time involved is lower if there is a well-designed budgeting procedure in place, employees are accustomed to the process, and the company uses budgeting software. The time requirement can be unusually large if there is a participative budgeting process in place, since such a system involves an unusually large number of employees.
- Gaming the system. An experienced manager may attempt to introduce budgetary slack, which involves deliberately reducing revenue estimates and increasing expense estimates, so that he can easily achieve favorable variances against the budget. This can be a serious problem and requires considerable oversight to spot and eliminate.
- Blame for outcomes. If a department does not achieve its budgeted results, the department manager may blame any other departments that provide services to it for not having adequately supported his department. • Expense allocations. The budget may prescribe that certain amounts of overhead costs be allocated to various departments, and the managers of those departments may take issue with the allocation methods used.
- Spend it or lose it. If a department is allowed a certain amount of expenditures and it does not appear that the department will spend all of the funds during the budget period, the department manager may authorize excessive expenditures at the last minute, on the grounds that his budget will be reduced in the next period unless he spends all of the amounts authorized in the current budget.
- Only considers financial outcomes. Budgets are primarily concerned with the allocation of cash to specific activities, and the expected outcome of business transactions - they do not deal with more subjective issues, such as the quality of products or services provided to customers. These other issues can be stated as part of the budget, but this is not typically done.
- Strategic rigidity. When a company creates an annual budget, the senior management team may decide that the focus of the organization for the next year will be entirely on meeting the targets outlined in the budget. This can be a problem if the market shifts in a different direction sometime during the budget year. In this case, the company should shift along with the market, rather than adhering to the budget.
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