Advantages and disadvantages of financial budget

The Advantages of Budgeting

A budget is a document that forecasts the financial results and financial position of a business for

one or more future periods. At a minimum, a budget contains an estimated income statement that

describes anticipated financial results. A more complex budget also contains an estimated

balance sheet, which contains the entity’s anticipated assets, liabilities, and equity positions at

various points in time in the future.

A prime use of the budget is to serve as a performance baseline for the measurement of actual

results. Budgets may also be linked to bonus plans in order to direct the activities of various

company employees. A budget may also be used for both tax planning and treasury planning.

Despite these valid uses, there are also a number of problems with budgeting that have given rise

to a movement dedicated to the elimination of budgets.

Budgeting has been with us a long time, and is used by nearly every large company. They would

not do so if there were not some perceived advantages to budgeting. These advantages include:

▪ Planning orientation. The process of creating a budget takes management away from its

short-term, day-to-day management of a 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.

▪ Model scenarios. If a company is faced with a number of possible paths down which it can

travel, you can create a set of budgets, each based on different scenarios, to estimate the

financial results of each strategic direction.

▪ 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 which aspects of a business generate cash and which ones use it, which forces

management to consider whether it should drop some parts of the business or expand in

others. However, this advantage only applies to a budget sufficiently detailed to describe

profits at the product, product line, or business unit level.

▪ 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. Senior management can tie bonuses or other incentives to how

employees perform in comparison to the budget. The accounting department then creates

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 scrap rate) can also be added. We will

address a countervailing argument in the Command and Control System section later in

this chapter.

▪ Predict cash flows. Companies that are growing rapidly, have seasonal sales, or which

have irregular sales patterns have a difficult time estimating how much cash they are likely

to require in the near term, which results in periodic cash-related crises. A budget is useful

for predicting cash flows in the short term, but yields increasingly unreliable results further

into the future.

▪ 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.

▪ Cost reduction analysis. A company that has a strong system in place for continual cost

reduction can use a budget to designate cost reduction targets that it wishes to pursue.

▪ Shareholder communications. Large investors may want a benchmark against which they

can measure the company’s progress. Even if a company chooses not to lend much

credence to its own budget, it may still be valuable to construct a conservative budget to

share with investors. The same argument holds true for lenders, who may want to see a

budget versus actual results comparison from time to time.

These advantages may appear to be persuasive ones, and indeed have been sufficient for most

companies to implement budgeting processes. However, there are also serious problems with

budgets.

The Disadvantages of Budgeting

A budget is based on a set of assumptions that are generally not too far distant from the operating

conditions under which it was formulated. This article gives an overview of the general issues,

while the following sections address the particular problems associated with capital budgeting, as

well as the use of budgets within a command and control management system.

Inaccuracy. A budget is based on a set of assumptions that are generally not too far distant from

the operating conditions under which it was formulated. If the business environment changes to