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

any significant degree, then the company’s revenues or cost structure may change so radically

that actual results will rapidly depart from the expectations delineated in the budget. This

condition is a particular problem when there is a sudden economic downturn, since the budget

authorizes a certain level of spending that is no longer supportable under a suddenly reduced

revenue level. Unless management acts quickly to override the budget, managers will continue to

spend under their original budgetary authorizations, thereby rupturing any possibility of earning

a profit. Other conditions that can also cause results to vary suddenly from budgeted expectations

include changes in interest rates, currency exchange rates, and commodity prices.

Rigid decision making. The budgeting process only focuses the attention of the management

team on strategy during the budget formulation period near the end of the fiscal year. For the rest

of the year, there is no procedural commitment to revisit strategy. Thus, if there is a fundamental

shift in the market just after a budget has been completed, there is no system in place to formally

review the situation and make changes, thereby placing a company at a considerable

disadvantage to its more nimble competitors.

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 work required can be more extensive

if business conditions are constantly changing, which calls for repeated iterations of the budget

model.

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 man

ager 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. This is a particular problem when departments are not allowed to

substitute services provided from within the company for lower-cost services that are available

else where.

Use 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

manager may authorize excessive expenditures at the last minute, on the grounds that his budget

tends to make managers believe that they are entitled to a certain amount of funding each year,

irrespective of their actual need for the funds.

Only considers financial outcomes. The nature of the budget is numeric, so it tends to focus

management attention on the quantitative aspects of a business; this usually means an intent

focus on improving or maintaining profitability. In reality, customers do not care about the

profits of a business – they will only buy from the company as long as they are receiving good

service and well-constructed products at a fair price. Unfortunately, it is quite difficult to build

these concepts into a budget, since they are qualitative in nature. Thus, the budgeting concept

does not necessarily support the needs of customers.

The discussion of budgeting has cast serious doubts on the need for a detailed and rigorously-

enforced budgeting system, especially one that integrates the budget model with bonus plans.

Nonetheless, the decision to install a budget is up to the reader.