Setting business budgets and measuring performance against budgets is a very important management function.
Budgeting has both advantages and disadvantages. Let’s take a look at them in details.
Advantages of budgeting
- Aids strategic planning. Budgeting helps managers to plan ahead any sales revenue and costs to be incurred within the next 12 months. In this way, targets can be set for different activities in a business organization. Any short-term future profits can also be forecasted. Also, budget-holders can look upon a budget to determine how much they can spend and whether their department has any redundant resources that could be used elsewhere.
- Helps to allocate scarce resources. Budgeting helps managers to allocate resources to different departments and divisions within a firm. Detailed and coordinated set of plans, aka budgets, will steer capital in the right direction making sure that money is allocated effectively. Without appropriate budgeting, it would be very difficult to decide ‘Who gets what?’. Employees would not know what and how much to produce, how much should be spent on promotion, or how many new employees the HR department should hire.
- Creates a sense of direction. Budgeting helps a business organization with agreeing targets and controlling the direction in which the business is moving towards to. Coordinating resource and controlling whether targets are met give responsibility to both managers and workers. It is much easier for everybody in the company to work towards one goal when the money is planned in advance.
- Helps with performance management of the business and its parts. Budgeting helps to assess how well the business had done in the past year. Detailed appraisal reports can be generated for different business departments and divisions to check and evaluate their performance against a clear series of targets with which the results are compared. Without having clear figures to monitor progress during the budgetary process, it would be impossible to know where the business is, how well it is doing and what changes should be made next year.
Disadvantages of budgeting
- Poor flexibility. While budgeting is definitely useful for a business with stable sales revenue and costs, it is much less useful for new businesses, firms with costs that are difficult to predict, importers and exporters who are impacted by exchange rate fluctuations or businesses with heavy seasonality in demand. Trying to reflect in the budget all those changing circumstances would be very time-consuming and sometimes even impossible.
- Focused on the short-term only. Budgets are usually set for the relatively short period of time such as the next 12 months. Because of that, some managers may focus on making decisions that benefit them in the short-term to stay within the budget instead of doing what is best for the whole business in the long-term. For example, reducing the workforce size will harm the firm’s ability to grow in the future, therefore, going against long-term interests of the business and its shareholders.
- Can lead to stakeholder conflicts. Poorly allocated budgets or wrongly constructed budgets can harm the business in several ways. For example, pay cuts and job losses leading to demotivated workforce, damaged business reputation leading to poor sales, lower quality of products leading to dissatisfied customers, one department receiving more money than another leading to conflicts in the workplace and perceptions of unfairness, etc. The process of appropriate planning, setting, controlling, monitoring and reviewing the budgets to make them right will therefore be extremely time-consuming.
- May lead to unnecessary spending. When the end of the budgeting period approaches and managers realize that they have underspent their budgets and still have money available, unnecessary spending decisions might be made. They do it so that they can receive the same level of budget next year. Otherwise, having a large surplus at the end of the year gives no incentive for budget holders because next year’s budget would be lowered to match the real situation. This can cause excessive unjustified expenditure.
- Training must be offered. And training employees is expensive. Firstly, budgets can be set by senior managers who have no direct involvement in the running of the specific department. This can cause discontent inside the department as senior managers might not understand the needs of that particular department. Secondly, all managers with delegated responsibility for budgets will need extensive training in this role as planning, setting, coordinating and controlling the budget is not easy. Thirdly, preventing the Garbage-In-Garbage-Out (GIGO) situation is of the utmost importance to keep the budgets correct at all times. The outcomes of the budgets will only be as accurate as the quality of the input data used to make them.
- Ignores unforeseen changes. Unforeseen changes can cause large variances. These unexpected changes in the external environment can make even the best budgets become unrealistic and unachievable. For example, price increases of raw materials and energy costs, sudden hikes in interest rates, natural disasters, military conflicts, and so on, to name just a few. Therefore, budgeting as a process is rather inflexible for today’s fast-paced and ever-changing external business environment.
- Does not consider any qualitative factors. Budgeting focuses solely on the financial performance of a business organization while ignoring qualitative factors that also affect the firm. For example, rigid production budgets may harm quality of products, strict recruitment budgets may hinder business expansion, lack of Corporate Social Responsibility (CSR) and neglecting the natural environment may negatively impact brand reputation, etc.
Based on favorable arguments of setting budgets and budgetary control, all business organizations, both small businesses and large firms, are going to undertake some form of financial planning.
However, despite several potential benefits of budgeting such as improved planning, coordination and control, there are also numerous limitations that business managers need to be aware of and consider when budgeting.
