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.
The Advantages of Budgeting
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.
This article is an excerpt from Steven Bragg’s Budgeting: The Comprehensive Guide. To learn about budgeting, visit his course or join us for next week’s blog The Disadvantages of Budgeting.