Many companies, especially smaller ones, do not create a budget. This can lead to financial problems down the road. Spending can easily get out of line with cash inflows when there is nothing to guide expenditures. Setting a budget can help companies better manage their cash flows, aligning expenditures with operating activities. Operating without a budget is like driving in the dark.
The budget requires management’s ongoing attention for it to remain relevant. A change in operating conditions may cause budget projections to be out of line with reality. Many companies prepare budgets and then ignore them, which leads to mismatches between actual and budgeted amounts. Rolling forecasts can be used to minimize differences between actual and budgeted amounts, by incorporating changes in circumstances to better reflect current business and economic conditions.
Budgeting helps managers to better plan and operate their businesses, but like many other tools, there is good and bad to the budgeting process.
The Pros of Budgeting
1. The budgeting process provides insights into a company’s operations. Since all departments are included in a comprehensive budget, management gets to understand how each unit is expected to perform in the future. This provides useful insights and can be used in the strategic planning process.
2. A budget helps management decide how to allocate resources, by identifying units which are meeting their budgetary targets. Management can use this information to decide which units to spend resources on or which customer relationships to devote more resources to. It can also help management decide whether to reallocate resources from under-performing units to better performing ones.
3. A budget predicts future cash inflows and outflows, and prevent potential cash shortfalls, which can lead to operational issues and in extreme cases, bankruptcy.
4. Budgets can be used as a tool to motivate and empower employees. Budget targets can be incorporated into performance evaluations, giving employees an incentive to increase productivity and meet specified targets.
5. A budget can help to reduce waste and save on costs. Management must insist that all expenses identified in the budget are fully justified.
The Cons of Budgeting
1. The budget is created at a point in time and may not reflect changes in the business or in economic conditions. Managers may base their spending on budgetary allocations arrived at when operating conditions were different. This could lead to operating losses as expenditures based on the existing budget may outweigh revenue.
2. Companies that perform the budgeting process only once a year run the risk of not making appropriate changes as the business environment evolves. A budget done six months ago might not reflect current business conditions.
3. Employees might be tempted to include favorable metrics in the budget for their units. A manager might set lower revenue and higher expense targets so he can easily beat them and have his unit look good compared to the budget.
4. Managers might spend unnecessarily to meet budgetary allocations. Managers may believe that if they do not spend all their budgeted amounts, they might lose it in the next budget. The result is wasteful spending and loss of profits.
5. Constructing a budget is a time-consuming process that takes resources from other activities. A budget may require several iterations before it is completed. Staff may become demotivated during the budgeting process, and this can lower productivity.
These pros and cons are by no means exhaustive. If properly constructed and used in the right way, a budget is a useful tool in both tactical and strategic planning. For a budget to be useful it must reflect the current environment in which the business is operating. Too often managers create a budget but never revisit it until the next budget cycle comes up. Management can overcome this by using a rolling budget process, where the budget is updated periodically to reflect changes in operating conditions.
A budget should be nimble and allow a company to adjust spending either upward or downward based on circumstances. In lean times spending might need to be reduced, but managers might want to keep spending because funds are allocated in the budget. Likewise, if an investment opportunity presents itself, it could be lost if the budget does not allow for the expenditure. Again, the budget should be flexible enough to allow for this investment once proper due diligence has been done and management concludes it is a worthwhile venture.
Rolling Budgets – a Cure for Stale Budgets
A rolling budget is one that is updated periodically to reflect changing circumstances. For companies with less complex operations, the entire budget might be updated once a month or so. For companies with more complex operations, specific budget components might be updated based on agreed upon criteria. The budget may also be updated for unanticipated events, for example a slowdown in economic activity having a severe impact on the company’s operation. A rolling budget is not a panacea for all budgeting ills, but it can address some of the criticism leveled at the budgeting process.
Businesses large and small should considering creating a budget. Many small businesses opt to forego a budget, which often leads to poor cash flow management, because management does not have visibility into future revenue and expenditure. At The Accounting Analyst, your CFO encourages you to create a budget, no matter the size of your company. The budget is a useful tool to in managing your business.