Question

budgeting can lead to some pretty dysfunctional employee behavior, so why budget? Do the advantages really outweigh the disadvantages?

Answer 1

A budget is a quantitative plan prepared for a specific time period. It is normally expressed in financial terms and prepared for one year.

1. The advantages of budgeting include:

• Risk Management: Compared to non-contingency budget methods that do not plan for potential unknowns, the budget contingency method sets aside additional resources that can be drawn on if the unexpected happens in future business activities. Business risks are perceived future uncertainties based on management past experience, such as price fluctuations, changes in cost structure due to product or service modifications or other projection errors and omissions. Management often is aware of these risk factors, and not including them as part of the estimates could render a budget potentially unreliable.
• Planning orientation: The process of creating a budget takes management away from its short-term, day-to-day management of the 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.

• Price setting: Market conditions such as your competitors’ prices aren’t the only parameters you need to set your fees, rates and prices. You must know your manufacturing and overhead costs before you set your prices. A budget lets you project your utility, health care, marketing, rent, wages, debt service and other costs so you can learn the true cost per unit of making your products or delivering your service. Once you know this, you can set your prices to make the profit you want. If this price is too high for you to be competitive in your marketplace, you can use your budget to identify areas where you can reduce your costs.

• Profitability: 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 what aspects of the business produce money and which ones use it, which forces management to consider whether it should drop some parts of the business or expand in others.
• 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: You can work with employees to set up their goals for a budgeting period, and possibly also tie bonuses or other incentives to how they perform. You can then create budget versus actual reports to give employees feedback regarding how they are progressing toward their goals.
• Funding planning: A properly structured budget should derive the amount of cash that will be needed to support operations. This information is used by the treasurer to plan for the company's funding needs.
• 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.