Question

You have been hired as a controller of Hughes Co., a small but growing business that manugactures high end electronics distributed through retail superstores. You plan to prepare the current-year budget based on the previous year's actual revenues and expenses. The company has never had a formal budget.

Write a memo to the CEO justifying the need to establish a formal budget. Discuss the advantages and disadvantagers of the budget process.

Answer 1

Solution:

Budget means forecasting about the future performance on the basis of the actual result of the previous years. It has various advantages and disadvantages. The same are explained in details.

Advantages of budget:

Planning Orientation: The first step of the management process is planning. Budget plays an important role in the same. The management planning for the production and sales are depending upon the budget. The budget is prepared on the basis of previous years’ data, the available resources, market of the products etc.

Profitability Review: Budget helps to identify the weak and strong areas of the production process. The profitability of the business is reviewed through proper budget. The weak areas of the production are identified and controlled through proper cost management to improve the profitability of the business.

Assumption Review: Budget helps to the management to review various key assumption of the production process. The viability of the assumption and the effectiveness of the production is reviewed by the management through proper budgeting.

Funding Planning: The funding planning is very important for expansion of the business. The proper funding planning helps the management to collect the require funds with optimize cost of capital. Budget plays an important role in the same.

Cash allocation: Cash is the liquid assets of the business which are required to invest in the fixed assets and the working capital of the business. The budget process helps to identify the areas where the cash should be allocated.

Bottleneck Analysis: It is very important to all the organization to identify the bottleneck situation and take decision whether the capacity of the business will expand or shift work around the bottleneck. Budget helps to analysis the same.

Disadvantages of Budget:

Time Required: The budget requires time to prepare and implement. For poor organized environment, the time require is high in compare with well-organized environment. If there is participative budgeting process, then the requirement of time is very high.

Gaming the system: The budgetary slack may be introduced by the experienced manager which reduces the income estimate and increases the expenses estimate. The reason behind the same is to achieve favorable variances against budget which is the serious problem and requires to eliminate.

Expense allocation: The expenses are allocated in the various department as per the budget. This is not always right to allocated the expenses to all the department. All department are not performing equal activities at the same time. So the allocation of the expenses should be done as per the Activity Based Costing.

Strategic Rigidity: The management is relying upon the budget throughout the year and analysis the performance of the business and making business strategies on the basis of the budget. But this rigidity is not good for the business. Due to change in the market scenario and condition the business strategy should be made. So the budget process most of the time create rigidity in the planning and business strategy of the management.

These are the main advantages and disadvantages of the budget process.