Many companies go through the budgeting process every year simply because they did it the year before, but they do not know why they continue to create new budgets.
What are the objectives of budgeting? They are:
- Provide structure. A budget is especially useful for giving a company guidance regarding the direction in which it is supposed to be going. Thus, it forms the basis for planning what to do next. A CEO would be well advised to impose a budget on a company that does not have a good sense of direction. Of course, a budget will not provide much structure if the CEO promptly files away the budget and does not review it again until the next year. A budget only provides a significant amount of structure when management refers to it constantly, and judges employee performance based on the expectations outlined within it.
- Predict cash flows. A budget is extremely useful in companies that are growing rapidly, that have seasonal sales, or which have irregular sales patterns. These companies have a difficult time estimating how much cash they are likely to have in the near term, which results in periodic cash-related crises. A budget is useful for predicting cash flows, but yields increasingly unreliable results further into the future. Thus, providing a view of cash flows is only a reasonable budgeting objective if it covers the next few months of the budget.
- Allocate resources. Some companies use the budgeting process as a tool for deciding where to allocate funds to various activities, such as fixed asset purchases. Though a valid objective, it should be combined with capacity constraint analysis (which is more of an industrial engineering function than a financial function) to determine where resources should really be allocated.
- 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. Though useful, this objective can result in highly unlikely results if management lets itself become overly optimistic in inputting assumptions into the budget model.
- Measure performance. A common objective in creating a budget is to use it as the basis for judging employee performance, through the use of variances from the budget. This is a treacherous objective, since employees attempt to modify the budget to make their personal objectives easier to achieve (known as budgetary slack).
Conversely, budgeting may not be of much use for a well-established business that has a consistent track record of performance. In this case, a better approach may be to manage the organization from a rolling forecast that is updated on a regular basis. Doing so reduces the work associated with financial predictions, and also allows the business to shift its operational focus on short notice.