A Budget is an organization’s operational plan for the future. It illustrates a firm’s estimation of expected revenue and expenses as well as the inflow of resources and their allocation.
Why Do Companies Need a Budget?
Through budgeting, companies chart the course of their business in an unpredictable world. Planning for the fast-approaching future allows companies to act against short-termism and biased perspectives. In this way, they are better able to identify, recognize, and seize opportunities and innovations. Although it seems challenging to rationally calculate the future effects of current decisions, the budgeting process has indisputable benefits.
Benefits of Budgeting
Most importantly, budgeting helps organizations outline what they want to achieve in the near and distant future. That’s why some professionals call it the “business compass” of an organization. In a way, it is the Budget that translates firms’ corporate strategies into specific objectives. So, we can say that budgeting is the tactical implementation of a firm’s strategic goals. Put differently, it’s a company’s plan for the future, formalized in quantitative terms.
Consider an FMCG company. Do they plan to increase the advertising expenses related to the point-of-sale displays in retail stores next year? Will they boost promotions in bars and dining places instead?
It all comes down to the firm’s sales strategy for the upcoming periods, which in turn, reflects on the respective budgeted figures. Should the company plan for a major restructuring, the expected cost reduction will be visible in the Budget, too.
So, we can conclude that the Budget is a “snapshot” of a company’s medium-to-long-term objectives. As such, it is considered a strictly confidential piece of information. Thus, organizations should be careful not to share any projected facts and figures with their rivals!
Moreover, budgeting is a great target-setting tool. In the Annual Business Plan of an organization, you can find the predicted sales growth percentage, the planned net profit figure, as well as the net cash flows that the company expects to generate.
All too often, managers’ compensation is based on their ability to meet or exceed the projected numbers. Is this fair? Some of you would argue that unexpected events might cause the actual figures to deviate significantly from the budgeted ones. If there are no extraordinary events, however, the management of a company should be able to make realistic predictions, so most firms consider performance-based bonuses fair and legitimate.
Now, a general rule to remember is that targets must be ambitious, yet achievable. Setting them a bit higher than historical performance leaves room for improvement; in this way, the Budget drives managers to put their best efforts to achieve the goals.
In turn, too high or too low target levels may be quite demotivating for most employees. Ideally, the Budget is a tool that allows firms to assess whether they are doing better or worse than expected. It is a reality check – a guiding light that provides a sense of accountability and a desire to reach the set targets.
What’s more, companies use budgeting as a controlling tool. Department managers usually compare the actual performance with the budgeted one. Quite often, it is the Budget itself that helps department heads stay on track with their spending. Think of the budgeted figures as the maximum amount of allowed expenses for the respective period. In times of economic slowdown, companies would typically impose tight budgets, so that they minimize the expenses and make it possible to drive the organization through the recession.
When it comes to revenue, on the other hand, managers strive to exceed the budgeted revenue, as they receive performance bonuses on sales above expectations.
Above all, the Budget is a communication tool that contains a company’s plans and clearly conveys those projections to department managers. In this way, everyone gets a clear understanding of their role and contribution to the overall objectives of the organization.
The Bottom Line
Every company needs a Budget in order to have a good grasp of its financials. Thus, we can safely say that budgeting is an essential part of the planning, performance management, and financial control activities in any organization.
To properly plan for the future, firms generally make use of two basic approaches to budgeting.