The advantages and disadvantages of budgets

1. Introduction

A budget is a planning instrument expressed in quantitative terms. It generally gives the costs incurred in a certain period and compares them to the revenues earned in that period. The purpose of this paper is to provide an overview of the budget, its types, advantages, disadvantages and how to prepare one.

2. What is a budget?

A budget can be defined as a qualitative or quantitative expression of management’s plans for a future period of time. It is a detailed plan that quantitatively expresses an organisation’s objectives and policies regarding the allocation of its financial resources (Baggaley, Sharman, 1994).

The main purpose of a budget is to ensure that an organisation’s resources are best used to achieve its objectives. A well-prepared budget also provides a yardstick against which actual performance can be measured (Cooper & Kaplan, 1988).

There are several different types of budgets, each with its own advantages and disadvantages. The most common types of budgets are the fixed budget, the flexible budget and the bottom-up budget.

3. The types of budgets
3.1 Fixed budget

A fixed budget is one in which the total amount of money to be spent is fixed in advance, regardless of the level of activity achieved. This type of budget is usually prepared on an annual basis and remains unchanged unless there are significant changes in the business environment (Maskell, Baggaley, 2000).

The main advantage of a fixed budget is that it provides a clear target for managers to aim for and motivates them to improve efficiency. The main disadvantage is that it does not take account of changes in activity levels, so it may not be an accurate reflection of reality (Kaplan & Cooper, 1988).

3. 2 Flexible budget

A flexible budget is one which adjusts to changes in activity levels. This type of budget is prepared using a number of different activity levels, each with its own set of planned costs (Baggaley & Sharman, 1994).

Flexible budgets are more accurate than fixed budgets but can be more difficult to prepare. They also require good forecasting skills and may be less useful in motivating managers to improve efficiency (Cooper & Kaplan, 1988).

3. 3 Bottom-up budgeting

Bottom-up budgeting is a type of flexiblebudgeting in which budgets are prepared from the bottom up rather than top down. This means that budgets are prepared by individual managers rather than being centrally imposed (Maskell et al., 2000).
The advantage of this approach is that it takes account of local information and so can be more accurate than top-down methods. The disadvantage is that it can be time-consuming and difficult to coordinate all the different budgets (Baggaley & Sharman, 1994). Benchmarking budget Benchmarking is a process whereby an organisation measures its performance against that of others in order to identify areas where improvements can be made (Kane-Urrabazo, 2005). Benchmarking budgets are often used in business organisations as a way of comparing performance against competitors (Cooper & Kaplan, 1988). Benchmarking can be an effective way of identifying best practice but it can also be time-consuming and expensive (Kane-Urrabazo, 2005).4. The advantages and disadvantages of budgets

4. 1 Advantages of budgets

Budgets have a number of advantages which make them a useful tool for planning and control.

One advantage is that they force managers to think about the future and to consider what resources will be required to achieve the organisation’s objectives. This can help to improve the coordination of effort and the allocation of resources (Cooper & Kaplan, 1988).

Another advantage is that they provide a system of targets and performance measurement. This can motivate managers to improve efficiency and effectiveness (Maskell et al., 2000).

Finally, budgets can improve communication within an organisation by forcing managers to state their plans in a clear and concise way (Baggaley & Sharman, 1994).

4. 2 Disadvantages of budgets

Despite their advantages, budgets also have a number of disadvantages which should be considered when deciding whether or not to use them.

One disadvantage is that they can be inflexible and slow to respond to changes in the environment. This can lead to unrealistic plans which are not achievable in practice (Cooper & Kaplan, 1988).

Another disadvantage is that they can be too focused on short-term results. This can lead to sub-optimal decisions being made in the long term in order to meet budget targets (Maskell et al., 2000).

Finally, budgets can create tensions and conflict between different managers who are competing for scarce resources (Baggaley & Sharman, 1994).

5. How to prepare a budget
5.1 Step 1: Define the business objectives

The first step in preparing a budget is to define the organisation’s objectives. These should be specific, measurable, achievable, relevant and time-bound (SMART) (Budgeting Basics, n.d.). Once the objectives have been defined, they need to be translated into specific quantifiable targets. For example, if one of the organisation’s objectives is to increase sales by 10%, then the target would be to increase sales revenue by 10%.

5. 2 Step 2: List the resources required to achieve the objectives

The next step is to list all of the resources which will be required to achieve the organisation’s objectives. These could include human resources, financial resources, raw materials, equipment, premises, etc. (Budgeting Basics, n.d.).

5. 3 Step 3: Quantify the resources required

The third step is to quantify the resources required. This means estimating the amount of each resource which will be needed. For example, if the budget is for a manufacturing company, the quantity of raw materials required can be estimated using production forecasts.

5. 4 Step 4: Convert the quantities into costs

The fourth step is to convert the quantities of resources into costs. This means estimating the cost of each resource per unit and then multiplying this by the quantity required. For example, if the cost of raw materials is $10 per kg and the quantity required is 500 kg, then the cost of raw materials would be $5,000.

5. 5 Step 5: Prepare the budget spreadsheet

The final step is to prepare a budget spreadsheet. This should list all of the costs incurred in achieving the organisation’s objectives and compare them to the revenue generated. The spreadsheet should also show the organisation’s net profit or loss for the period.

6. Conclusion

Budgets are a useful tool for planning and control but they also have a number of disadvantages. When deciding whether or not to use a budget, the advantages and disadvantages need to be considered in relation to the specific circumstances of the organisation. If a budget is to be used, it is important to ensure that it is prepared in a clear and concise way.

FAQ

A budget is a financial plan that allocates future income towards expenses, savings and debt repayment.

Having a budget is important because it allows individuals to track their spending, save money and make informed financial decisions.

A budget can be used to help manage finances by creating a spending plan, setting financial goals and monitoring progress.

Some tips for creating and sticking to a budget include: knowing your income and expenses, setting realistic goals, tracking your progress, and making adjustments as needed.