What Is Budgeting?

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INDEX

1. WHAT IS BUDGETING?        

1.1. The budgeting process        

2. BUDGETING: ROI OR NOT ROI?        

3. CRITICISMS OF BUDGETING        

4. OUR PERSPECTIVE ON BUDGETING        

5. BUDGETING APPROACHES        

5.1. Traditional and beyond budgeting        

5.1.1. Management        

5.1.2. Organizational structure        

5.1.3. Performance measure        

6. ALTERNATIVES TO BUDGETING        

7. BUDGETING IN PRACTICE: EUROZONE COUNTRIES        

8. SOURCES        

APPENDIX 1        

APPENDIX 2        

1. WHAT IS BUDGETING?

        Budgeting is the process of identifying, gathering, summarizing, and communicating financial and non-financial information about an organization’s and individual's future activities. This process is very important among companies due to its ability to evaluate the performance of it and its perspective of the future; whether they are setting to high revenues, expenses and evaluating overall expectations.

        In order to do accurate budgets, companies tend to rely in their financial statements or past/current financial conditions and also medium and long term goals and expectations.

        The process of creating a budget can also be instructive in the sense that forces managers to project realistic behaviors based on past records and real facts. For example, companies make their sales budget based on historical sales and also take into account projections of increased demand that will make sales grow in a higher amount.

1.1. The budgeting process

        Budgets are very important tools for organizations and even for individuals, and since it is a very wide used process it doesn´t have a specific process to follow. The budgeting process can vary depending the organizations believes and usually every company has a specific guidance and steps to follow in order to build up the budget. Nevertheless there are some usual steps that organizations tend to follow, as can be seen in Appendix 1.

        It is very important in the budgeting process to start by defining the goals: not setting them would make the work pointless and useless. Also, reconciling the data and analyzing its variances is important, since the company can therefore evaluate itself and understand its performance, what can it can do to improve and whether the budget was set in a conservative and reasonable way.

2. BUDGETING: ROI OR NOT ROI?

        As many other processes in companies and organizations, budgeting can be considered an activity. Consequently, as every other activity that consumes companies’ resources (e.g. management time, software expenses), it needs to have a positive Return on Investment (ROI).

        There are several advantages and disadvantages in doing budgets. Some of the major advantages are:

↗It allows to keep the control of costs in the short term

↗It provides big corporations top managers a macro overview of the performance of each department

↗After it is finished, it avoids conflicts between departments in the company

        However, budgeting also poses some major disadvantages:

↗Has some lack of flexibility

↗Is a time-consuming activity

↗Becomes quickly outdated

↗Creates no incentives to employees to innovate

↗Can create the incentive to overspend

        Some of this disadvantages present the biggest criticisms to the budgeting activity, which will be presented in detail in the next section.

3. CRITICISMS OF BUDGETING

        The three main criticisms of traditional budgeting are considered to be: (1) Time-consuming; (2) Quickly outdated and (3) Innovation restrictive.

3.1. Time-consuming

        Budgeting is a process that can take a lot of management time. The several processes associated to it can be painful for different company stakeholders. Due to the several assumptions that are implicit in the budgeting process, sometimes it becomes a worthless activity. It is possible to provide the following example:

        A company sold 10,000 units in the last year. The management expected to have a 20% increase in sales in the next year. Given that this was not a slight increase, it had to predict the several changes in the costs associated to its production and nonproduction departments. Therefore, some company managers spent almost two weeks preparing the budget for the next year, allocating costs to each department and estimating which investments need to be made in order to keep the service level at acceptable levels.

        In the next year, after a viral marketing campaign (that they did not anticipate) the sales increased by 50%, making the budget estimates completely wrong. Because they didn’t had the time  to re-do a new budget, they understood which ones were the major metrics and investments associated to this sales increase and agreed in following those keep track in the short term of the company’s evolution.

3.2. Quickly outdated

        The previous example perfectly illustrates that budgeting is really based in assumptions. If, by some reason, these assumptions fail, and if the budget was highly specific, it rapidly become obsolete. Because companies operate in a dynamic and constantly changing business environment, most of the time tight assumptions don’t realize, generating rapidly outdated and worthless budgets.