Why companies need budgets

April 24, 2016

Why do companies use budgets?†How do firms see budgets from the standpoint of their importance and performance?†In this article we will talk about these aspects of budgeting (planning).

1. Reasons companies need budgets

When people hear about budgets, they are often overwhelmed with negative emotions.† In personal life, budgets usually mean restraining yourself from buying what you want (though, at the same time, it means buying what you want in a long run).† In business settings, budgets often mean a long and painful process of estimating future sales, expenses, headcount, and so forth.

But let us look at the positives of budgeting.† There are many great outcomes from budgeting; and letís be honest, if budgets were to result only in wasted time and energy, companies would not be using them.

Several reasons budgets can be used by companies are as follows (and this list is not all inclusive by any means):

  1. Operational planning: budgets are used to prepare and monitor operational plans.
  2. Performance evaluation: budgets are used to evaluate performance of departments, divisions and other discrete units, employees or groups of employees.
  3. Communication of goals: budgets are used to inform involved parties about goals (leadership to subordinates, subordinates to leadership, or subordinates to subordinates).
  4. Strategy formation: budgets are used to form strategies.

These four reasons to prepare budgets are analyzed in a research paper titled ďMultiple facets of budgeting: an exploratory analysisĒ Management Accounting Research 2004.

2. Importance and perceived performance of reasons to budget

The research authors surveyed 57 managers responsible for preparing budgets in their companies.† Surveyed companies were quite large (i.e., mean annual sales were about $1.0 billion).

As part of the survey, the authors looked at the (a) importance and (b) perceived performance of reasons to use budgets.† For example, how important is communication of goals as a reason to use budgets would be the importance factor.† And how good of a job a budget does in communicating goals is the perceived performance factor.

Some notable findings related to the importance and perceived performance of using budgets:

  1. The mean number of iterations to finish unit budgets was 4.25 (standard deviation of 3.72, low of 1 and high of 5).† This is quite a bit of iterations especially when one considers extreme cases.† Note that performance of budgets for operational planning was shown to decrease with higher numbers of iterations.
  2. The mean extent to which unitís management participated in setting budget targets was 3.88 (standard deviation of 0.87, low of 1 and high of 5).† This indicates that in a fair amount of instances, unitís management gets an opportunity to participate in establishing budget targets.† Another notable finding is that performance of budgets for performance evaluation purposes increases with the increase in managementís participation in setting budget targets.
  3. The mean number of the difficulty to achieve budgets was 3.39 (standard deviation of 0.73, low of 1 and high of 5).† This implies that a lot of survey participates felt their budget targets were hard to achieve.
  4. 77% of respondents did not use rolling budgets (i.e., where budgets are extended to the next period after the current period has been passed; this process happens on a continuous basis).† 62% of those who do use rolling budgets (thatís the remaining 23%) used three months as the rolling period.† Interestingly, performance of budgets for operational planning increases with use of rolling budgets.
  5. Organizations with more easily traceable resources to final products use budgets for performance evaluations. At the same time, competition reduces the use of budgets for performance evaluations (i.e., companies facing more competition donít use budgets for this purpose as much due to higher uncertainty in achieving budget targets).
  6. Companies that have a job shop environment or higher interdependency of production processes use budgets to communicate goals to a higher extent.† The same is true for companies facing more competition.
  7. Companies use budgets for strategy formation when they are divisionalized, have a differentiation strategy, and have a job shop type and competitive environments.
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