What are the purposes of budgeting?

Forecasting, setting goals and formulating strategies

First, budgeting is an opportunity for managers to think about the future environment (forecasting), define what they want to achieve (setting goals), and plan how they intend to achieve their objectives (formulating a strategy). Building budgets directs their attention towards the future and prevents an excessive focus on day-to-day operations. It is also an opportunity to surface potential disagreements and foster debates about goals, strategies, and tactics in a context which does not require quick decisions.

This attention to the future allows managers to anticipate potential challenges and opportunities and give them the time, since there is no urgency, to design and assess several courses of actions in different scenarios. Properly done, budgets provide simulations about the likely effects of strategic plans; they indicate whether these plans are feasible or on the contrary should be revised. Such simulations also facilitate learning, showing how operating risks and profit are sensitive to specific forecasts, estimates, and decisions.

Moreover, because resources are more flexible on a longer time-horizon, thinking ahead allows managers to prepare more effective and efficient ways to achieve organizational goals, ways which typically cannot be implemented on a shorter time-horizon because of time constraints. For instance, redesigning products or re-engineering production processes is impossible in a week, but is possible in a year. In other words, more options are available when decisions are made a long time in advance.

Assessing, acquiring, and allocating necessary resources

Another very important set of functions of budgets is to identify and assess the amount of resources the organization will need to run its operations (assessing necessary resources), negotiate these resources with investors and suppliers (acquiring necessary resources), and decide on which activities these resources should be invested in priority (allocating resources).

Some resources cannot be obtained quickly. For instance, borrowing a large amount of money can take several months, even years. Therefore, it needs to be planned long in advance. Budgets are quantitative expressions of planned cash inflows and outflows; therefore, they reveal future temporary or permanent cash shortages or excesses, long enough in advance for the organization to make the necessary arrangements.

Moreover, investors do not provide resources without scrutiny. They need to see that the organization will be able to create enough value to safeguard their assets and remunerate their investment. Budgets also allow organizations to justify the need for these resources and negotiate with investors based on expected returns.

Finally, financial resources are limited and not every opportunity can be pursued. It is therefore important for organizations to determine which activities should be expended or maintained in priority, because they offer the best prospects, and which ones might have to be sacrificed. Budgets also reflect how limited financial resources should be distributed across the organization.

Delegating and coordinating the actions of autonomous managers

In large organizations, budgets also serve the very important purposes of communicating organizational goals to, and coordinating the actions of, many interdependent yet autonomous managers. By considering the interrelationships among operating activities, budgets help reduce the risks that some managers undo what other managers have done, and increase the chances that their coordinated actions reinforce each other.

Moreover, having a formal document synthesizing what each part of the organisation is expected to do is an effective way to communicate a consistent set of plans to the organization as a whole. Communication is complex between managers who are not necessarily located in the same place. Many decisions have thus to be agreed upon in advance to limit the need for mutual adjustments as operations are running. In a way, budgets crystallize many decisions so that every manager knows the role she has to play and how this role contributes to the common strategy. The budget also communicates a shared understanding of the business model, so of how the organization consumes resources to create value. Based on this common understanding, managers can make coherent decisions without necessarily interacting with each other.

Controlling and evaluating managers’ performance

A last function of budgets is to serve as a benchmark against which actual performance can be compared to assess whether goals were achieved or whether some corrective action should be taken. As we will see in the next chapter about variance analysis, deviations from budgets signal that something might be wrong with either the strategy or its implementation. Therefore, they result in greater scrutiny from the top management and keep lower-level managers in check since they have to correct or justify these deviations (comply or explain). Performance metrics showing gaps between expectations and realizations thus trigger corrective actions and make people accountable.

The budget is also a way to set S.M.A.R.T. (Specific, Measurable, Ambitious, Reachable, and Time-bounded) goals for managers, and to evaluate them based on whether they are able to meet agreed upon targets. In some organizations, budgets serve as contracts between managers and their superiors and incentives are tied to meeting budgeted targets.

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