Why do managers need budgets?

Implementation of a business’s strategic plan often begins by determining management’s basic expectations about future economic, competitive, and technological conditions, and their effects on anticipated goals, both long-term and short-term. As detailed in Chapter 7, planning involves developing future objectives, whereas controlling involves monitoring the planning objectives that have been put into place. Budgets play a role in planning, controlling and evaluating.

The business will develop strategies and plans to help them achieve these goals. Budgeting helps businesses consider the costs of their strategies and plans (over both the short and longer term). A good budgeting system will help a company reach its strategic goals by allowing management to plan and to control major categories of activity, such as revenue, expenses, and predicting and managing the cash required for these activities.

There are many advantages to budgeting, including:

• Communication
  • Budgeting is a formal method to communicate a business’s plans to its internal stakeholders, such as executives, department managers, and others who have an interest in—or responsibility for—monitoring the business’s performance.
  • Budgeting requires managers to plan for both revenues and expenses.
• Planning
  • Preparing a budget requires managers to consider and evaluate
    • The assumptions used to prepare the budget.
    • Long-term financial goals.
    • Short-term financial goals.
    • The business’s position in the market.
    • How each department supports the strategic plan.
  • Preparing a budget requires departments to work together to
    • Determine realisable sales goals.
    • Compute the manufacturing or other requirements necessary to meet the sales goals.
    • Solve bottlenecks that are predicted by the budget.
    • Allocate resources so they can be used effectively to meet the sales and manufacturing goals.
    • Compare forecasted or flexible budgets with actual results.
• Evaluation
  • When compared to actual results, budgets are early alerts and they forecast:
    • Cash flows for various levels of production.
    • When loans may be required or when loans may be reduced.
  • Budgets show which areas, departments, units, and so forth, are profitable or meet their appropriate goals. Similarly, they also show which components are unprofitable or do not reach their anticipated goals.
  • Budgets set defined benchmarks that may be used for evaluating business and management performance, including raises and bonuses, as well as negative consequences, such as firing.

As with every set of advantages, there are also disadvantages

• Budgets can be inflexible
• They are based on assumptions which may not turn out to be correct
• They can take a long time to create – especially in large organisations where each department must prepare a budget

To understand the benefits of budgeting, consider Big Bad Bikes, a company that manufactures high-end mountain bikes. The company will begin producing and selling bike trainers this year. Trainers are stands that allow a rider to ride their bike indoors similar to the way bikes are used in spinning classes. Big Bad Bikes has a 5-year plan and has always been successful in managing its budget. Managers participate in developing the budget and are aware that all expenses must be related to the company’s strategic plan. They know that managing their departments is much easier when the budget is developed to support the strategic plan.

The plan for Big Bad Bikes is to introduce itself to the trainer market with a sales price of $70 for the first two quarters of the year and then raise the price to $75 per unit. The marketing department estimates that sales will be 1,000 units for the first two quarters, 1,500 for the third quarter, and 2,500 per quarter through the second year. Management will work with each department to communicate goals and build a budget based on the sales plan. The resulting budget can be evaluated by all departments involved.