Some businessmen still think that they do not need a budget because their business is simple and they are able to keep everything in their head. However, reality shows that businessmen can dramatically improve their resource management if they care to implement even a simple budget. Budgets serve as a compass for an organization, steering the use of resources into most effective channels. Without a budget, an organization is like a ship that has lost navigation: if there is an island in sight, you can get there, but if you are in the open sea, unsure of direction, you will be lost.
The main reason why budgeting is so important is its role in the planning process. Using a budget, an organization will see what sources of income it will have during the given period and what expenses it can expect. For instance, a young start-up company may see that it can expect to sell 1,000 units for $4,000 in the second quarter. However, in the first quarter these units will have to be manufactured, and to buy materials, it needs $3,000. The company now sees that they have to borrow $3,000 from somewhere in the first quarter to compensate for this shortfall. The managers can also calculate at what rate they can borrow so that it makes sense – at the rate that is not higher than profit margin.
Usually, business processes are much more complicated and require more calculations. Budgeting helps the organization to manage its resources more effectively and distribute these resources before it begins to spend them. Unless there is a reliable budget, resource spending can turn into a chaos as every department will try to grab the largest share. With a budget, they can agree beforehand how much to spend and on what.
Budgeting is part of the one of the key organizational functions, financial management. This function includes control of resources that the organization has including buildings, equipment, other material resources, personnel, and intangible resources, such as, for instance, a copyright. The budgeting process involves allocation of these resources, specifying what to use them for and when. This turns this activity into “a very political process when a determination is made about who gets what, when and how” (Flinders University, n. d.).
Thus, budgeting may lead to conflicts between financial managers who usually decide over money distribution and those who will use these funds. For this reason, an effective budgeting system is one where a maximum number of employees can participate in resource distribution. In an organization with an effective budgeting system, budgets will be a subject for discussion, and a great number of employees will be able to make their input in decision-making.
To be effective, budgets require not only maximum participation of all parties involved, but also strict correspondence between the organization’s aims and objectives and budget numbers. For example, if a company wants to launch a new product, it should provide funds for research and development of this product; otherwise, filling other gaps may not leave enough funds for such an investment. Therefore, “unless you have consistency and clear links between your strategic objectives, your service plans and the outputs they should secure, your financial plans and the annual budget, the objectives of your organisation are unlikely to be achieved” (Improvement Network, n.d.).
Besides, an effective budgeting system will allow the organization not only to plan its activities, but also ensure the feedback on performance of the budget, permitting effective reporting and monitoring of results. Besides, cost inputs “should be provided by managers with detailed knowledge and direct control over costs” (SECAF, n.d.). The input that goes into the budget should be detailed enough, and budget estimates should help the organization to prepare for different scenarios, for instance, calculate losses if market hits a downturn. Such effective budgets will help the organization improve its resource management and contribute to its success.
Improvement Network (n.d.). What are the main elements of financial management? Retrieved January 26, 2006 from http://www.improvementnetwork.gov.uk/imp/core/page.do?pageId=10998
Flinders University (Adelaide, Australia). (n.d.). Basic information about organizations. Retrieved January 26, 2006 from http://www.flinders.edu.au/teach/Practicum/WorkingToLearn/module_1/mod1_basic_information.html
Small and Emerging Contractors Advisory Forum (SECAF). (n.d.). Effective Budgeting. Retrieved January 26, 2006 from http://www.secaf.org/Effective_Budgeting.pdf