Budgeting is the process of creating a plan or a forecast for a future period of a business. Budgeting is one of the most important parts of any business as all businesses operate under a budget.
Budgets allow a business to allocate its resources at the start of a period so it can generate maximum profits. Budgets have many benefits for businesses as they permit the business to plan its future spending and monitor and control future performance against the budget.
While budgets can be advantageous for a business, there are some limitations of budgets that it must also consider. The limitations of budgets are as below.
1) Are forecasts or estimates
No matter how good the budgeting process of a business is, it may still fall short of perfection because budgeting involves forecasting and estimating the future performance of a business.
Since the budgeting process consists of a lot of judgments, sometimes, it can lead to inaccurate budgets. This can be particularly problematic in volatile business environments where unpredictable changes occur regularly and can disrupt the budget of a business.
2) Require time
Before the start of every period, the management of a business must develop a budget for the period. The process of budgeting requires a lot of time from all levels of the management of the business.
Some types of budgets, such as incremental budgets may require lesser time. However, once a business drafts a budget, it must go through a rigid review process which also requires a lot of time.
3) Promote overspending
Some types of budgets, such as incremental budgets may promote overspending among the managers of a department or activity. These budgets use the prior period’s information.
In case the actual expenses of a department are higher than or equal to the previous period’s budget, then the limit for these expenses is increased in the next period’s budget.
However, if actual expenses are lower in the budget of the previous period, then the allowance for these expenses is decreased in the next period.
This may encourage some managers to overspend their budgets to get a higher budget in the upcoming period regardless of the actual expenses of the department being lower than the budgeted limit.
4) Based on past results
Most budgets made by businesses use past results as a base. While it is beneficial for a business to learn from past results and apply corrections to future activities, it also means the next period’s budget may have undetected issues that relate to the previous periods.
Similarly, any activities or events that did not require special attention in the past but may require attention in future periods can go unnoticed. While businesses can tackle this problem with a zero-based budget, it can take a lot of time and effort to develop.
5) Can be too rigid
The budgeting process of a business usually begins right before the start of a new period. Once a business sets its budget, it uses the budget for the rest of that period.
Even though there might be some changes in the environmental factors of the business, it will continue to use the same budget.
Typically, businesses do not review a budget after changes in the environmental factors of the business unless the changes are drastic.
This means that the managers of a business have their hands tied and must use old and unrealistic budgets, even though they might not be reflective of the current circumstances of the business.
6) Can be manipulated
If the top-level management of a business puts too much emphasis on strict adherence to budgets, it may lead to the manipulation of information that goes into a budget.
This means that departmental managers may try to manipulate the budget, such as underestimating revenues and overestimating costs to create a slack margin for themselves.
It can lead to these managers getting favorable variances when the actual results come in due to the exaggeration of budgeted amounts.
7) Can create conflicts
As mentioned above, businesses make budgets at the start of a period to allocate their resources within different departments or activities.
This may create conflict within departmental managers as the manager of every department will want to have the most of these resources. Similarly, budgets may promote a ‘blame game’ within a business, thus, furthering conflicts within the business.
The budgeting process of a business involves planning and forecasting for an upcoming period of the business. While budgets can have many benefits, they come with some limitations as well.
The first limitation of budgets is that they are forecasts and can be inaccurate sometimes. Budgets also require a lot of time and may promote overspending in the business.
Furthermore, budgets use past results as a base and may carry over some errors from the past into the next period. Lastly, budgets can also be too rigid, can be manipulated, and can create conflicts within a business.