Budgets are instruments of planning and control. Budgets specify the expenses an employee or an organizational unit in an establishment is authorized or permitted to incur for different types of activities or assets. Generally, a budgetary planning and control systems includes some mechanism to restrict incurring of expenditure exceeding the budget, and to monitor the actual expenditure against the budgets. Thus, for example, budget of marketing department of a company may specify the budgets under various accounts heads such as salaries, advertisement and travelling. The marketing manager will have considerable freedom to take decisions in matter of number of salesman to be employed, salaries to be paid to them, their travel cost and amount spent on advertisement and promotion as long as the total expenditure under any head does not exceed the budget. The manager may need to obtain special sanction for incurring expenditure exceeding the budget. Also the actual expenditure incurred by the marketing department will be periodically compared withe budgets, and the performance of the marketing manager will be influenced substantially by the extent to which actual expenditure are equal to or less than the budgets.
The biggest benefit of a budgeting system is that it allows managers the freedom of decision making as long as they do not exceed the budgets. It also enables a company to lay standards of performance and levels of activities of different functions and departments within the company. This ensures that various departments and functions operate within the framework of a common overall plan. Budget also serves as a means of evaluating the performance of different functions and managers within an organization.
The biggest limitation of traditional budgeting system is that it focuses primarily on expenses, paying little attention to the results obtained as a result of the expenses incurred. Thus in the above example, the marketing manager may fail to cash on an opportunity to sell more by increasing the travelling of his sales-persons because that will lead to the travel expenditure exceeding the budget.
The emphasis on input cost to the inclusion of the consideration of results obtained makes budgeting quite meaningless when the level of operations are very much fluctuating. For example, production cost in any company are closely linked to the level of production. Therefore, a rigid budget, that fails to take into consideration the level of production can become quite inappropriate as planing or controlling tool.
Another common problem of budgeting system is related to the way budgets are finalised. In many organizations the budgets are often prepared on the basis of past performance rather than the future requirements. This tends to create a false feeling of planned working, when in reality the organization is only drifting along with the flow of past trends.
There have been many attempts to overcome the limitations of budgeting systems by introducing many innovations such as flexible budgeting, zero based budgeting, and performance budgeting.