Establishing a budget helps an organization allocate its resources for the coming fiscal period. As the organization disburses funds, it traces its disbursements to the amounts it budgeted and adjusts the budget to meet unexpected expenses. Involving managers in the budgeting process helps managers understand the financial operations of the business and makes them accountable for their department's expenditures. A line item budget is just one approach to making a budget, and there are numerous strengths and weaknesses of budgeting this way.
Line Budgeting System Purpose
The line item budgeting system serves several purposes. First, it helps a business understand whether its income is sufficient to cover its expenses. Second, a line item budget makes it easy to verify when a single item exceeds the budget or comes in under budget. For example, if a company suspects that its materials costs are getting out of hand, it can specifically pay attention to this item and compare the variance over time. Finally, a line item budget helps finance managers obtain information about which detailed expenses roll up into each of the major functions of a business; this is important to determine if one department is performing worse financially than others.
Advantages of Line Item Budgets
A line item budget is easy to prepare and monitor. Each organizational unit itemizes its expenses and allocates a precise amount for each expense. Managers use the budget from the last fiscal period to create the budget for the next fiscal period and adjust expenses to account for cyclical differences, seasonal differences and inflation.
Over time, the use of line item budgets creates valuable statistical information that demonstrates trends and opportunities to save money. For example, retailers who have higher labor expenses during the winter holiday months can use data from line item budgets to find ways to cut labor costs in less busy times of the year.
Disadvantages of Line Item Budgets
The disadvantages of the line item budget demonstrate that it is not necessarily the best budgetary model. For example, this type of budget does not demonstrate the return on investment. A line item expense that grows over time may seem excessive and invite scrutiny when, in fact, a manager can justify the increase for the item by pointing to increased revenue or increased performance. On the other hand, if a company notices its expenses are increasing while revenue does not, this can indicate a real problem area.
In addition, adjusting individual items in the budget can also encourage inefficient micro-management. Tying the budget to performance and revenue information can mitigate these shortcomings.
Alternative Budgeting Systems
An organization may decide to consider alternatives to line item budgeting. Performance budgeting, for instance, is a useful model for routine processes that are easy to measure, such as paying invoices. Zero-based budgeting is another alternative. This approach starts from scratch in each fiscal period. Rather than automatically carrying a budget item forward, management must provide justification for each item before adding it to the budget, even if the prior budget included the item. Zero-based budgeting is useful to identify and eliminate obsolete expenses.