What is an Operating Budget?

An operating budget is a forecast of the revenues and expenses expected for one or more future periods. An operating budget is typically formulated by the management team just prior to the beginning of the year, and shows expected activity levels for the entire year. This budget may be supported by a number of subsidiary schedules that contain information at a more detailed level. For example, there may be separate supporting budgets that address payroll, the cost of goods sold, and inventory. Actual results are then compared to the operating budget to determine the extent of any variances from expectations. Management may alter its actions during the year to bring actual results into line with the operating budget.

Disadvantages of an Operating Budget

There are several disadvantages associated with the preparation and use of operating budgets, which are as follows:

Time-consuming. Creating an operating budget requires significant time and effort. It involves analyzing past data, forecasting future needs, and getting input from various departments. This can strain resources, especially in smaller organizations.
Rigid and inflexible. Operating budgets can become too rigid, making it challenging to adapt to unforeseen circumstances. If market conditions change drastically, the budget might become obsolete, yet organizations may hesitate to deviate from it.
Potentially inaccurate. Budgets are based on estimates and forecasts, which can lead to any number of inaccuracies in how resources are allocated through the budget period.
Prioritizes in the short-term. The emphasis on meeting budgetary goals may lead to the prioritization of short-term results over long-term growth. This can also lead to reduced innovation, as teams might hesitate to invest in new ideas that aren't accounted for in the budget.
Encourages “use it or lose it” actions. In some organizations, managers may feel pressured to use their entire budget to avoid future reductions, leading to wasteful spending.
Leads to internal conflicts. Departments may compete for a larger share of the budget, causing internal conflicts. Additionally, one department’s over-spending might force cuts in others, leading to dissatisfaction.
Difficult to enforce. Monitoring adherence to the operating budget requires robust systems and controls. If these are inadequate, the budget may not serve its purpose effectively.
Discourages risk-taking. A strict budget might limit an organization's ability to take advantage of unexpected opportunities that require financial flexibility.

By being aware of these disadvantages, organizations can take steps to mitigate them, such as adopting flexible budgeting techniques, investing in accurate forecasting tools, and encouraging a balanced approach to resource allocation.