Advantages and Limitations of a Budget

In the previous article, we learned about the three financial statements. We also learned how income statements and balance sheets are backward-looking financial statements. We also understood that the budget is the only forward-looking financial statement in the personal finance domain. It is the only statement that can be used to prevent economic mistakes from happening. This is the reason why a budget is given special importance in personal finance studies. Individuals who are highly successful in managing their personal finances attribute their success to budgeting techniques. However, there are many personal finance experts who criticize budgeting techniques as well. In this article, we will have a closer look at the advantages and disadvantages of budgeting.

Advantages of a Budget

1. The harsh reality of personal finances is that people spend a lot of their money subconsciously. If these people knew the big picture about how their frivolous expenses such as eating out and vacations were impacting their long term goals, they would probably cut down on some of these expenses. This is where a budget helps them. A budget provides the big picture to an investor and, in the process of doing so, compels them to do financial planning.

2. Another major problem in personal finance is that many people do not realize the impact that small monthly payments have on their savings and net worth. When a person does a written budget, they know exactly how an increase in monthly payment will impact them. This prevents people from undertaking unnecessary expenses. As a result, people who a written budget find themselves in fewer financial problems in the course of their lifetime.

3. A written budget puts every member of the family on the same page. In the absence of a budget, different people in the family may have different notions about what the right amount of expenditure is. A budget helps build consensus on the thought process and in the due process gets buy-in from different family members.

4. The act of preparing a new budget also acts as an evaluation of the previous budget. This can help investors identify whether they have reached their goals or not. If the goals have been missed, the reasons behind the same can also be discussed. One time adverse events related to healthcare or job losses can be ignored. However, if the budget targets have been missed because of impulsive purchases, then the same can be avoided in the future.

Limitations of a Budget

1. People who make budgets for the first time are not very successful in doing so. This is because budgets are based on assumptions. Hence, if the underlying budgets are extremely strict or based on unrealistic assumptions, then the users will not be able to follow them and use them. Over a period of time, people get tired of the disappointment that the budgeting process brings along. This is the reason that they simply give up the process in the long run.

2. Budgeting takes a lot of time from financial members. The members have to decide on the monthly budget and then make sure that they follow it. This might mean that they have to meet quite often to discuss the deviations from the budget. If all the members of the family are not on board with the budgeting idea, then this might end up building resentment amongst the family members.

3. Simply budgeting will not help a family. If they keep on adding wasteful expenditure to the budget, their savings rate will not increase. The process of budgeting brings along a certain level of introspection. If that is not done, simply writing down numbers on a piece of paper does not prove to be of much use.

4. Budgets are not very useful for families where the income is extremely low. A family with an unusually low income would spend most of their money on necessities. This is the reason why there might not be many opportunities for them to cut their expenses. The real problem in such cases is that the income should be increased, which cannot be addressed using the process of budgeting.

5. Another problem is that while budgeting, a lot of people make assumptions that they can live without fun or entertainment of any kind. This assumption is obviously unrealistic, and over the long term, it just means that the budget will not be followed. A good budget is realistic in the sense that it allows a reasonable lifestyle. Also, budgets should not be kept the same from month to month. The entertainment expenses go up during the holiday season, whereas the heating expenses tend to go up during winters. Different months cause a spike in different expenses.

6. People tend to budget for cash flow. This means that if an expense is annual, they do not budget for it every month. This is the reason why it completely disturbs the cash flow in the month where the annual expense actually has to be paid out. Making a monthly provision for annual expenses would help them in planning out the budget better, but it is seldom done.

The bottom line is that a budget is an important tool that can be used in the process of financial planning. However, its usefulness is subjective. Some investors derived a greater value from the budgeting process than the others.