Budgets enable a company’s managers to measure actual performance against predicted performance. Budgets can overcome two limitations of using past performance as a basis for judging actual results. One limitation is that past results often incorporate past miscues and substandard performance. Suppose the cellular telephone company Mobile Communications is budgeting sales for the current year (2020). The 2019 performance was poor because of a weak sales force, many of whom have since left the company. The president of Mobile said of those salespeople, “They could not sell ice cream in a heat wave.” Using 2019 sales would set the performance bar for 2020 much too low.
The other limitation of using past performance is that future conditions may differ from the past. Suppose, in 2020, Mobile had a 20% revenue increase, compared with a 10% revenue increase in 2019. Does this increase indicate outstanding sales performance? Not if the forecasted and actual 2020 industry growth rate was 40%. The 40% budgeted growth rate for the industry provides Mobile Communications with a better benchmark against which to evaluate its 2020 sales performance than using the 2019 actual growth rate of 10%. Many companies evaluate managers based on how well they perform relative to their peers.
One of the most valuable benefits of budgeting is that it helps managers gather information for improving future performance. When actual outcomes fall short of budgeted or planned results, it prompts thoughtful senior managers to ask questions about what happened and why and how this knowledge can be used to ensure that such shortfalls do not occur again. This probing and learning is one of the most important reasons why budgeting helps improve performance.