Sample: Finance Assignment Criticism of Budgeting

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Introduction

“A budget is a plan, expressed in financial and or more general quantitative terms, which extends forward for a period into the future.” (Gowthorpe, 2003, p 457). “A budget may be defined as a financial or quantitative statement, prepared and approved prior to a defined period of time of the policy to be pursued during that period for the purpose of attaining a given objective. It may include income, expenditure and employment of capital.” (The chartered Institute of Management Accountants of England and Wales).

Traditional budgets

It is a long time practise to prepare budgets; every organization wants to succeed, attain competitive advantage, earn high revenues, incur low costs, and achieve high EPS, long term loyalty of customers and finally high market value. To achieve the above objectives, the business must plan out its activities in the most optimum manner by taking in to consideration planning tools, such as budgets. Budgets are prepared for future after taking into account the changes that are expected to occur in future times. The motive behind the preparation of budget is the optimum use of capital, labour and better utilization of other resources. The actual figures are expected to match the budget unless something contrary happens; in fact it is the constant duty of the management to see that the actual figures do correspond with that of the budgetary figures. Budgets are prepared by the managers for their departments along with his subordinates to manage the processes taken care of by them. Thus the manager's subordinates will each bear an individual responsibility to ensure that a specific area of activity complies with the values and expectations expressed within the overall budget. Budgets are prepared for internal use and do not accompany the annual financial statements published by the company. According to, Richard Barrett, of ALG software, “the preparation of annual budgets is still the most widely used tool of controlling expenditure and setting up of related performance targets.”

Traditionally the budget serves the functions of planning, coordination, communication authorising and delegating, and motivation, control and performance evaluation. Let's discuss these functions separately (Drury C. 2003):

  • Planning: as seen above, planning is the first and foremost function of budgeting, planning requires quantifying the resources to be used in the budgeting period like, materials and labour etc. budget is a planning techniques because it involve planning for future.
  • Coordination: budgeting is also coordination, because activities are to be coordinated in such as manner in which there is achievement of organizational goals. For example, coordination is required between the operating activities such as, sales, production, consumption inventory etc.
  • Communication: budgeting is a communication tool as well, as the results attained by the various part of the organization helps the organization in prioritization of activities.
  • Motivation: it is also an important aspect of budgeting as when the managers achieve their targets, they are motivated to work harder.
  • Controlling: whenever, any activity is going out of track, through budgeting as a controlling technique, we can get it back to track by either changing it completely or stopping it temporarily.
  • Performance evaluation: budgeting helps in performance evaluation because the performance of the managers is evaluated on the basis of the targets achieved, if they achieve the targets, they get promotions and bonuses etc.

Short comings of Traditional budgets

Traditional budgeting have been criticised on the basis of planning problems and performance evaluation problems. There has been widespread dissatisfaction with traditional budgets in recent times. (e.g., Schmidt 1992; Hope and Fraser 1997, 2000, 2003; Ekholm and Wallin 2000; Marcino 2000; Jensen 2001). Budgets lack behind in meeting the demands of the business; they fail in identifying waste, do not support continuous improvement, do not involve activities based costing, do not identify the cost pools and cost drivers, and a general lack of ownership and buy in is observed in traditional budgeting, (Cassell. M, 2003). As said by Lester (2000), “it may invite micro –management by administrators and governing boards as they attempt to manage operations with little or no performance information”, moreover they are very lengthy and time consuming. They are also criticised by investors as budgets do not provide any information to investors about the operations and activities going on in the organization, they are prepared on calendar year and not to match the schedules of product. Traditional budgets are therefore regarded too slow, backward looking and one-dimensional. Budgets are criticised of their long established and oft researched susceptibility to induce budget games or dysfunctional behaviours, (Hofstede 1967; Onsi 1973; Merchant 1985b; Lukka 1988).

The major drawbacks can be summarized as below:

  • Lack concentration of strategy and contradicts them.
  • Lengthy i.e. takes a lot of time and costly to prepare
  • Rigid, lacks flexibility
  • Do not allow change
  • No value additions when compared with the efforts and time put in
  • Main focus of budgets are on cost reduction rather than adding value to the business
  • Gives importance to vertical control

Inspite of the drawbacks above, in a survey by David Dugdale and Stephen Lyne, nearly 40 companies are still willing to use budgets, they agreed only on two areas. They said that, yes budgeting is time consuming and the actions may get delayed due to some constrains. They disagreed to abandon budgets because of the following reasons:

  • Viewing Budgets as a framework to control, budgets are still regarded as helpful tool in coordination and control
  • Organizations culture to prepare budgets, budgets is indispensible part of an organization. (Scapens and Roberts, 1999)
  • The need of decentralization.

Advanced developments in the Budgeting Process

After classifying traditional budgeting as “Bane of corporate America” and “tools of repression”, companies worldwide are using Activity Based Budgeting, rolling Budgeting, Zero base Budgeting and 4P based budgeting (PBB), which is Paradigm –Based Budgeting, Process-Based Budgeting, Priority based budgeting and Performance based budgeting. As suggested by Anthony, Hawkins and Merchant (2003), a change in the practise and methodology used can make a huge difference in the processes and systems that underline business performance management. The definitions of the new budgeting alternatives to traditional budgets are discussed below:

In the words of Peter a Pyhm, zero base baudegting (ZBB) is “an operating planning and budgeting process which requires each manger to justify his entire budget requests in detail from scratch (hence zero base). Each manager has to justify why he should spend any money at all. This approach requires that all activities be identified as decision on packages which would be evaluated by systematic analysis and ranked on order of importance.” Thus “ZBB is a management tool which provides a systematic method for evaluating all operations and programme, current or new, allows for budget reductions and expansions in a rational manner and allows reallocation of resources from low to high priority programmes.” (David Heminger).

Performance budgeting is described as a technique, “the process of analysing, identifying, simplifying and crystallising specific performance objectives of a job to be achieved over a period, within the frame work of organizational objectives, the purpose and objectives of the job. The technique is characterised by its specific direction towards the business objectives of the organization,” The National Institute of bank Management, Mumbai. Performance budgeting is based in the achievement of specific goals in a period of time.

Rolling budget can be defined as Method in which a budget established at the beginning of an accounting period is continually amended to reflect variances that arise due to changing circumstances.

“Activity based budgeting is the allocation of resources to individual activities. Activity based budgeting involves determining which activities incur costs within an organization, establishing the relationships between them, and then deciding how much of the total budget should be allocated to each activity.” Cost Dictionary.

Balanced score card is a part of ABB; it is a set of financial and non financial measure relating to company’s critical success factors. It is an approach which provides information to the management to assist in strategic policy formulation and achievement. It emphasizes the need to provide the user with a set of information which addresses all relevant areas of performance in an objective and unbiased manner. As a management tool it helps companies to assess overall performance, improves operational processes and enables management to develop better plans for improvements. It offers managers a balanced view of their organization upon which they can base real change. (Kalpan and Norton 1992)

They say that abolishment of budgets open up new financial as well as non financial measures of performance. The company’s after abandoning budgets need to identify the Key Performance Indicators (KPI) for example, profit, return on capital, cash flows, quality and customer satisfaction. Such KPI’s are continuously reviewed and changed according to the changing world thus allowing the company to adapt according to the shift in market conditions.

Beyond Budgeting (BB)

Hope and Robin Fraser achieved prominence in criticising budgeting in their book, Beyond Budgeting: How Managers Can Break Free from the Annual Performance Trap (2003). The authors urged that, “Budgeting, as most corporations practice it, should be abolished”. According to Hope and Fraser, "abandoning the annual budgeting process opens up two opportunities; one is to enable a more adaptive state of management processes, and the other is to enable a radically decentralized organization." The authors are of the view that if the company wants to adapt to changing economy it should abolish using budgets, once it stops preparing budgets, the companies will make their employees more creative, motivated, willing to work hard and ready to share information, which are the most necessary requisitions for any company’s’ long life.

The authors suggested Beyond Budgeting is the result of the Beyond Budgeting Round table (BBRT), which is an independent industry led research consortium. Hope and Fraser (2003) is the founder of “Beyond budgeting: how managers can break free from the annual performance trap.”

Beyond budgeting, p212 says, “A set of guiding principles that, if followed, will enable an organization to manage its performance and decentralise its decision making process without the need for traditional budgets. Its purpose is to enable the organization to meet the success factors of the information economy (e.g being adaptive in unpredictable conditions.” Beyond budgeting have two advantages:

  • It make the organization adaptable to the changing market conditions
  • It is not like traditional budgeting process, it is a decentralized process where organization is taken care of by the leaders centrally. BB by the word “budgeting” means the entire performance management.

The Six Adaptive Process Principles of ‘Beyond Budgeting’ given by Hope and Fraser are as follows:

  • Set stretch goals aimed at relative improvement
  • Base evaluation and rewards on relative improvement contracts with hindsight
  • Make action planning a continuous and inclusive process
  • Make resources available as required
  • Coordinate cross-company actions according to prevailing customer demand
  • Base controls on effective governance and on a range of relative performance indicators

Source: Beyond Budgeting, pp. 69-89.

References:

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