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Budgeting system can be defined as the various methods of preparing a budget by an organization. Budget is prepared for short-term objectives but helps an organization to achieve the long-term objective that can be sub-divided into various short-term objectives. Owing to huge capital involvement, budget is required for planning capital investment.
Budget can control the expenditure and production costs by continuously comparing actual with planned results using variance analysis, and taking appropriate corrective action on the significant variances reported. Budget also has the ability to motivate managers to better performance and serves as a yardstick for performance evaluation.
Top-down budgets of Qualicious began with the limiting factor - sales budget and using the volume of sales, predict inventory levels, capacity utilization and staffing levels needed to meet expected demand. CEO set the revenue target of 15% growth from last year's actual and senior management basically established spending limits within which departments would allocate costs to the specific line items.
This budgeting system saves time as only board of directors are involved in budgeting. Being goal congruent and clearer idea of sales growth and profit that will satisfy shareholders, it also ensures that the budgets set are aligned with its long-term objectives.
The limitations, however, are the level of commitment by lower level managers are low since there's no ownership and motivation to meet the target. Top-down budgets can ignore the problems experienced by operational managers and so may not be realistic. Furthermore, there is no budget committee or formal guidelines for budget preparation in Qualicious. It is thus recommended that senior management should consult and gather feedback from relevant lower level managers before budget implementation, justify on why the budget is being set to employees and form a budget committee for better co-ordination of the budget preparation and improve the effectiveness of its budgeting process.
This paper serves to illustrate author's understanding with the Budgeting Systems and how it could be used as instruments for planning and control. It also examines the current budgeting system of Qualicious and makes recommendations for improving its effectiveness.
Chapter 2 provides the background of Qualicious Pte Ltd, an F&B company with a restaurant located in Singapore, offering uniquely different Taiwanese food that no other competitors have.
Chapter 3 defines the budget, budgeting and budgeting system prior to reviewing the various budgeting systems: top-down, bottom up, participative and zero-based budgeting that different organizations can select and adopt any one of them.
Budgeting system can further be engaged as an instrument for planning and control as illustrated in Chapter 4.
Chapter 5 describes the current budgeting system of Qualicious - the top-down approach, its budgeting process and advantages and limitations.
Chapter 6 provides recommendations for improving the effectiveness of the existing budgeting system before making final conclusion in Chapter 7.
2. Background of Qualicious
Introduction of Qualicious
Name of company: Qualicious Private Limited
Date of incorporation: 1 Jan 2008
SSIC Code: 56111
Yearly Revenue: S$5,400,000 [End Dec 2008]
S$6.216,000 [End Dec 2009]
15% growth in revenue from 2008
Location: ION Orchard Mall
Principal activity: A food & beverages [F&B] company with a restaurant, located in the bustling Orchard area, which focuses primarily on offering various Taiwanese food which are delicious and uniquely different from all other restaurants in Singapore.
Vision: A market leader in uniquely different Taiwanese food
Mission: To excite the taste buds of all customers to yearn and crave for more.
2.2 Organization Chart of Qualicious
There are 7 key members (board of directors) in the management team of Qualicious, as indicated by its organizational chart in Fig. 2.1:
3. Budgeting System
3.1 Definition of Budget & Budgeting
According to Blocher & et al. (2008, p. 255), a budget is a financial or non-financial expression of an organization's plan of action for a specified period and budgeting is the process of preparing a budget.
Chadwick (2002, p.258), however, defines a budget as a plan expressed in money that is prepared and approved prior to the budget period and may show income, expenditure and the capital to be employed and budgeting is mainly about the allocation of scarce resources between competing influences.
Horngren, Foster & Datar (2000, p.178) states that a budget is a quantitative expression of a proposed plan of action by management for a future time period and is an aid to the coordination and implementation of the plan.
Secrett (2000, p.3) defines a budget as a statement of allocated expenditure and/or revenue, under specific headings, for a chosen period. The allocated expenditure generally must not be exceeded and the revenue must be achieved.
The author's definition of a budget is simply a detailed quantitative statement of monetary plans prepared in advance that shows how the organization will acquire and allocate different types of resources for a forthcoming period, usually one year. It is felt that a budget provides a focus for the organization by planning ahead, helps the co-ordination of activities and facilitates control.
3.2 Comparison of various Budgeting Systems
Budgeting system can be defined as the various methods or approaches of preparing a budget by an organization. The common budgeting system includes top-down, bottom-up, participative, zero-based, incremental or rolling budget system. Most of the companies will choose and use only one type of budgeting system.
Top-down budgeting system is based on the fact that budgets are set by key executives or top management and given to department heads to meet (Epstein, 2005). Most employees are not involved in the budgeting process; instead, the numbers are imposed on the employees by those at the top and the employees are expected to meet them. This very simple method works out last year's budget or actual and then adds or subtracts a sum or percentage (Brookson, 2000). The flaws in this approach are that it is very unlikely to give optimum resource allocations if the previous year's figures are wrong and that it may also miss hidden gradual cost changes and can perpetuate inefficient practices (Brookson, 2000). However, top-down budgeting is still the most common way to produce budgeted figures as a manager can produce a budget in one day without reference to any other part of the business (Brookson, 2000).
In bottom-up budgeting, budgets are created at the department level based on overall companywide goals and guidelines set by the board of directors and top executives (Epstein, 2005). This approach encourages employees' participation in the budgeting process, so the employees have more of a sense of ownership in the budget. According to Brookson (2000), the basis for budget is activity-based building blocks and some managers prefer not to use it because it is very time consuming and considered to be an aggressive approach.
The comparison of top-down and bottom-up budgeting is shown in Table 3.1 below:
In participative budgeting, a budget committee is formed in that top management or department representatives will get together to discuss the budget for the organization. Brookson (2000) feels that a budgeting committee should comprise senior managers from the major business segments, the management accountant, and heads of all departments involved in the budget preparations and should set the guidelines for the budgeting manual, review departmental budgets by studying budget forecasts at meetings, create a master budget and ensure that the whole process is completed effectively and on time.
Zero-based budgeting is budget that is prepared without referring to the past. It identifies the costs that are necessary to implement agreed strategies and achieve goals, as if the budget-holder were beginning with a new organizational unit, without any prior history (Sharma, 2009). It states the purpose and outcome of varying expenditure for each activity, starting from a base of nothing or zero (Brookson, 2000). This is very time-consuming because every budget figure needs to be justified.
4. Budgeting System used as instruments for planning and control
Anthony & Govindarajan (2000), Horngren, Foster & Datar (2000) and Blocher & et al (2008) describe budgeting as important tool for effective planning and control.
Figure 4.1 shows the planning and control sequence within a business (Atrill & McLaney, 2002). The budget is a short-term financial plan for the business that is prepared within the framework of the long-term plan. Control can be exercised through the comparison of budgeted and actual performance. Where a significant divergence emerges, some form of corrective action should be taken. If the budget figures prove to be based on incorrect assumptions about the future, it might be necessary to revise the budget.
As instrument for Planning
Budgeting systems turn managers' perspectives forward and by looking to the future and planning, managers are able to anticipate and correct potential problems before they arise (Horngren, Foster & Datar, 2000). Through budgeting, management can plan ahead and maintain enough cash to pay creditors, to have adequate raw materials to meet production requirements, and to have sufficient finished goods to meet expected sales (Kieso, 2002).
Careful planning is required to guide all parts of the organization towards its strategic long-term and short-term objectives. Anthony & Govindarajan (2000) saw strategic planning as being focused on several years, contrasted to budgeting that focuses on a single year and so a budget is a one-year slice of the organization's strategic plan. The budget prepared for planning purposes, as part of the strategic planning process, is the quantitative plan of management's belief of what the business's costs and revenues will be over a specific future period (Davies & Boczko, 2005). According to Atrill & McLaney (2002), a budget's role is to convert the long-term plans into actionable blueprints for the immediate future and budgets will define precise targets concerning:
I. Cash, receipts and payments
II. Sales, broken down into amounts and prices for each of the products or services provided by the business
III. Detailed stock requirements
IV. Detailed labour requirements
V. Specific production requirements.
A series of long-term plans identifies how each objective is to be pursued, and budgets identify how the long-term plan is to be fulfilled (Atrill & McLaney, 2002) and a master budget expounds action plans to attain the organization's short-term objectives (Blocher & et al., 2008).
Hence, the long-term [strategic] objectives may be divided and broken down into short-term [budget planning] objectives and budgeting can be used to fulfill these objectives as it provides a written plan of action that facilitates proactive management whereby diverse elements of the organization are guided towards a common set of objectives and managers are forced to develop a set of actions ahead of time and quantify them in financial terms (Berry, 2006).
Figure 4.2 shows the sequences of each step in the process and the relationship between strategic planning and budgeting and how budgeting can fit into the overall strategic planning process.
In addition, budget can be used to plan for capital expenditure of the organization. Capital investment is often costly and is tied to strategic and operational planning of an organization. According to Blocher & et al. (2008), long range plan [strategic] often entails capital budgeting, which is a process for evaluating, selecting and financing major projects such as purchases of new equipment and addition of new products. These plans will need to be carefully monitored and action taken to combat the effects of changes in the perceived environment. Through budgeting, management can allocate sufficient funding for this capital expenditure, if justified. It is important to calculate the return of investment [ROI], conduct risk analysis and risk assessment so as to justify for every capital expenditure in the budget and to note that all budgets, eg. Sales, production, capital expenditure, research and development, are interrelated.
As instrument for Control
Control and monitoring are the continuous comparison of actual results with those planned, both in total, and for the separate divisions within the organization, and taking appropriate management action to correct adverse variances and to exploit favorable variances (Davies & Boczko, 2005).
The budgeting system also provides a mechanism for achieving control for both costs and revenues by continuously comparing actual with planned results (Chadwick, 2002). Hence, by setting a budget in advance, organization can control the expenditure as well as the production costs by performing the variance analysis to compare the actual with planned budgets so as to avoid over-spend on the budget allocated.
Areas of efficiency and inefficiency are also identified through reporting of variances, and variance analysis will prompt remedial action where necessary. For example, in reporting the variances, those that are considered to be significant and the reasons why they have occurred, should be highlighted on the comparative statement. This will subsequently enable management to focus on them, and give priority to sorting out the appropriate corrective action. Chadwick (2002) describes this system of highlighting significant variances as 'management by exception'.
Part of the budget process should identify the people responsible for items of cost and revenue so that areas of responsibility are clearly defined. Budget holders can only be responsible for controllable costs or revenues within their areas of responsibility. For example, a production manager may be responsible for ensuring that he does not exceed the number of direct labour hours allowed within their area of responsibility for a given level of output. In a similar way, a budget holder may be responsible for controlling costs of a department that relate to sales volumes or other variable activities. Monitoring of actual performance against the budget is used to provide feedback in order to take the appropriate action necessary to reach planned performance, and to revise plans in the light of changes.
The budget prepared for control purposes is used for motivational purposes to influence improved departmental performance. Budget has the ability to motivate managers to better performance. Having a stated task can motivate managers and staff in their performance. Atrill & McLaney (2002) argues that managers will be better motivated by being able to relate their particular role in the business to the overall objectives of the business. Since budgeting are directly derived from corporate objectives, budgeting makes this possible.
Budget can also provide a basis for a system of control (Atrill & McLaney, 2002). If senior management wishes to control and to monitor the performance of more junior staff, it needs some yardstick against which the performance can be measured and assessed. If there are data available concerning the actual performance for a period, and this can be compared with the planned performance, then a basis for control will have been established.
5. Current Budgeting System of Qualicious
Budgeting Process of Qualicious
Qualicious basically adopts the top-down budgeting system, where the senior management of each budget areas originates the budget targets. Its budgeting process is broadly shown in Figure 5.1.
The budgeting process of Qualicious can be described briefly and in sequence, as follows:
Long-range, strategic planning starts 12 to 18 months in advance of the next operating year by senior management of Qualicious. From 6 to 3 months before the next year, management will translate the overall strategic goals into annual objectives.
Budgets are intended to be the short-term plans, for the next operating year, that seek to work towards the achievement of long-term plans and to the overall objectives of Qualicious.
The key or limiting factor of Qualicious is identified which is the sales volume.
Sales volume is based on economic and industry forecast and conditions, including competition but revenue target is usually set based on past year's actual results plus 15% growth [Set by CEO].
Develop detailed sales and marketing budgets [prepared by Sales & Marketing Director] by market sectors, major customers and different food product categories.
Prepare production budgets - raw materials, labour and overhead [prepared by Master Chef, Operations, HR and Finance Directors] in order to produce goods and services needed to satisfy the sales forecast and maintain agreed levels of inventory.
Prepare non-production budgets by cost centre [Sales & Marketing Director, Master Chef, Operations, HR, Finance Director].
Prepare capital expenditure budgets [Master Chef and Operations Director].
Prepare cash budget and identify financing requirements [Finance Director].
Prepare master budget - profit and loss, balance sheet and cash flow [Finance Director].
Obtain board approval of profitability and financing targets.
Once master budget is approved, monitoring of actual performance relative to the budget, using variance analysis, will be carried out by respective directors on a monthly basis, and appropriate corrective actions taken.
Strategic and Performance evaluation subsequently will be done based on the actual reported results.
Master Budget Framework of Qualicious
Figure 5.2 illustrates the individual interconnecting budgets that make up the master budget of Qualicious
Advantages and limitations of current budgeting system of Qualicious
Advantages of current budgeting sytem
Top-down budgets of Qualicious begin with the sales forecast [limiting factor] and using the volume of sales, predict inventory levels, capacity utilization and staffing levels needed to meet expected demand (Atkinson & et al, 2001). Senior management basically establishes spending limits within which departments allocate costs to the specific line items [salaries, travel, office expenses, etc.].
This top-down budgeting approach adopted by Qualicious is simple, straight-forward and time-saving as it only involves top management and does not require any participation from departmental managers and employees. Departmental managers therefore can focus on their routine tasks and not be burdened with the time-consuming budgeting tasks. This also enables senior management to communicate plans to employees and to co-ordinate the activities of the business more easily (Weygandt, Kieso & Kimmel, 2001).
CEO sets the revenue target [usually 15% growth from last year's actual sales] and senior management set the spending limits that they believe are necessary to achieve profits that will satisfy shareholders. Thus, this approach ensure that the budgets set are aligned with Qualicious' long-term objectives as the boards of directors often have a clear idea of the sales growth and profit requirement that will satisfy their shareholders (Shank & Govindarajan, 1993).
In addition, the budget process, as shown in Figure 5.1, is goal congruent as there is a feedback loop from the budget and actual reported results to Qualicious' strategic goals and short-term objectives, where the organizational mission, goals and strategic plans are adjusted as necessary. This control mechanism will ensure that the company will continuously evaluate and review its strategic plan and performance when comparing the actual with its budget. The organizational unit's goals and objectives are also tied to the organization strategic goals, short-term objectives and master budget-setting, in order to achieve the overall objectives for the next operating year. As a result, Qualicious was able to achieve 15% revenue growth from 2008 to 2009.
Limitations of current budgeting system
Top-down budgets originates from senior management can ignore the problems experienced by operational managers because there is no discussion with lower levels of management on budget targets. Moreover, there is no ownership from these lower level managers and other employees in the organization due to lack of participation in the budgeting process. This may result in lack of commitment or motivation by employees or lower level managers to the targets set since many of those responsible for achieving the budgets will be excluded from the budget-setting process.
More importantly, the budget prepared by senior management might not be realistic as top management may not be in touch with what is going on 'in the field' (Emery, Finnerty & Stowe, 2007). The 15% growth in revenue target that is determined by CEO, may be due to expectation from the shareholders only, and this figure is not subjected to any challenge or question by lower level managers or even senior managers. Hence, this figure may not be realistic if no detailed analysis on the field [both external - trend analysis, industry forecast, economic situation, etc. and internal - company's capacity, promotional activities, etc.] is being taken into account.
There is also no budget committee or formal guidelines for budget preparation. Budget preparation process is just one of the topics that is being discussed during regular board of directors' meeting.
6. Recommendations to improve the effectiveness of existing budgeting system of Qualicious
To improve the effectiveness of existing top-down budgeting system of Qualicious, it is felt that senior management should consult the lower level managers and provide them the opportunity to participate in the budgeting process by providing feedback on the relevancy of the budget before being implemented. The lower level managers will then be better motivated as they are able to relate their particular roles to the overall objectives of the business.
Furthermore, if targets are to be fair and realistic, it is important that lower levels of management and worker representatives are involved in the budget preparation process. They could be able to put their points of view forward, and because of their specific knowledge ['in the field'] , they may be able to explain why what is being proposed may not be feasible. Consultation with lower level managers could lead to the setting of targets that are considered to be fair, reasonable and attainable.
Senior management should communicate and justify on why certain budet is being set to lower level managers. Example is to justify on why Qualicious targets to achieve 15% revenue growth and how this relates to company's strategic objectives and shareholders' expectations. The approved budgets, objectives and policies should be clearly communicated to appropriate personnel so that they know what they have to achieve.
It is highly recommended to form a budgeting committee in Qualicious and have guidelines for budget preparation [ie. budget manual] to improve the budgetary co-ordination and ensure that the whole budgeting process is completed effectively and on time. As budgets are inter-related, the budget committee should comprise of senior management and relevant lower level managers or representatives of various departments who meet on a regular basis during the budget preparation period. According to Berry (2006), this communication and coordination process allows for the balancing of goals vertically from top management to lower management and horizontally by the balancing of goals across the various functions in an organization, such as operation, sales, and support functions.
The common budgeting system includes top-down, bottom-up, participative, zero-based, incremental or rolling budget system. As an instrument of planning, budgets can be used to fulfill the long-term objectives and plan out the capital investment of the organization. As an instrument of control, budget can be used to control the expenditure and production costs of the organization. The budget prepared for control purposes can also be used for motivational purposes to influence improved departmental performance and a basis of control for performance evaluation of employees.
Qualicious basically adopts the top-down budgeting system, where the senior management of each budget areas originates the budget targets. The individual interconnecting budgets are sales, production costs, capital expenditure, marketing and sales, general and administrative budgets, that make up the cash budget and the master budget of Qualicious.
This top-down budgeting approach adopted by Qualicious saves time and being goal congruent, it ensures that the budgets set are aligned with its long-term objectives.
However, there is no ownership from lower level managers and other employees and the budget prepared by senior management might not be realistic. Also, there is no budget committee or formal guidelines for budget preparation in Qualicious. It is thus recommended that senior management should consult lower level managers before budget implementation, justify on why the budget is being set and form a budget committee to improve the effectiveness of its budgeting process.