This report will define budgeting; mention the benefits and some of the uses of budgets. The report will mention some of the problems which may arise in motivating staff to achieve higher levels of operating efficiency when using incremental budgeting approach and finally it will mention the different approaches available and suggest two approaches which could be used to improve the company's current system.
What is budget?
''A budget is a detailed plan, expressed in quantitative terms, that specifies how an organisation will acquire and use resources during a particular time period'' Hilton et al (2000). Budgets are used to guide the activities of the organisation and also for control Wood (2008). A budget brings many benefits to an organisation such as; encouraging managers to think into the future and budgets enables managers to find out problems earlier and therefore they are able to think of suitable solutions to solve the problems Mclaney et al (2008). With budgets coordination of the various units and their activities is simplified. Budgets are prepared to motivate managers towards achieving better performance and overall objectives of the business Mclaney et al (2008). Budgets provides a parameter against which the performance of employees and managers can be evaluated therefore it is a type of system of control. Through the use of budgets, the technique of management by exception can be used to direct resources to areas of the operations of the business which is not giving maximum results Mclaney et al (2008). Budget gives the manager the authority to spend up to a certain limit on some activities of the business.
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Incremental budget approach is one of several traditional approaches of budgeting used by different organisations. Incremental budgeting approach uses current year's figures as a starting point and then makes adjustments to prices due to inflation, product mix and volumes. It is reliant on ''the traditional command-and-control approach to management'' Loren (2003 p. 1).
Incremental budgets are poor performance and performance reporting indicators because it is not concerned about the relationship between activities and costs. It does not provide enough information for managing indirect costs and support activities and budgeting indirect costs and support activities are on an incremental basis therefore most of the expenditures related to the base level of activities remains the same Drury (2008). This type of budgeting approach is mostly used in public sector organisations such as the local government, schools and also in certain types of activities in commercial organisations Drury (2008). As may have been noticed in the company, Incremental budgeting approach is simple to use and set up, easily understood by managers, there is fewer risk, less cultural issues, less costly to operate, easy to review ideas and reach a consensus however it has many problems. According to Neely et al (2001) budgets are a barrier to change; they are not linked to the strategic plan of the business and are often contradictory.
Incremental budget is concerned about reducing costs and not ways to create value, it does not show the emerging network structures that organisations are using, budgets are based on unsupported assumptions and inaccuracies, managers refuse to own the budget because it is not based on their own ideas and it is developed and updated not as often as it should be rather annually Otley (2003 p.2). Incremental approach can never be appropriate as a control mechanism of management as it does not grasp the uncertainty involved in the fast paced changing environment Otley (2003 p.2). For a particular budgetary system to be useful it has to provide a high degree of operational stability to enable the budget to be planned for a longer term and also ''managers must have good models so that budget provides a reasonable yardstick against which to hold managers accountable'' Otley et al (1980).
1. Two suggested approaches:
Several studies have shown that a clearly stated, quantitative goal will most likely motivate higher levels of performance than where no such targets are set. Managers and other staff members will most likely perform higher when they have a target and know the standard with which their performance will be measured Drury (2008). A suggestion to the management to set financial targets to improve the current approach should be carefully applied. There are three approaches which can be used to set financial targets. They are obtained from engineering studies of input-output relationships, historical data and from negotiations between the senior management personnel and the lower-level managers Drury (2008). Engineering targets can be used in an environment where it is easy to know the relationship between the input and the output. Historical target is used in an organisation where the relationship between input and output does not exist and this type of target is derived from the outcomes of previous periods. This is an equivalent of incremental budget where past inefficiencies are incorporated in the current period and therefore it encourages staff to become complacent and underperform as the present budget is based on previous period Drury (2008).
Always on Time
Marked to Standard
Negotiated targets are targets set through negotiations between the senior management staff and the lower level management staff. This approach bridges the gap between this two managerial levels enabling information which are necessary for decision making to flow freely between both levels. The type of financial target set by the use of negotiation approach will enable inclusion of the limitations at both the operational and the company as a whole. Because financial targets represent a particular quantitative goal makes it a strong motivational tool for management. Managers need to accept planned targets if they are to be motivated Drury (2008). Setting up a demanding budget and allowing for small adverse variance should encourage managers Drury (2008).
From the three explained approaches to setting up financial targets, the negotiated target approach is recommended if the company want to keep on using budget as a control system. With this approach, the lower-level are included in the budgeting process, the managers will more likely accept the targets and will be committed to achieving them, participation minimizes the gap between the way information flows in the company. It happens that most times people working at the lower managerial level have information regarding the relationship between inputs and outputs and the problems which exists at the operational level and on the other side of the company, the senior managerial staff have information about the whole company and the limited available resources but through participation of both levels of management in the budget process, the gap in communication. Managers are discouraged and are less motivated when budgets are imposed on them. Incremental budget approach does not provide managers with a sense of achievement and self esteem which can be of benefit to the company in terms of increased levels of commitment and aspiration.
Even as this approach is being suggested, it should be used with care as there are various studies which suggested that participative/ negotiation approach may not necessarily be more effective than other approaches due to the following drawbacks; managers' performance are evaluated by the same standard which they have helped to set up, personality traits of the participants may hinder the benefits of participation, the manager must believe that he or she can make significant impact on the budget and receive a feedback in relation to it as just participating in setting up the budget may not be enough and finally, in highly programmable environment where the relationship between input and output is clear and stable, a top-down approach to budget setting may be more preferable Hilton et al (2000).
1.2 Beyond budgeting approach:
According to Fraser et al (2003, p.2), budgeting is a ''vestige of the old command-and-control approach to management'' and they propose ''Beyond budgeting'' as an approach suggesting that abandoning budgeting entirely and finding other alternative