Pros and Cons of budgeting in modern environment

Budgets are recognized as time-honored tools for planning and setting organization’s goals, for communicating among corporate constituencies, and for providing basis for operating results review as well as performance evaluation. While it is difficult for firms to have perfect budgets that make use of all functions equally well, differential emphasis on the respective uses of budgets reflects the environment variation and contracting needs. The modern economic environment is associated with a rapidly changing environment, flexible manufacturing, short product life cycles and highly customized products and services (Abdullah N.B. 2008). The keys to survive is flexibility and rapid response whereby companies are able to move quickly to exploit opportunities as they arise and does not operate according to elaborate business plans (Abdullah N.B. 2008).

“We were being overtaken by events. Traditional planning and budgeting strategy had to give.” Senior vice-president in Fujitsu Computer Products of America, Kevin T. Parker said that, department managers budgeted at the detail level before the company had agreed on strategic objectives. (Banham, R. 2000.) Fujitsu were long on process and short on valuable information to run the business. Department managers would forecast product availability and customer expectations independent of one another, then negotiate with top management for few times until they were final. This circuitous routine took two months, an exceptionally long period of time in the fast-paced computer industry. (Banham, R. 2000.)

Most organizations recognize budgets as a key element in their management control systems, but the usefulness of budgets has generated intense discussion and debate. Budgets have been proven by some of the researches that budgets are less useful in today’s highly challenging business environment. Traditional budgeting, budget planning is a top-down process which will not support the types of extreme decentralization and employee empowerment initiatives that are required for firms to be competitive today (Libby T., and Lindsay M., 2007).

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Budgets are no longer useful in the current environment

Budgets constraint responsiveness and flexibility and are often a barrier to change. Traditional budgeting is focused on the achievement of the specific plan or budget and this resulted in organization’s eyesight to constantly focus on how to achieve and beat the budget. But indeed, the objectives of a company should not be to beat the budget but to beat the competition. (Leone, A.J and Rock, S. 2000) Whereas, in traditional budgeting there is rarely an opportunity to amend, change or update the budget once it has been approved, should there be any changes in the environment or assumptions employed (Abdullah N.B. 2008). Thus, managers only can decision within the budget, but the particular decision that he make, might not be the perfect solution; managers are tended to abandon best solution due to not exceed the budget, and thus inhibits management response to change. This focus can act as a constraint, decreasing the firm’s flexibility and ability to adapt and deal with new opportunities, threats or changes in customers’ requirements (Abdullah N.B. 2008).Traditional budgets prevent empowerment and the opportunity for employees to contribute to the achievement of strategic objectives. It is blocking employee initiatives and demotivated employees, where employee initiative and motivation are needed in today’s highly challenging environment, which can make a marked improvement in performance and productivity, thus it is a barrier to continuous improvement and success, because, less focus is given on how to maximize the organization’s potential. According to the Shastri K. and Stout D.E., many segment-level employees1 than corporate-level employees felt that budgets had negative behavioral consequences in terms of employee initiatives, motivating short-term decision making, and pressure to achieve targets.

Budgets encourage gaming and dysfunctional behavior. (Abdullah N.B. 2008). Libby T., and Lindsay M., (2007) explicitly addressed the issue of budget gaming. Majority of the respondents surveyed indicated that three “gaming” phenomena occur at least occasionally: spending money at year-end to avoid losing it – the old-age “use it or lose it” syndrome, deferring necessary expenditures and negotiating easy targets – the

Segment-level was defined variously as a subsidiary, division, department, or product level.

“sandbagging syndrome” (Libby T., and Lindsay M., 2007).This is especially the case when meeting the budget is directly linked with rewards and incentive payments to individuals and/or team. Indeed, many organizations incorporate budgetary performance subjectively into the overall performance evaluation of managers (Libby T., and Lindsay M., 2007). Moreover, managerial compensation plans, including incentive compensation formulas, incorporate achievement of specified budget objectives for financial performance measures. (Shastri K. and Stout D.E. 2008) The dual roles of budgeting gives rise to agency problems in the budget-setting process and affect the accuracy of budgets. Majority of participants seek to maximize their personal gain during the process of setting budgets. Once, goal congruence is not achievable, there are conflicts of interest between company and employees, and this is where the agency problems are occurred. Tying budget targets to compensation contracts encourages managers to game the budgeting system to increase the probability they will receive positive performance evaluations and, therefore, any related bonus (Libby T., and Lindsay M., 2007). Budget gaming is when managers are use to receive positive performance. For examples, when companies are using budget integrated with incentive program, managers will try they best to show a good performance but gaming the budgets. Managers might defer necessary expenditures (such as, maintenance of machine, advertising cost, research and development) to meet current period budget targets, which will affect effectiveness and efficiency of company. Besides that, managers will take ‘big bath’ when budget targets could not be attained, which mean the effort of producing the budget is not appreciated. Using budget as the tools of evaluating performance will lead to negative behavioral consequences.

Budgets can still be useful in the current environment

Budget should use as the basic for performance evaluation but not the only means to evaluate performance. As mentioned above, solely focus on budget as the only way to evaluate performance and compensate managers will result in agency problems. Agency problems will lead to company underperformance. Budget can be useful once, the incentive program is not mostly depending on it. In order to measure performance, budget is not the only option; companies should design an effective performance measurement system by integrated financial2 and non-financial3 indicators as tools of measuring efficiency or performance. Moreover, companies should design an effective system which can link to strategy and goals of the organization to encourage goal congruence, recognize controllability and emphasize on employees empowerment. By designing a system besides budget to measure performance can solve agency problem. Measure performance of managers based on controllability and responsibility, which mean top management should back out non-controllable variances before comparing actual to budget. For instance, companies such as Allstate, Fujitsu, Nationwide Financial Services, Owens Corning, Sprint and Texaco, are compensating the managers for achieving measurable results (Banham, R. 2000). For example, when evaluate performance of production managers should back out the machine breakdown hours, because it was not under his controllability but is engineer’s responsibility. Besides that, provide incentive to managers who manage to generate an accurate budget, managers will tend to provide secret information to the budget, thus, it make the budget more accurate. In addition, Hope and Fraser propose a new management model to take the place of budgeting for control purposes. This new model is based on employee empowerment and alternative methods of performance management, which to suit the requirement of today’s highly challenging environment (Libby T., and Lindsay M., 2007).

Financial indicator such as, return on investment (ROI), residual income (RI) and economic value added (EVA).

Non-financial indicator such as, benchmarking, balance-score card, customer satisfaction measures, defect measures, product quality measures, accident measures, machine downtime measures, delivery time measures and etc.

Moreover, there is a new model which known as “Beyond Budgeting” was developed by two consultants, Jeremy Hope and Robin Fraser, in order to find and develop alternative tools to the planning and budgeting process (Abdullah N.B. 2008).This new model is based on employee empowerment and alternative methods of performance management (Libby T., and Lindsay M., 2007).

Most of the organizations which are high profile companies, have abandoned the major annual budget preparation, the Beyond Budgeting Round Table (BBRT4) members realized that attempts to make incremental changes to improve the budgeting system by introducing zero-based, activity-based or faster budgeting are not solving the problems caused by the fast-changing business world (Abdullah N.B. 2008), but to change the underlying culture of “contract, compliance and control” embedded in the traditional budgeting. Beyond Budgeting model, BBRT have developed a generic model that is based on 12 principles to create a flexible a responsive management model with an underlying culture of “responsibility, enterprise and learning”. Companies that operate in a business environment that is market led, highly competitive and unpredictable, and in which intellectual capital is the key strategic resource; and which have already successfully implemented various management tools like the Balanced Scorecard, Activity-Based Management and Rolling Forecast, should be the ideal candidate for the Beyond Budgeting model.

The BBRT is the combination of a new concept (‘beyond budgeting’) and a community (’round table’). The BBRT community is an independent research collaborative that shares its knowledge across its global network through conferences and workshops.

Source: Abdullah N.B. 2008. Chapter 3: Scenario of Corporate Planning and Budgeting in a rapidly changing environment.

These 6 principles (Table 1.a) concern creating a flexible organizational structure in which authority is devolved to employees. The following 6 principles (Table 1.b) deal with designing an adaptive management process for a flexible organizational structure.

Table 1.b: The 12 Beyond Budgeting Principles and Practices

Source: Abdullah N.B. 2008. Chapter 3: Scenario of Corporate Planning and Budgeting in a rapidly changing environment.

Conclusion

Budgeting, despite being proven to effectively act as one of the building blocks of management control system, was commonly viewed as a restriction of companies’ flexibility and competitive ability. Yet, despite various criticisms, budgets are in fact alive and well, rather than becoming obsolete, most organizations use a traditional budget because they are easy to put together and simplify coordination of budget assumptions across different departments. This is the simplest method of budgeting. But, indeed, with a traditional budgeting, company might be underperformance. In order to be more competitive in today challenging world, adopting advanced budgeting approaches is needed as it is focus on empowerment employees as well as responsibility.