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What is budget?
A budget is a financial document used to project future income and expenses. It is a process used by company or individuals which enables them to decide whether they can continue to operate with the projected income and expenses (Murray J.W.). Budget constitutes to an important part of the organizations as it helps them in checking the cash flow across various departments in the organization. Depending on the organisational demands budgets can be monthly or annual. Mostly industries/organizations follow an annual budgeting process.
What is annual budget?
Annual budget is a plan for company's expenditures for a fiscal year. Annual budget involves balancing an organization's revenue with its expenses. A budget is in balance if revenue equals expenditure, it is in deficit if the person or company must resort to borrow to meet the expenses and it is in surplus, if money is left over to be used for savings or expansion. Budget gives a realistic idea to the management on the decisions of expansion, growth of the organization and cash flow control (Farlex, 2009).
A Company without a proper budgeting is similar to a driver who drives the car in night without its lights being turned on. Budget provides the organization with a realistic idea on the following. Budget tells us how much money an organization needs to carry out its activities. Budget plays significant role in activity planning and helps the organization in rethinking the action plans when needed. When implemented properly, budget gives the organization an idea about when they need certain amounts of money to carry out the activities. Budget enables the organization to monitor expenditure and income and identify any problems. Organization cannot rise from donors without a proper budget. Budget forms the important basis on which donors makes the decision.
Traditional Budget Model:
Figure 1: Traditional Budgeting Model
The above depicted chart is the process followed by most organizations for preparing the budget once in a year. The word once in a year has been the biggest disadvantage for the traditional budget method. With the recent market fluctuations and advancements happening in the technology, an organisation should be in a position to change its forecast and act in a faster way when there is a sudden market change. The traditional budget is formulated with little insight into the sudden market changes that may happen during the course of one year. Managers spend a lot of time in formulating the budget but their efforts go in vain as the model is not in tune with the reality. The forecast once presented does not change throughout the lifespan of the budget. Organisations are becoming increasingly frustrated with traditional budgeting tools as they continually fail to meet today's business demands. The traditional budget process fails to identify waste, does not identify the incoming workload, does not support continuous improvement, does not identify cost drivers, and appears to have a general lack of ownership and buy-in (Hope J. and Fraser R., 2003).
The main inherent weaknesses of traditional budget are as follows (www.docshare.com).
The most severe criticism is that it presents little useful information to decision makers on the functions and activities of organisational units. Most of the budgets are based on the previous year's expenditure.
Traditional budgeting methods are proving ineffective in today's unpredictable and fast-paced business climate. Traditional budgets are based on a calendar or fiscal year, creating artificial time lines that do not match new product schedules.
Since this budget presents proposed expenditure amounts only by category, the justifications for such expenditures are not explicit and are often unintuitive. It may invite micro-management by administrators and governing boards as they attempt to manage operations with little or no performance information.
Other criticisms of the traditional budgeting process are that it is extremely time-consuming for the benefits achieved and it focuses on resource inputs instead of the outputs generated by those inputs.
What is more key performance indicators are not incorporated into existing budgeting processes and therefore traditional tools are too slow, one-dimensional and backward looking.
Traditional Budget Model - US Banks Case:
The US banks' budget is taken as a source for analysing the above mentioned weakness. Lets us consider the budget for the year 2011. For example, in most banks around the US the process starts in August and concludes in December. The budget developed will be for 2011. During 2011 forecasts will be made to supplement the budget information. But the forecasts will only go through December 2011. So forecasts made in April will be for only nine months; in July the forecast is for only six months; and in October for only three months. The forecasts are always concentrating on the achievement of the current year's earnings per share goal.
Unfortunately, this budget process acts as if 2012 doesn't exist. Instead of a seamless transition from one year (2011) to the next (2012), 2012 doesn't exist, until it gets serious attention at the beginning of the next budget cycle. Moreover budget plan does not take into consideration the economic threat that may affect the operations of the bank. The bank when designating the budget plan for 2008 has never taken into consideration the recession mania that has swept the entire banking industry. So the same process continues for 2011 also. The budget does not even consider the technical advancements happening. Despite the minimum focus on most of the important things that decide the fate of the organization, the time taken to produce the budget on paper eats away immense time of the officials. Bank managers spend days working out the strategies to arrive at the final budget. But the budget will not consider the micro organizational changes which might alter the cash flow during the fiscal year (Nolan G.J., 2005).
As the traditional budget model has a lot of disadvantages, alternative models have come up which helps the organization in designing a budget plan which gives a clear forecast to them . The alternative budget models are as follows.
Activity Based model
The above models take into consideration the various factors the traditional budget has not taken care of. Let's get into a brief description of these models and the factors that it takes into consideration.
A benchmark is 'A surveyor's mark indicating point in a line of levels; a standard or point of reference. Benchmarking is a powerful performance management tool, which can be used to generate both incremental change and wide-ranging strategic reform for the organisation. It is a learning process in which information, knowledge and experience about leading practices are shared through partnerships between organisations. It allows an organization to compare itself with others and, in the process, step back from itself and reflect. In addition comparative measurement through benchmarking helps to identify problems and opportunities, and also tests ideas and "gut feelings" about performance and spend. Benchmarking is an ongoing process for finding improved ways of doing things (Walker D., 2006).
The three important aspects that benchmarking model takes into consideration are
A Company relationship with customers
Key Internal Process.
Learning and Growth of the organization.
When used effectively benchmarking can identify paucity of information, assist in realistic target setting, review service delivery methods and procedures. The possible shortcomings of undertaking financial comparisons can be outweighed by the need to point services in the right direction. It was noted that it can also be used to steer funding to under resourced areas.
Balance scorecard is a management system that enables organization to translate vision and strategy into action. This system provides feedback on internal business processes and external outcomes to continually improve organizational performance and results (Margarita I., 2008). The balance score card has its design based on the four factors as indicated in the diagram below.
Figure 2: Balance Scorecard.
Activity Based Budget:
A method of budgeting is one in which the activities that incur costs in every functional area of an organization are recorded and their relationships are defined and analyzed. Activities are then tied to strategic goals, after which the costs of the activities needed are used to create budget.
Activity based budgeting stands in contrast to traditional, cost-based budgeting practices in which a prior period's budget is simply adjusted to account for inflation or revenue growth. As such, ABB provides opportunities to align activities with objectives streamline costs and improve business practices (www.investopedia.com).
Objectives of AcTIVITY BASED Budgeting:
The objectives of activity based budgeting eliminates the inherent weaknesses of traditional budget model which includes (Mulder J., 2004).
An efficient use of budgetary resources
- To assure a more efficient use of resources in full coherence with political priorities and objectives.
A stronger political steer in the budget process.
- The focus is shifted from budgetary inputs to how the budget contributes to the attainment of objectives.
- Priority setting, budgeting and reporting take place within the same conceptual framework.
A more transparent budget for the citizens.
- Offering a clearer and politically more relevant view of how European public funds are used.
- This requires a budget structure based on Policy Areas and Activities.
- Administrative resources to be structured by destination, while maintaining a simplified classification by nature.
Having got a fair idea about the aspects of these models, now let's get into detail how traditional budget acts as a barrier in the implementation of these. Even when these models have their advantages, when applied with traditional budgeting models, there are lot of barriers which is preventing them from enjoying the advantages. Let us see in detail how these models are applied with.
Benchmarking considers the three important factors for its design. They are key internal process, relationship with customers and learning and growth of the organization. The standard budgeting model never takes into consideration the internal operations of the organization. The standard budgeting model is based on the past figures of the organization but is not dependant on how the organization functions internally, how are the internal process designed and working in the organization. When benchmarking model is used in the traditional budgeting model, it does not match up with the considerations of the traditional budget model. Consider an example where in an organization wants to implement benchmarking to the traditional budget model. The organization would have prepared an annual budget and when they need to implement budget benchmarking they have to take into consideration the consumer relations and how it plays a role in the organization and how the share holder value has effect on the organization. So the entire process of the budgeting plan has to be altered and the figures will also change when benchmarking factors are included in the budget plan (Walker D., 2006).
Now coming to balanced scorecard, this model also takes into consideration some of the aspects which the traditional budget model has not taken care of. Balance Scorecard for its model functioning takes into consideration the four factors namely financial vision, internal business processes, learning and growth and customer. The model gives much advantage to the organization in forecasting the future for any sudden changes as learning and growth factor of the organization is considered. The traditional budget model never takes into consideration the learning and growth factor of the organization. Learning and growth constitutes an important factor for the organization as it gives a idea of how well the organization has performed in the past fiscal year, how the organization is heading towards meeting the challenges. So it is very clear that the traditional budget model cannot incorporate the learning and growth for the organization which prevents it from incorporating the balance score card (Margarita I., 2008).
Now moving to activity based modeling, the model has been designed where in the different functional areas is related and analyzed. Each and every functional area will be related and their process will be studied in detail. By looking at the cost structure of an organization via the processes that are actually being performed, managers can more effectively analyze the profit potential of a company's products and services. Cost efficiencies can be found by comparing activities performed in different areas of the organization and consolidating or rerouting certain functions. At its essence, activity-based budgeting begins by looking at results and the activities that created them. Also the standard budgeting model does not consider the relationships among various functional units in the organization. The standard budget model cannot consider the relationships within the organization as mostly the standard budgeting model follows top-down or bottom-up approach. These are the factors that prevent the standard budgeting model in applying the activity based modeling (Player S. and Keys D.E., 1999).
In the essay we have analyzed the pros and cons of traditional budget model and the supplement models which can be used effectively to increase the performance of the budget plan. The three alternatives considered are the best in terms of forecasting the budget plan as they take into consideration various aspects like relationships within the organization, mainly the customer focus and also the threats and alarming situations. Even though the models are efficient in their approaches, it could not be fitted with traditional budget model because of the narrow scope of focus followed by the traditional budgeting model and this is standing as a barrier in adapting the alternative models to the traditional model