The budgeting process in current dynamic environment

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According to Sullivan and Sheffrin (2003), a budget is a list of all planned expenses and revenues, which would therefore make budgeting, the process of planning expenses based on expected revenues. The budgeting process is meant to aid in providing a forecast of income and expenditure and also enable the actual performance of the company to be measured against the budget. The key problem with this model and the topic of the discussion of this essay is the fact that the current market place is so volatile and so active that predictions are becoming very unreliable, caused by unpredictable global recessions, instability in the EU and in the global market as a whole. There has been a shifting paradigm surrounding the topic, authors Libby and Lindsay (2007) have been anti budgeting advocates for an exceedingly long period of time. No question can be raised against the fact that it is very time consuming, this can be a hugely detrimental hindrance in a world where the phrase "time is money" rings true more than any other time in history. However they even go as far as claiming that budgeting is the driving factor behind the manipulation of earnings by managers and can even be considered as a barrier to change.

The original paradigm in relation to budgeting is that it is an important tool to help plan and predict income and expenditure. It is also useful as a motivational device, providing managers with the ability to propose targets to their employees. Having these targets not only gives employees a goal to work towards, it also gives them a further idea of what is happening behind the scenes in the company and makes them feel more like part of the organisation instead of just labour. The budgeting system in relation to performance does not only give the employees targets but also provides targets for the managers themselves, as they too are being monitored. The comparison of predicted figures and the actual figures are used to determine managerial performance with regards to efficient use of machinery and labour. This however prompts a manager to begin undertaking a few unscrupulous activities such as padding or bargaining for slack.

It cannot be said that budget padding is a current development; in fact studies were carried out as far back as 1973 and according to Onsi (1973), 80% of managers bargain for slack. Cyret and March describe padding or slack as the difference between "the total resources available to a firm and the total necessary to maintain the organization coalition" (R. M. Cyert and J. G. March, 1963 Quoted in Onsi 1973). The current market is far more competitive and far more dynamic which can only mean that there would be a possible growth in Onsi (1973) figure as Prendergast (1997) rightly claimed. In todays' market there is no longer a place for the traditional long term competitive advantage. We find more firms today competing in what is called "hyper competition"; the concept is explored by Richard D'Aveni (1994). It has become in fact, the norm to slightly exaggerate the budget to achieve a required amount through funding negotiation. The concept of padding or bargaining for slack is very simple. In a system where the manager is assessed based on performance against a budget that they prepare, all that needs to be done is to understate profits and grossly overstate costs. When the actual results arrive the manager will appear to be a hero for not having figures remotely close to the predicted budget. Libby and Lindsay(2003) have also pointed out several other issues that can arrive as a result of performance appraisal through budgeting, aside from padding; if there is a the stipulation that the entire budget should be spent at the end of the budgetary period to avoid losing one's "entitlement" in the next period. In the sales department if the targets are in terms of items sold and not a monetary target, managers as well as sales staff may offer higher discounts near the end of the period so as to sell as many products as possible to achieve that target at the expense of revenue. In some cases undertaking activities to attain the budgeted figures at the expense of the company's long-term goals; for example reducing optional expense such as research and development or even employee training. Managers hold back profits if they know they are not going to make the budget, which is in effect a ploy to incur the next year's expenses in this year's budget or persuading customers to delay delivery. There have even been situations where-by managers would hold back profits from this year in reserves when they know they will surpass their targets, to make it easier to achieve the next year's budget.

On the other hand Prendergast (1997) argues that these creative but deceitful actions can be managed rather easily. He claims that via research conducted, using 91 managers in four organisations and a valid response rate of 81% that roughly only a quarter of the managers admitted slack in their budgets. "Simple and multiple regression tests showed no significant relationship with three predicted variables. There was no significant correlation between management participation in budget-setting, the degree of budget emphasis felt by the manager, or the extent of interdependency with budgetary padding." (Prendergast, 1997) In one of the firms in the survey where padding was the lowest it was discovered that the managers were not padding because they were fully aware of every operational activity. In fact the only instances where padding occurred was when finance did not understand the operations side fully and also in situations where costs were directly attributable to volume there was no opportunity given for slack. From this research article it is clear to see that the effects of "information silos" within the organisation are prompting managers to pad their budgets for uncertainties, whereas integration of knowledge may be a viable solution to these difficulties.

Regardless of the enlightenment provided by Prendergast, there is still the overriding negative psychological factor due to performance appraisal aspect of budgeting. Even though padding can be controlled it needs to be eliminated, because not all industries lend themselves to full integration between finance and operations. Libby & Lindsay(2003) have also put forward their ideas which seem to lean towards eradicating the budgeting procedure all together, but one can see that budgeting is core aspect of business life and may not be eliminated easily. Therefore some sort of reform is required, the budgeting process needs to be reviewed and a new form of budgeting that moves away from performance based budgets needs to be proposed as the new paradigm.

Rather than completely wipe out the budgeting process or any other methods of traditional financial measurement, Kaplan & Norton (1992) suggest supplementing it with the "balanced scorecard" method. The scorecard provides a more general look at the organisation and does not only take into account financial drivers as with the traditional methods. Having one measurement to govern all of the goals within an organisation is foolhardy and short-sighted in the opinion of the author and that view is shared by the Kaplan & Norton (2007). The business is interconnected as it stands however only the finance department is held responsible for creating goals and targets via budgeting, and as previously stated finance mangers are not always fully aware of the internal workings of the operations department. The balanced scorecard according to Kaplan & Norton (2007) is a method devised to strengthen the link between both departments. The balanced scorecard not only supplements the financial measurements but it also takes accounts for employee training, internal processes and innovation through research and development, the acquisition of new customers and the satisfaction and retention of older customer. As a note to customer it has been stated that "When a company consistently delivers superior value and wins customer loyalty, market share and revenues go up, and cost of acquiring and serving customers goes down" (Reichheld, 1993). The holistic view of the balanced scorecard helps to ensure that quality and perceived value remain high. With the budget governing overall direction the scorecard provides short term targets than can be easily adapted based on the current state of the market. This allows managers more breathing room and lowers the possibility of padding because they are in a better position to adapt their strategies. With these qualities in mind it appears that the balanced scorecard approach is on the podium as a possibly deterrent to padding and ultimately a way of making the budgeting process more dynamic to suit the environment in which today's businesses operate.

There are however, persons who are prepared to challenge Kaplan & Norton and the balanced scorecard. Among them are Norreklit et al (2008), who claim that there are several pitfalls that managers fall into. They have explored six possible negative consequences to using the balanced scorecard (BSC) method. First of which is the fact that the BSC simplifies the organisation far too much sometimes. The claim is that although Kaplan and Norton(1996, cited in Norreklit et al, 2008) claim that the organisation can be likened to a pilot in a cockpit, corporate managers cannot just resort to "pressing buttons" and "pulling levers" to make changes and get results. Corporate managers are in charge of a reactive environment with a human element in the mix. Therefore the claim is that BSC does not fit all business models.

The second claim is that the BSC makes no clear priority and managers and employees need to have a clear understanding of the "relative importance of the different measures" in order for them to function properly. That in fact the BSC may be too balanced giving everything an equal weighting.

There is the claim that the cause-effect assumption where-by, for example, customer satisfaction is regarded as a leading gauge for profitability is misleading to mangers. To achieve these high retention rates it is claimed that a manager in the sales department for example may be offering price cuts or extending credit periods which can effectively reduce revenues overall which is the same effect we witnessed previously in relation to performance based budgeting. Another valid argument for this case is in the situation where managers already have competent well-trained staff, it would be in the best interest of the company to cut back on training, hence internal and external factors such as the ones mentioned have effects on the scorecard that could cause it to provide misleading predictions.

The afore mentioned cause-effect relationship requires a delay in from the time the cause occurs to the time the effect can be seen. The effect of some of the lead measures on the BSC may not be seen immediately while others will occur almost instantaneously. "Settling on preconceptions about the effects of changes in lead indicators is therefore dangerous, yet that is exactly what the BSC model encourages." (Norreklit et al, 2008)

Norrekilt et al, (2008) also claim that the top down approach of the BSC, based on the saying "you get what you measure" is unrealistic because people do not react mechanically. The goals that are set need to be understood by the people they are issued to and the method to achieve the goals should be clearly defined as well. In the example given by Norrekilt et al, (2008) if a pizza chain were set a target of get your meal within seven minutes or get your meal free, staff may react buy not taking orders or not seating customers until they know that they will be able to provide the quoted target specifications. This is obviously highly counter-productive and may even result in the dissatisfaction of their customers.

The final point raised by Norrekilt et al, (2008) against the BSC is that the "manage from the cockpit" statement may encourage managers to become more detached from operations. If managers are not witnessing the effects of the decisions first hand then knowledge of the process may be lost. In their example they gave, the case of an unprofitable customer wanting to leave. A manager operating from the cockpit may not be aware that this customer is always squeezing low prices out of the company and is not cooperating with procedures, thus the manager will be arguing for customer retention foolishly in this scenario.

Zero based budgeting (ZBB) is another possible solution to the problems of the traditional budgeting system. Richard J. Maturi (2009) describes it as a budgeting process where all items need to "re-justify" itself to be approved. It is a process of cutting costs and improving cash flow via a clear concept of the firms' long objectives and short term goals. Expenditures are given a rigorous analysis in terms of costs, benefits alternatives, measures of performance and review. As stated before managers tend to spend excess budgeted funds before the end of the budgeting period to avoid having their budgets cut for the next period, however zero budgeting erases this fear because every new budget is treated as unrelated to the previous one. It also means that managers will not be able to escape with padding because the costs will be under much more thorough inspection.

The main criticism of ZBB, in relation to the current environment is that although it does reduce the ability of managers to pad their budgets, it does not fully aid in becoming more reliable in dynamic situations. It is still as inflexible as the traditional methods of budgeting, and no firm in today's environment can survive being rigid. Secondly it is obvious to deduce that more attention paid to the costs means more time spent preparing a zero budget. Dynamism waits for no man.

It can be seen from the evidence provided that there are varying models and tools that can be used to either compliment or replace the traditional methods of budgeting but none come without their own flaws. It can also be seen from the financial status of many companies who are still employing the traditional methods; it is still profitable PBB leaves far too much room for padding and manipulation because of the human element of self-actualisation. ZBB effectively eliminates the possibility for padding and slack but takes a considerable amount of time to implement, and does not address the ability rigidity of the traditional methods. The BSC is by far the greatest improvement to the budgeting process but it too still has flaws with regards to its interpretation and its adaptability to newer, different business models. In all of the afore mentioned modifications or models there is an inherent problem. The budgeting system itself is flawed. Placing patches that have their own problems on top of an already problematic system only leads to further problems. The newest paradigm is to do away with budgeting all together and create a new system.

Beyond budgeting is the brainchild of the Beyond Budgeting Round Table BBRT (2010), it is essentially a rethinking of the traditional industrial models and modifying them to suit the post-industrial modern world. According to Steve Player (2003) managers often speak of a fear of failure as being the driving force behind them not performing as well as they should or not being as creative as they need to be. He says "The budgeting process assumes that managers can "predict and control" their way to the future. It provided a rational and coherent approach to managing performance when market conditions were relatively stable, capital was the primary constraint on growth and improvement, strategy and product lifecycles were lengthy, and the management behaviour required was one of compliance with plans and procedures. But in the competitive climate in which most organizations operate today, it is no longer effective." (Player Steve, 2003)

For this reason some managers have now shifted towards removing budgeting altogether. In some companies such as Rhodia, a specialist chemicals company mentioned by Steve Player (2003), they have replaced their budgeting process with two "performance management cycles". The first looks ahead strategically two to five years into the future and the other takes an operational view looking two to five quarters in to the future, both having annual an annual review or a quarterly review respectively. This has urged managers to focus on "medium" targets and not short term fixed goals and rather than detailed numbers they are focused on achieving key performance indicators. This allows for more flexibility when making decisions.

There are those including Lindsay & Libby (2007) who, although they are anti-budgeting, are saying that beyond budgeting is a drastic measure that is not absolutely necessary. The justification for this thinking is simply the fact that companies today are still profitable and therefore there is no major need to change.

However in the view of the author, beyond budgeting is the future of planning and control in organisations and should be spread throughout the post-industrial business world. The benefits outweigh the risks because it is a relatively risk free transition. Cost reduction from not having to produce clunky archaic budgeting system, no need for padding and less pressure to meet fixed targets, faster response times to change and free, creative managers able to have time to come up with new ideas to take organisations forward. Sometimes drastic change is necessary to take a company to a higher level than it is currently at.

REFERENCES

Web sources

What is BB?. 2011. What is BB?. [ONLINE] Available at: http://www.bbrt.org/beyond-budgeting/bbwhat.html. [Accessed 5 January 2011].

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