The main objective of a profit making company is to maximise shareholder wealth. Secondary objectives including corporate social responsibility, environmental issues and employee welfare may place strain on the concept of wealth maximisation. Organisations must carefully manage resources, seek more efficient ways of working and continuously identify new opportunities to succeed in a competitive global economy. Strategic planning allows companies to plan both short-medium term and long term, and thus allocate expenditure to different areas of the business using budgets. Budgets are a vital part of an organisations strategy; Hanson and Van der Stede (2004, p418) identify four main reasons to budget "(1) operational planning, (2) performance evaluation, (3) communication of goals, and (4) strategy formation." All are key aspects of successful company strategy.
Research & Development (R&D) in Organisations
Why Companies Require Research and Development (R&D)
R&D is integral to company strategy "spending too little could mean reducing future profits, while spending too much could overtax company resources" (Heidenberger, Schillinger and Strummer 2003 p.16). In an increasingly global economy companies must endeavour to innovate by creating new products ahead of competitors "Research and development (R&D) investment decisions have a profound impact on a firm's competitive position in the market" (Herath and Bremser 2005, p55). The current nature of the economy has decreased product life cycles making R&D more vital than ever "all companies (but especially those dealing with high technologies) face an environment characterised by accelerated technological change and shortened life-cycle" (Maccorrone 1998, p149). The company operates in a fast paced technology market which makes the R&D department a key operating unit within the organisation. Budgeting for R&D is complex and based heavily on subjective judgements and company strategy "frequently, a diversified combination of R&D investments is developed in the hope of generating the proper flows of profits to achieve both long- and short-range corporate goals" (Souder 1970, p32). Strategy will impact on expenditure within the department, together with external factors including competitor's strategy, product demand and overall economic factors.
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Discretionary costs are costs which management choose to spend on items which have no clear link from inputs to outputs and include R&D. R&D expenditure is difficult to allocate and monitor "experience has shown that most R&D programs eventually require vastly more funds than are originally allocated" (Souder 1970, p33).
Budgets can be formulated in two ways; by overall management setting the budget then issuing set targets to each department or by an integrated process where department managers have input. Both methods strive for a similar goal "everyone in the organization should have a clear understanding of the part they are expected to play in achieving the annual budget" (Drury 2008, p355). Issues with the first method are that department managers may view the budgets as unrealistic thus becoming de-motivated; easy to achieve budgets may cause inefficiencies. Participatory budgets may enhance motivation and drive managers to seek cost reductions and improved efficiencies, but they may include budgetary slack to assist achievement of targets.
Successful budgeting of discretionary spend is likely to be based on an in depth understanding by management of its industry, market, competition and customer base; together with departmental managers understanding of costs and resources "the budgeting process must also be participatory, in that, those who will be accountable for the results are also involved in the determination of the resource allocation" (Ralston 1986, p1)
Methods for Budget Allocation
At present the company determines the budget using fixed percentage of turnover; this suggests that no consideration is made to preparing breakdowns, considering alternative project options, that the costs are not analysed in detail to see if the budget is accurate or being used effectively. Recognised alternative budgeting techniques are identified below.
Incremental budgeting uses the previous yearly budget as a base point for determining the new budget for the specific department. This process makes some basic assumptions; that the previous budget was accurate, that no budgetary slack was hidden within the previous budget "obsolete expenditure is enabled to make its appearance year after year" (Ralston 1986, p1). It assumes that the previous budget is a sound basis for this year's budget. Whilst it has some advantages; it is reasonably simple to prepare, less time consuming than other methods and is based on some historical knowledge and understanding of the business. The disadvantages are; in addition to budgetary slack, it does not allow for in depth analysis into alternative options for the department and it makes no consideration of outputs, only inputs. Also it does not form a suitable basis for performance monitoring and managers may be inclined to spend the entire budget, to ensure the budget is not reduced in future years.
Activity-Based Budgeting (ABB)
Always on Time
Marked to Standard
This technique is commonly used in the manufacturing process, but is thought to have merit within an organisation's support activities. Elements of the process are broken down into activities which may span across several departments. Activities are analysed to identify what causes the costs, known as cost drivers. From this cause and effect relationships can be identified, making more accurate budgeting possible; activities are considered "the key element to understand the consumption of resources inside the organisation, as well as to improve efficiency and effectiveness of internal processes" (Maccorrone 1998, p148). It is argued that this technique identifies value added and non-value added activities; value added activities are those which the customer perceives as important elements of a product for which they are willing to pay for; non-value added are conversely those which customers perceive as valueless, and through analysis, can be simplified or removed to enable future profits to be increased; ABB is thought to have "great potentialities in the field of budgeting and control of product development costs" (Maccorrone 1998, p149). This method, when used in conjunction with life-cycle costing is thought to aid identification of product design issues and solutions reducing the impact of such issues during the manufacturing process. Life-cycle costing is described in Section 2.3.4.
Zero Base Budgeting (ZBB)
Zero-base budgeting entails producing a budget from afresh. It allows department managers and higher management to carefully analyse expenditure and makes consideration of potential cost savings, productivity improvements and available resources. It identifies alternative courses of action allowing different strategic options to be identified and analysed. It focuses management to maintain discipline and ensure the department is working towards achieving the overall strategic objectives of the organisation "Knight (1979) refers to the basic concept of ZBB as an operations planning and budgeting process where the manager presents proposals, and gives alternatives using cost-benefit analysis which are then ranked" (Ralston 1986, p2).
ZBB is a framework for planning and effective management and consists of "the establishment of goals and objectives; identification of decision units; development and ranking of decision packages; allocating resources; and evaluation of performance (Phyrr, 1976)" (Ralston 1986, p3). It aligns closely with the concept of Management by Objectives (MBO) "the complementary matching arises from the nature of the resource allocation process; MBO stresses desired outputs while ZBB emphasizes required inputs" (Williams, Newton and Morgan 1985, p458). The principles of MBO are described by Mullins (2007, p454) as; the setting of objectives and targets, participation by individual managers in agreeing unit objectives and criteria of performance; and the continual review and appraisal of results. Together this helps managers and employees to focus towards meeting overall strategic objectives "ZBB is an interactive process which links formalized priorities and objectives to a particular level of operations" (Ellis and Pekar 1978, p26).
Disadvantages are that it is a lengthy time-consuming process and data may be difficult to collate. As with ABB, this method can also be used together with life-cycle costing to allow more detailed analysis and performance monitoring to be achieved.
This technique works well in addition to either ABB or ZBB and considers costs over the whole life span of the product; from conception to obsolescence "life-cycle costing estimates and accumulates costs over a product's entire life cycle in order to determine whether the profits earned during the manufacturing phase will cover the costs incurred during the pre- and post-manufacturing stages" (Drury 2008, p538).
The majority of product costs are committed during the product development stage "approximately 80 per cent of a product's costs are committed during the planning and design stage" (Drury 2008, p538) and this technique helps management determine whether the product is feasible from a cost perspective. It also helps to identify whether costs need reducing to make the project profitable which may entail changes to product design prior to production.
As well as a tool to detect profitability issues, the technique can then be used to monitor progress and performance; together with either ABB or ZBB this provides strengthened cost control systems.
The Most Appropriate Method of Allocation for R&D
Incremental costing has been discounted because the company is already under pressure to increase profit margins, and therefore it will be worth the extra time taken to implement alternative, more detailed methods. ABB and ZBB are appropriate and both require detailed analysis of costs and provide breakdowns which assist management in control and monitoring costs. These could be used together to form a detailed budget "great benefits for the planning and control of R&D activities can derive from the application of activity-based principles" (Maccorrone 1998, p153). Research confirms that "ZBB is best applied to discretionary costs or activities" (Ralston 1986, p3) but no research has been identified into using a combination of ZBB and ABB. Both allow the department to maintain cost control and work towards being as efficient and effective as possible "one benefit that can almost be guaranteed by implementing a zero-base system: better resource allocation" (Goldman 1978, p19) which is vital in a technology environment to prevent ever increasing costs and products being developed which are already considered obsolete.
2.4 The Most Appropriate Method of Allocation for R&D (continued)
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This opens up opportunities to identify alternative projects and options. This could be achieved through a bid process where each alternative option is given a detailed breakdown of costs and potential revenue. These could be analysed by an independent committee to ensure the costs are justified; that the research is in line with current company strategy; and that customers would be interested in the product at an acceptable price for both customer and company.
A further option would be to invite input from other departments to allow the optimal project to be determined and to analyse future costs of production and administration "the objective is to operate that business at maximum efficiency, and to integrate it effectively with the other business activities of the company" (Rance 1968, p176). This enhances department integration and management participation, which could assist all departments in focussing towards a single objective. Input from all departments is also more likely to create a better end product that is feasible for the overall business. ABB allows for a better understanding of each departments impact on activities and costs and may identify new improved methods of working; eliminating any duplicated activities "one of the most important issues in the product development management theory is represented by cross-functional integration" (Maccorrone 1998, p152).
Measurement & Control of the R&D Costs
Measurement and control of this type of department is extremely difficult "the inherently unpredictable course of R&D activity makes it all the more necessary to keep the closest check on what is spent, and to review the progress of expenditure at regular intervals" (Rance 1968, p175); outputs are not seen until the product is manufactured meaning that the costs are locked in before profits are determined. R&D projects are likely to span over multiple accounting periods; choosing the wrong project could have a detrimental impact on long term strategy, in terms of costs and if a product does not become developed. The company will still require a product to manufacture to generate revenue and profits.
2.5 Measurement & Control of the R&D Costs (continued)
Measurement and control concerns costs, strategy and management effectiveness; by allocating budgets using both ABB and ZBB methods detailed information will be available for monitoring costs and performance. Both assist with analysis using the life-cycle costing technique "the adoption of an activity-based approach can enhance the quality of life-cycle costing estimates for a new product" (Maccorrone 1998, p152). This adheres to Ouchi (1979) and Merchant (1998) principle of "results (or output) controls" (Drury 2008, p388).
Management should ensure frequent reports are submitted to include breakdown of expenditure, product development progress, target completion dates and potential issues. This ensures departmental focus and allows re-assessment where necessary "R&D efforts must be replanned frequently to reflect rapidly changing technologies or competitive situations" (Souder 1970, p32). It allows the company to identify if the budget is appropriate and gives time to find additional money if necessary. If major problems arise, it could assist in making a decision to discontinue the project at an earlier stage; minimising both impact on costs and identification of alternative projects. This conforms to feed-forward control "predictions are made of what outputs are expected to be at some future time. If these expectations differ from what is desired, control actions are taken that will minimize these differences" (Drury 2008, p392).
The company could hire an independent R&D expert to analyse both cost breakdowns and the potential of the new product. An independent observer may identify potential issues and whether the costs appear accurate. They may also identify cost reductions and efficiencies through experience gained in other organisations.
Benchmarking is a further way to substantiate costs incurred through R&D. This entails analysing expenditure of competitors and other companies operating within a similar environment "the identification of target levels of efficiency for each activity is usually considered a critical issue: in this perspective, the analysis of historical data is certainly important, but the recourse to internal/external benchmarking is of fundamental importance (Maccorrone 1998, p150-151).
2.5 Measurement & Control of the R&D Costs (continued)
A longer term method of determining the effectiveness of the department is by analysis of life-cycle costing. This presents the costs of a product over the whole of its life span, from development to discontinuation. It identifies how profitable the product has been and what percentage of costs have been spent in the different areas and could provide a further benchmark for the department, as overall budgets for a new product will include sales and profitability forecasts.
There are suggestions that budgeting is no longer appropriate, and alternative methods should be considered, such as rolling forecasts "the term beyond budgeting is used by Hope and Fraser to elate to alternative approaches that should be used instead of annual budgets" (Drury 2008, p377). Criticisms suggest budgeting is too rigid and time-consuming and in a fast-paced global economic climate setting a 12 month budget may no longer be appropriate; having a rigid budget may cause unnecessary expenditure and strategy becomes based on short-term cost measures. However, working without a budget could prove difficult and alternative methods of performance measurement would need to be stringent. Participatory budgeting "compels managers to examine the relationship between their own operations and those of other departments, an, in the process, to identify and resolve conflicts" (Drury 2008, p355). A company which effectively integrates its departments can improve overall processes, reduce duplication of work and identify cost reductions. This will aid goal congruence which is vital in sustaining a successful organisation.
For R&D departments, it is thought that elements are inherent and repeated yearly without analysis of necessity or effectiveness "the product development process is generally characterised by a number of both formal and informal standardised procedures, which have been developed during several years, and are deeply rooted in the organisation" (Maccorrone 1998, p150). By choosing to re-evaluate discretionary spend in this area, improvements and efficiencies may be identified, providing future increases in performance and profits.
3 Conclusion (continued)
Discretionary costs provide additional complications as they do not relate directly to outputs; this applies in particular to R&D. The budgets require input using industry knowledge, organisational expertise and an understanding of the overall company strategy. They additionally need careful monitoring and assessment to maximise the efficiency of the department which can prove difficult and time consuming. With various recognised techniques available management should carefully consider the most appropriate for their organisation. Allowing department managers to contribute to the budgeting process will focus all employees to strive for the same goals and objectives as organisations should recognise that "in a competitive economy, above all the quality and performance of the managers determine the success of the business" (Drucker 1961. p1).
Organisations must acknowledge that managers will understand their costs and resources intimately and by empowering them to participate, this may motivate them to improve processes which will benefit the company overall. However careful assessment of budgets must be undertaken, which may include assistance from independent professionals, to ensure the budgets are accurate and not inflated.