Impact of Budgeting Process on the Performance of an Organisation - Term Paper Example

Isuues In The Budgeting Process And Its Impact On The Performance Of An Organisation Executive summary Preparation of budget is important to gain strategic advantage. The budget gives an estimate of what the probable expenses and investments are likely to be. The deviations from the budget target help organisations to know or assess the reasons for such deviations and take corrective actions. All such corrective actions are only fruitful if the budget preparation process is flawless. Though it is not possible to produce an exact replica of the best budget but the organisations try to produce the most optimum budget helped by the years of experience gained from such repeated activities and watching and learning what others organisations from same sectors are doing. This paper elucidates the problems faced by organisations while preparing the budgets. Table of Contents 1.0 Introduction 3 2.0 Issue associated with consolidation of balance sheet items of subsidiaries for large organisations 3 3.0 Impact of errors in consolidation of multiple subsidiaries on performance of organisation 4 4.0 Issue of unrestricted use of top down or bottom up budgeting process 5 5.0 Impact of unrestricted use of top down or bottom up budgeting process on organization performance 7 6.0 Issues like the failure to follow up and analyze variances 7 7. Impact of the failure to follow up and a analyze variances on organisational performance 9 8. Issue of lack of clarity in the budgeting process 11 9.0 Impact of lack of clarity on organisational performance 12 14. Conclusion 13 Reference 14 1.0 Introduction Processes of budgeting and organisational performance are linked intrinsically. The budgets are like self restricted mechanism. This self restriction limits the chances of exceeding the limits set of for expenses, investment and over head costs. Most of the time the organisations are far apart from achieving the target set in the budget. This may not be due to the incompetent nature of the organisation for which it is unable to stick to what is prescribed in the budget. The reason is due to the faulty budget estimates. More specifically due to inability to filter the various problems and issues that arise while preparing budgets. The present research study tries to explain the issues associated with budgeting process and its impact on the organisation performance. The issues are first identified and the impacts associated with that issue is explained with suitable examples. 2.0 Issue associated with consolidation of balance sheet items of subsidiaries for large organisations Large organizations which have various strategic business units and subsidiaries and spread across different countries face problem when consolidations occur. Large companies while preparing the annual budgets have to consolidate the annual statements of the various subsidiaries and the strategic business units (Binkert and Jose, 2006). This consolidation involves transferring the liabilities and the assets of the subsidiaries into the accounts of the mother company. Most of the errors occur in this consolidation process. The problem gets multiplied when the subsidiaries are located overseas and are dealing with different currencies. 3.0 Impact of errors in consolidation of multiple subsidiaries on performance of organisation When subsidiaries are located overseas, then the consolidation of the balance sheet items needs to be done in parlance with the exchange rate. Now the currency exchange rate is prone to change and not static in nature, so the actual budgeting process may commence 2 months ago (Fölscher, 2006). By then the consolidated balance sheet is reflecting the value of the assets and liabilities calculated at the exchange rate then. Although the present exchange rate might have moved up or have gone down. If the projections need to be done about the future value of the assets and liabilities in the balance sheet in the coming 2 years, then the projection will have a large room for errors if they are done on the basis of the then exchange rate (Heller et al. 2006). When the change in the exchange rate is calculated for multiple subsidiaries spread across multiple countries, the chances of error increase even more. For example, different subsidiaries operating in different countries may have different system of following depreciation method. Again the different subsidiary does not follow the same accounting standards. The accounting standards are mandated by the region or the country where the subsidiary is situated. And these standards keep on changing as addional policies are adopted by the various accounting bodies. So the problem gets compounded since there is need to follow different depreciation method for different subsidiaries and that too for a different country. In order to avoid the complicacies of such an elaborate method, organisations tend to follow a more or less median path. A path that does not emphasis too much on details but is never the less alright. Adoption of such median path at times leads to serious discrepancies. For example, the mother company is involved in a cross country deal to buy new machinery for its subsidiary in another country. The proceeds from the sale of the old asset are used to buy the new asset. The proceeds from the sale of the old asset are going to be converted to the required currency for buying the new asset at the current exchange rate. The amount estimated to be spent for the new asset is already defined in the previous budhet estimates. Now if the budget estimates are prepared following a method of straight line depreciation for the old asset and if in actuality the asset is depreciated at written down value then the scrap value of the old asset will be markedly different in both the cases. So the management may have to rethink on the deal once again or have to cancel the deal altogether if they don’t have enough proceeds from the sale of the old asset based on the current depreciation method. This delays the procurement of the new asset and consequently also slows down the production capacity also, if the assets happen to be part of the production facility 4.0 Issue of unrestricted use of top down or bottom up budgeting process Organizations have the habit of using any one type of budgeting process like the top down budgeting process or the bottom up budgeting process. All strategic business units do not have the same strategic advantage and all does not even follow the same kind of strategies (Keating, 2007). When organizations insist on using the same strategy like the bottom up or the top down approach, irrespective of the strategic advantage available to the business units, then it runs the risk of too much generalization. Too much generalization in the assumptions increases the chances of following e general budget plan instead of preparing a business specific budget plan. Fig 1: Top down mandated budget process Fig 2: Bottom up mandated budget process Source: (Nylen, 2002) Fig 2: Bottom up budget process Source :( Alonso et al. 2006) Source: (Nylen, 2002) 5.0 Impact of unrestricted use of top down or bottom up budgeting process on organization performance Top down budgeting process reduces the chance of preparing for the long run, since the whole budgeting process is prepared at the upper management level and executed by the lower management level. The upper management level at times makes wrong assumptions about the needs in the grass root level. For example the top management level may decide that current the budget plan will include significant investment in the promotion of a new product. Although the real need is to improvise the existing products (Faust, 2008). This occurs due to the inability to understand the basic needs of the customers, and understanding the customers is the grass root approach for any product promotion. The top level managers allocate the funds to the respective business units according to the strategic need. This prompts the business units to get involved in unhealthy competition to gather more funds and this spoils the organizational culture (Fung and Erik, 2001). The non involvement of the bottom level managers makes them feel unwanted and undervalued and this prompts reluctance towards work commitment. This affects the organization work culture as well as performance. The problem associated with bottom up budget process is just the reverse. The bottom level managers are left with the power to allocate funds for their strategic business units. This gives them the power to allocate the funds for their own business units in order to address their own needs rather than the needs of the business (Morrison and Matthew, 2007). 6.0 Issues like the failure to follow up and analyze variances The budgeted cost and budgeted investments fall far shorter than the actual costs and the actual investments and costs most of the time. It is very important to check for the anomalies in the actual costs and the estimated costs, so that next time onwards a more accurate budget can be prepared. Such an analysis involves significant time and energy and most importantly the payoff from such detailed analysis (Hofman et al. 2006). Although most of the time the organizations are reluctant to check the reasons for such anomalies and start preparing for the new budgets. This voids the reasons for which budgets are prepared. Budgets are prepared to know by how much the actual cost and budgeted costs differ and find out the reasons for such variation. Fig 3: Variation of the budget estimates Source: (White, 2007) The above table gives an indication of the variation that occurs between the budgets forecasted. Total Resource DEL excluding depreciation indicates the actual budget forecast without considering the variation and the OBR Resource DEL excluding depreciation is the budget forecast including the variation. The latter forecast is adjusted for the variation. The variation indexes or values are prepared with the help of the knowledge gained through previous variations (Keating, 2007). The variations are also dependent upon the business cycle. If the business is in the boom phase where there is large scale expansion and transaction then the variation is more and in the lag phase is less. Starting from 2013 to 2015, the variation increases. Careful study of the variation indicates that the switches accounted for most of the variation. If such variation is allowed to linger then the business process will accustom itself with such variations. Then organisations get in a habit to allow for even larger deviations later on and it becomes almost impossible to fix such variations then. Studies indicate that large organisations unlike the small and medium scale organisations have a tendency to allow for the large deviations in the annual overhead expenses. Larger organisations do not go to the extent to find out the large deviations in the annual over head expenses. As the profits increase, the organisations simply allocate a bandwidth to accommodate for the increase in the overhead expenses. This leads to a practice for the overhead department to simply accommodate for more wastage without the need to find out the reason for such increase n the over head expense. 7. Impact of the failure to follow up and a analyze variances on organisational performance Budget preparation involves projection of the cash flow statements, projection of the income statements and the projection of the balance sheet items. The most important are perhaps the projection of the income statement and the projection of the cash flow statements. The cash flow statements projection provides a glimpse of the cash inflow and the outflow every year. The variation between the projected cash inflow and outflow points out the fact that there are unexpected operational activities and investment activities. The variation thus helps to pinpoint what particular operation or investment occurred due to which the difference occurred between budgeted cost and actual cost (Fung and Erik, 2001). For example if the analysis indicates that the extra cost in operational activities occurred due to unexpected ordering of raw materials on emergency basis. And this emergency basis ordering happened through almost 6 months in a row. Then this indicates that organizations did not plan the inventory management process efficiently. If this analysis is not done to find out the cause of the variation, then the company runs the risk of producing poor quality products. Since the raw materials ordered for emergency basis come from substandard suppliers. Other than that the quality team may not have the requisite time to check the quality of the raw material. The failure of organisation to analyze and follow up the difference in the overhead expenses is explained with the help of an example. Organisations appointed certain third party to distribute the products in remote areas. The products being perishable are transported through air conditioned and well equipped trucks. Due to some inconvenience the organisation is forced to appoint another third party to transport the products. Due to shortage of time no research is done to check if the new distributors have well equipped cars to do the distributions. The income statements start to show large proportions being paid due to carbon emissions as fine and prepaid expenses. The real reason is that the newly appointed distributor’s uses non Euro compliance trucks which uses more fuel and at same time emits excessively. If there is no analysis this will continue to remain as a drag on the profits of the organisation. So the organisation is using the good profit to pay for the extra fuel and useless emission. With proper follow up procedure, large variances in overhead expenses can be traced back to fuel and carbon emission expenses, and finally to the unaudited distributors. 8. Issue of lack of clarity in the budgeting process The issues like lack of clarity and consistency is acute in any large organisations. The issues of clarity and consistency are significantly more in those organisations that follow a bottom up approach of budget process. Unlike the top down process, where the top level managers have the first say as well as the last say in the budget fund allocation process, the bottom up budgeting process give the middle level and the lower levels a lot of flexibility in terms of freedom of expression and decision making. This freedom is sometimes misused by the middle managers in order to have more access to funds (Morrison and Matthew, 2007). The funds are supposed to be allocated according to the ability of the business unit to generate revenue. Recourse to unethical practices by business heads to gather more funds clearly indicates lack of clarity in the process. The lack of clarity are also noticed when the departments heads are not able to communicate effectively with the business heads in communicating the budget needs due to lack of proper reporting system years (Ablo and Ritva, 1998). For example, the SBU of any organisation deals into marketing of lubricants. The HR head of the SBU is not able to communicate the SBU head about the increase in the remuneration of the newly promoted employees in time due to absence of proper reporting mechanism. 9.0 Impact of lack of clarity on organisational performance Source: (Nylen, W. 2002) The above diagram indicates the chain of events that happen due to the absence in clarity and in-consistency in the budgeting process, timeliness and responsibilities. The immediate impact due to the lack of clarity and responsibility is the lack of confidence in the process. The lack of confidence in the process becomes evident in the various levels of the organisations. The middle level management cannot rely on the data provided by the lower level of management. The top level management in turn also cannot depend on the recommendation made by the middle managements (Fung and Erik, 2001). This escalates further to a point when the results of the lack of clarity and responsibilities lead to large deviation from the budget forecast. The operational expenses can reach to such a point that the organisations has to recourse to emergency funding to finance the cost of the operations. This affects the profitability of the company and consequently the investor confidence. 14. Conclusion The problems faced by the organisations while preparing the budget are mainly related to inter departmental misunderstanding and beaucratic interference. The beaucratic interferences involve the excessive use of the top down and bottom up budgeting process. Other kinds of problems are working with static-data. The use of static type data impairs the judgment of the budget analyst. Since the budget analyst need to work upon the current data which is dynamic in nature and which keeps in changing. If the individual departments are not clearly justifying the need for extra fund in their budget allocation, then this leads to absence of clarity and inconsistency. The individual departments need to be absolutely steadfast and clear in what their needs are and need to justify those needs with proper logical reasoning. The problems associated with the budget preparation are allure and there are as such no short cut ways to get around the problems. So the organisations have to rely upon the intuition gathered through years of experience and knowledge. Reference Ablo, E. and Ritva, R., 1998. Do Budgets Really Matter? Evidence from Public Spending on Education and Health in Uganda, World bank policy research working paper No. 1926, The World Bank, Washington DC. 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