Purpose and Importance of Budgeting an Organization - Essay Example

? RESEARCH PROPOSAL FOR INDEPENDENT STUDY ON THE PURPOSE AND IMPORTANCE OF BUDGETING TO AN ORGANISATION Module Independent Study STUDY OUTLINE The study will include a literature review, data collection, analysis and findings, conclusion, limitations of the study and recommendations for further study. The data that used in the study is secondary data from other resources. The following are the main topics in the study: 1.0. Title page 2.0. Problem statement 2.1. Importance of the study 2.2. Study objectives 3.0. Literature review 4.0. Study methodology 5.0. Analysis and findings 6.0. Conclusions and limitations of the study 7.0. Bibliography 8.0. Appendices PROBLEM STATEMENT A lot of effort has been made in the theoretical area of budgeting and its concept but little has been done to show the applicability and the importance of the budgeting process to organisations. Many students in the field of finance, accounting, strategic management and other related fields have more theory and little practicability about the theories. However, this study was aimed at linking theory with practical applications of the theory of management accounting; this was done by looking at how organisations apply the various theoretical aspects of strategic managerial accounting. IMPORTANCE OF THE STUDY This study is important since it was carried out to reinforce the theory of budgeting and its application in real life situations. The study also gives advice on how businesses can go about budgeting and this will go a long way to provide information on the same to organisations. OBJECTIVES OF THE STUDY The study objectives were: To appreciate the managerial accounting theory. Appraise the importance of budgeting to the success of an organisation and discuss the available budgeting methods. Discuss the budgeting process. Analyse the assumptions of budgeting. To link managerial accounting theory with practical application. LEARNING OUTCOMES Appreciate the purpose of traditional budgets. Appraise the conventional process of budgeting. Critically assess alternative methods of budgeting, including ‘beyond budgeting’. Analyse budget assumptions and critically review budget outputs. Research customised forms of budgeting developed for niche segments. LITERATURE REVIEW Management accounting is specialization of accounting that provides for information to the managers to help them plan, make decisions, and control functions (Bragg 2009). It involves collection, analysis and interpretation of accounting information for managers of an organisation to help the managers to make plans, make decisions and to exercise control to ensure that the organisation goals are being achieved. Management accounting extends to cover strategic management, performance management and risk management which are key issues in management. The tools used in management accounting are costing techniques, budgets and control charts among other tools (Waygandt, Kimmel and Kieso 2009). Budgeting is a critical function in management accounting and it is a key to the success of an organisation. When the resources are scarce, an organisation must determine the optimal way to allocate resources among the organisational processes to achieve the set goals. A budget is thus a coordinated plan of the operations and the resources available to an organisation represented monetarily for a specific period of time (Shim and Siegel 2008). A budget is a very important to an organisation since it provides a clear and measurable statement of expectations, improves communication and coordination in an organisation and provides a basis on which evaluation is done and control is exercised. Typically the objectives of budgeting can be stated as following: 1. Budgeting report provides information to help to determine the adequacy of current-year revenues pay for current-year services. 2. Budgeting report illustrates whether resources were obtained and used in accordance with the budget. 3. Budgeting report exhibits its adherence to other finance-related legal or contractual requirements. 4. Budgeting report provides the managers with the information to assist them in assessment of the service efforts, costs, and accomplishments of the organisation. There are various types of budgets—financial budgets, operating budgets, special decision budgets, fixed/static budgets and flexible/variable budgets. Operating budgets are budgets prepared in relation to the physical processes of an organisation like amount of units to be produced, amount of sales and debtors collection schedules. A financial budget is a plan of an organisation’s expected cash receipts and payments and the general financial position of the organisation. Financial budgets include a cash budget, budgeted lance sheet, income statement and statement of retained earnings. Special decision budgets are aimed at providing information for decision making on areas such as inventory controls, break-even analysis, make and buy decisions and so on. A flexible budget is one that is prepared on the basis of one level of activity and with no intention of modification to suit other levels of activity, whereas a flexible budget is one that can be modified to show different levels of operation (Hofstede 2003). In use for quite a long time, the traditional budget is still important in management accounting. It is an invariable budget prepared for a specified period; its forecasts do not change with the times. The reasons why traditional budgets are still in use are that they are easy to develop and use and they enhance coordination among various departments of an organisation (Smith 2007). Traditional budgeting is also called line-item budgeting. It provides for a fair amount of control flexibility in the use of resources, on the basis of expenditure level (e.g., fund, function, and object) expressed in the document. Not only this, a line-item budget allows for the accumulation of expenditure data to be used by an organisational unit in historical analysis. Other budgeting techniques like zero-based budgeting, participatory budgeting and others can be said to be more accurate and more functional, but their development might be too costly, and they can distract managers from other activities because they need more time to develop. A newer and most widely used form of budgeting technique is a program-based budget developed by the United States Secretary of Defence Robert S. McNamara in the Pentagon in the 1960s. After a few years of development it was also adopted by New Zealand and the UK with considerable amount of success. It is structured by program or units as compared to line-item budget which gives no program information. The emphasis of this type of budget is on goals and objective; it also helps in determining how available funding is to be matched to services. The advantage of program-based budget over other forms is that it helps decision makers with approving/disapproving programs. But due to specific expenditures being difficult to track and too much bookkeeping involved in ‘indirect costs’, program-based budget could be difficult to implement and provide substantial gains. Zero-based budgeting is complete reversal of traditional budgeting. In traditional budgeting, which is incremental in nature, managers have to justify only the escalation over last budget; the money already spent is automatically sanctioned, but zero-based budgeting presupposes reviewing of every department function comprehensively in the beginning of a financial year. All expenditures, including escalation, have to be approved. In a zero-based budgeting, the division managers must justify the budget in full detail, beginning at the zero base. Moreover, customised budgeting systems specific to certain domains have also evolved. One such system of budgeting is PBMA—Program Budgeting and Marginal Analysis. PBMA, with the aim of maximising the impact of healthcare on the health requirements of the local population, helps decision-makers in directing resources (Brambley, Fordham 2003). PMBA builds on two fundamental economic principles to get the insight whether changes should be made: 1. opportunity cost, or the forgone benefits of the next best alternative use of a given set of resources, 2. marginal analysis, which examines the incremental costs and benefits of shifting. Maximising the benefits and the opportunity costs for resources are its primary goals. ‘Beyond Budgeting’ is a fairly new concept in management accounting, and from the outset it means ‘managing and controlling without the budgets’. This concept acknowledges the fact that budgets are just a means and not an end thus managers can do without them. The concept enables managers to react more to the external environment and customer needs. It simply encourages managers to allocate resources and make decisions depending on the prevailing circumstances in rather than using pre-determined criteria for decision making (Meyers 1996). The 12 governing principles of Beyond Budgeting are given below (BBRT). The central idea of ‘Beyond Budgeting’ and its successful implementation lies in sound and clear understanding of these principles. The budgeting process consists of an inherent set of steps that must be followed sequentially. The first step is planning the budgeting process where the person responsible for coordination of the process is identified, key definitions and assumptions of the budget are made and key deadlines are set. The second step is communication of the budget assumptions, deadlines and responsibilities to the parties involved in the process; this step is followed by setting of the goals and objectives to be attained by the budgeting process. The fourth step entails gathering of information about income and expenditure and previous period’s budgets. The next step is compilation of the collected information, reviewing the information for consistency and revising it. This is followed by a review of the budget by the relevant committees and boards or departments. After the review, the budget is approved and then implemented. The last step is budgetary control and management where the activities of the organisation are measured and compared with the budget. In case of variances, corrective action is taken (Tracy J and Tracy A, 2008). Variance analysis is the process of determining how the actual result differs from the budgeted result. According to this process, if the actual results are better than the budgeted results, the difference is favourable and no corrective action is needed, whereas, if the actual results are worse than the budgeted results, the variance is adverse and corrective action is required to control further damage (Bragg 2009). The basic assumptions in budgeting are that the variables used in the budgeting will not change much over the time, and that the resources available to an organisation are scarce. The outputs of a budget are efficiency and effectiveness owing to proper communication, clear understanding of the goals and a good control mechanism. STUDY METHODOLOGY To carry out a comprehensible analysis of how different organisations take up their budgeting activities, a combination of theory and practical techniques have been employed. The relevant theories of budgeting that exist are first outlined and briefly explained by extensive and in-depth survey of texts and books written by experts on this subject. The implementation of such theories in actual practice is then highlighted through mention of various case studies and other examples found in journals, periodicals or online sources. Data was collected about the various aspects of budgeting techniques and later assimilated to provide a conclusion for the advantages and drawbacks of the various techniques in used in different organisations. First, the methods of traditional budgeting were researched and examples of its existence and practical usage are cited. However, today's unpredictable and fast-paced business climate is rendering traditional budgeting systems ineffective; actually, it is ageing now. Many government organisations are moving away from the line-item budgeting to modern forms of budgeting. According to Cassell, the traditional budgeting and appears to have a general lack of ownership and buy-in; it neither identifies waste nor the incoming workload; nor does it support continuous improvement, or identify cost drivers. (Cassell. M, 2003). This was highlighted by South Korea’s Ministry of Environment’s move from the traditional budgeting to program-based budget. Newer forms of budgeting have also evolved and have found customized existence in different types of organisations. One such new form of budgeting and financial management is Program Budgeting and Marginal Analysis (PBMA) which helps the higher officials to maximise the impact of healthcare resources on the health needs of specific population. Evaluating some South Australian Hospitals on the basis of PMBA shows the pluses and minuses of the system. Another model of budgeting is also discussed together with its pros and cons. It is an alternative method for budgeting, called System Dynamic Modelling. This cross-section study was based on an analysis of secondary data, pertaining to emergency patients, taken from the National Health Security Office in the fiscal year 2004. The sample included data of the emergency services provided to the patients outside their hospital’s (registered) coverage area. The new concept of Beyond Budgeting is also put to test by studying the case of ‘Whole Foods Market Inc.’ Whole Foods Market, the radical management practices of which have been an integral part of Beyond Budgeting Movement, maintained the alternative model since its foundation in 1978. ANALYSIS AND FINDINGS Budgeting is a very vast field in financial management and consists of many theories and practices worldwide. For our current independent study, we shall restrict ourselves to comparing the traditional forms of budgeting to the non-traditional ones like the program budgeting (APPENDIX A). We shall also look into the advantages and disadvantages of Zero-Base Budgeting System. We shall also be putting to test some of the new theories which have evolved recently like PBMA for healthcare sector and the latest concept of Beyond Budgeting. THE CASE OF ENVIRONMENT MINISTRY OF KOREA The Korean government plans to introduce program budgeting as part of a comprehensive reform effort, which includes medium-term expenditure framework (MTEF) along with top-down budgeting, aiming at improving the overall efficiency of PFM. This paper outlines weaknesses in the current budget structure that program budgeting seeks to address and proposes basic principles for developing an appropriate program structure for Korea. The Ministry of Environment (MOE) was selected as an example to showcase how a ministry might go about introducing a program structure. The move to the new form of budgeting was initiated because of a number of shortcomings of the traditional Line-Item Budgeting. The traditional budget process is incapable of identifying waste; it does not support continuous improvement. (Cassell. M, 2003). This type of budgeting provides very little useful information for the senior executives on the functions and activities of organisational units; these type of budgets are prepared on the basis of expenditure outlaid in the previous budgets. ANALYSIS OF THE CURRENT BUDGET STRUCTURE AND THE MINISTRY OF ENVIRONMENT Currently, there are 8 levels in the budget classification system; three functional levels—main, medium, and small; one organization level office or bureau; one activity level; one beneficiary level, and two object levels object group and object unit, which form the bottom rung of the structure. The three functional levels, otherwise referred to as jang, kwan, and hang, represent legislative budgetary items, while organization, activity, beneficiary, and object levels, otherwise known as se-hang, se-se-hang, and se-saup, mok, and se-mok, are administrative budgetary items. In terms of expenditure classification, the budget is divided into 20 jang, 66 kwan, 553 hang, 1,388 se-hang, and 6,014 se-se-hang. The jang, kwan, and hang classifications correspond approximately to a functional classification. Among the 8 levels, se-hang, which is basically an organizational classification, is the anchor that links all other classifications together. Se-se-hang is the activity and appropriations level. Figure A.1 provides a brief overview of the current budget classification system for expenditure for a line ministry’s annual budget with an example from the MOE. Analysis of the current budget structure highlighted four key weaknesses, which impede more effective and efficient management of public expenditure in Korea. There is insufficient information in the current budget classification system regarding how and where public expenditure is being directed. Insufficient autonomy is granted to line ministries due to an emphasis on inputs over outputs and outcomes, and transparency and accessibility is limited due to a confusing array of budget classifications and fragmented reporting. The shortcomings of the present system are given below: Insufficient and inappropriate information for resource allocation decision-making Insufficient autonomy granted to line ministries Weak accountability mechanism for designating responsibility Lack of transparency and accessibility of relevant information These weaknesses have prompted the National Assembly and general public to complain about how difficult it is to make sense of the figures in the budget and to request changes in budget classification and reporting. By re-organizing the current hierarchy into a more coherent structure, program budgeting aims at making the budget more transparent and accessible. Conceptual framework for a program budget The main changes from the existing classification system are as follows. First, as the diagram shows, the 8-level classification system would be reduced to 5 levels. Second, the new structure will support the NFMP by providing the basis for resource allocation decision-making and providing a link between the budget and the policy objectives. Third, unlike the existing classification structure, program budgeting would align with and thereby augment the performance management structure. Fourth, clearly linking the budget and performance management system and presenting this linkage through the budget document would seek to improve accessibility and user-friendliness of the budget. Program Budgeting and Marginal Analysis PBMA equips the top level management with the information for setting priorities in the provision of health services. It is very helpful for the management in directing resources to maximise the impact of healthcare for the local population. PBMA helps an organization to be: Comprehensive and inclusive Systematic and consistent Collaborative and fair Patient-focused and evidence-based Open and accountable An example of PBMA at work can be given as the following: Suppose the chief pharmacist of a hospital notices an increasing trend of overstay and increasing medicine costs for the elderly following surgery, due to venous thromboembolic disease (VTED). He decides for standardising on exonaparin, after due approval from clinical governance committee, even though it means that the overall drug budget for the hospital will rise. First, an analysis of the current VTED drug expenditure patterns is carried out by a competent authority. The results of which say that 4/5 of the total expenditure come from four specialties: orthopaedics, general surgery, geriatrics and general medicine. Whereas, the remaining 1/5 comes from the coronary care unit, the intensive care unit and the gynaecology department. Then a hospital activity analysis is carried out which shows an increase in the number of deep vein thrombosis and pulmonary embolism cases with concomitant increased expenditure in the last five years. Now the chief pharmacist shall concentrate on the 4/5 of drug use accounted for by the specialties. The chief pharmacist presents this case to the chief executive and suggests an increase in the drug budget. However, the drug budget can be increased provided that the changes are fully self-funded and resource-neutral to the hospital. Then the computerised prescribing system tells chief pharmacist that a switch to the new VTED therapy would cost him an additional ?100,000, forcing him to find out the possible areas where he can save money in the hospital so as to cover the increase in expenditure in the drug budget. Therefore he obtains the cost map from the finance department (an example cost map is given in APPENDIX B) for that very purpose. A model is constructed to observe the reduction in VTED and the resultant savings on the medical specialties. Many an avenue of reduction of costs would arise, of which one is also the closure of beds (‘fixed costs’) which is not practical however. These reductions would save on many a variable element, permitting ‘virement’ (transfer between budgets) from medicine budget to surgery budget in order to cover the prescribing costs. The chief pharmacist put forward his plans at the next meeting of chief executives. The proposals should be reviewed by the council so as to ensure their conformity to the clinical governance policies on reducing hospital complication rates, shortening stays and implementing NSF. The overall investment in the drug budget and other reduction is found to be cost effective as the nearby GP’s recognise the savings in primary care if VTEDs can be prevented and thus help in reducing overall costs. Thus, the new rationalisation policy is approved through the use of PBMA. Beyond Budgeting and ‘The Whole Foods Market Inc.’ The whole Foods Market Inc. does not function as a conventional organization. It refers to itself as a “Community of Purpose”. It relates to the modern management views that the modern organizations are increasingly evolving into communities. The Whole Foods Market has been maintaining the alternative model since 1978. It has a turnover of about US $ 7,000 per square meter and year and a profit margin 3.5 times higher than the industry, whereas the average food industry generates a turnover of US $ 3,600 per square meter and year. Also for the last eleven years at a stretch, Whole Foods market has been listed as one of the 100 best places to work for in the United States by Fortune. Principles of Beyond Budgeting at Whole Foods Market 1. Customers, Organization, Autonomy, Responsibility The organisational structure of Whole foods market Inc. is that of a Cell Structure. Every branch of it has eight to ten cells and several central supporting cells, which represent independent accountable profit centres. Furthermore, its cells consist of team leaders; even regional store leaders are called a cell; its cell is also represented by six regional presidents. This ensures minimum hierarchy. 2. Values The central principles at Whole foods Market Inc. has always been that of – “holistic interdependence”, and managing the affairs in accordance with prescribed values. This stayed on in spite of the evolution of Whole Foods Market's purpose and general values. As they replaced older generations, the new generations have brought in their own likes and dislikes and effected changes at Whole Foods Markets. 3. Transparency CEO John Mackey identifies the Whole Foods Market's transparency philosophy as "no-secrets" management philosophy which extends to even financial data and salary information. Here the annual morale survey results are disclosed to all. • All data pertaining to store sales, ream sales, product costs, store profits are accessible to all employees on a daily, monthly or weekly basis. • Each store has a book which is accessible to all employees in office and contains a list of pay of every employee. • The results of the annual morale survey are also disclosed to all in the annual report. This is done to investigate employee attitudes, the employees’ confidence in team leaders, store leaders, and regional leaders. Moreover, fears and frustrations of the employees, and the company's core values are also covered in this survey. 4. Goals & Controls A lot of competition exists among different cells at Whole Foods Market. Different cells—single store cells, complete stores, and even regions—set their own goals and compete vigorously to in the field of sales, growth, quality, service, profitability, etc. This benefits the employees; they get promotions and bonuses. Single teams are encouraged set their own ambitious goals and deduce way of achieving them. This pressure of performance however does not imply that the superiors have total control over their subordinates and indicates a bureaucratic and hierarchic oversight. The pressure for performance, in the form of internal competition, comes from peers rather than from the executives. 5. Rewards Apart from the basic salary a Whole Foods Market also pays bonuses to team on the basis of actual performance measured against several criteria. The maximum salary of an executive cannot go beyond 19 times the basic pay of the lowest earning employee of the company. All employees are offered with stock options irrespective of their position in the company; only 10% of the stocks are possessed executives. So the principles of ‘Beyond Budgeting’ are deep rooted into ‘Whole Foods Market Inc.’ and the company has been successfully functioning with remarkable success since the early 80’s. CONCLUSION Although pretty old and cumbersome, the traditional form of budgeting still exists in the modern day. Due to its attributes of being simple to put together and simplified coordination of budget assumptions across different departments, traditional budgeting is still preferred by many an organisation in public domain, especially many a government around the world. But, traditional budgets have come under attack from the people who think this budgeting process is not capable of catering to needs of modern organisations. They are of the view that budgets are either too long or too short; either too simplistic or too complex; or too rigid for a changing business environment. They rely on inappropriate measures and are too political. Recent surveys and case study has brought to light that the new and improved methods of budgeting over conventional ones have slowly ironed out many drawbacks like rigidity and inflexibility. The budgeting system of Program Budgeting is also not without its flaws. The Program Budgeting like other modern forms of budgeting is cumbersome and complex. It is usually time consuming and requires considerable effort and attention on one’s part to get it right. Customised systems of budgeting have also propped up like the PBMA for the healthcare service companies. It has been very helpful to those organisations that have understood the concept well and implemented it accordingly. The system enables hospitals to cut costs and gives them greater control over budgets and be more patient oriented. Zero budgeting does give more control to departmental manager in budgeting decisions and helps in cost cutting, but the exhaustive and time taking methods requires every manager to be trained to control budgets and it is imperative that they understand it completely. It also leads to more confusion in a workplace as communication is not fluent because an ever-increasing number of managers are involved in the preparation of budget. The ‘Beyond Budget’ has gained huge popularity since its genesis. Many a big organisation like TOYOTA has also implemented it; and it doesn’t have a budget allocation and sanctions to adhere to. Being more people centric than organisation centric leads to more than just being innovation friendly and having loyal customers, it also leads to faster response and lowers costs. This study of different methods of budgeting thus shows the importance of budgeting in an organisation. Budget is critical in fluid functioning of an organisation as the resources are never limitless. Careful planning is paramount in enabling a company to operate on a fixed cost and be profitable by optimizing available funds and use them wisely. The new theory of ‘Beyond Budgeting’, though revolutionary, has shown that an annual financial statement of allocation of funds to different departments may not be that necessary if other functions of business are run as per the sound principles of ‘Beyond Budgeting’. LIMITATIONS The accuracy of the findings of this study is limited to the accuracy of the sources I have referred to. I am not suggesting that one budgeting method is definitely superior to the other, as all systems have a valid place in different conditions in an n organisation. I merely state that in the current scenario, it seems that modern forms of budgeting are surpassing the more conventional forms. BIBLIOGRAPHY Besley, S., and Brigham, E. F., 2007. Essentials of managerial finance. New Jersey: Cengage Learning. Bowhill, B., 2008. Business Planning and Control: Integrating Accounting Strategy and People. London: John Wiley and Sons. Bragg, S. M., 2009. Controllership: The work of Managerial Accountant. London: John Wiley and Sons. Brambley, P, and Frdham, R., 2003. What is PBMA. Hayward: Hayward Medical Communications at www.evidence-based-medicine.co.uk Cassel, M., 2003. Can we budge it? London: Financial Management. Gazely, A. M. And Lambert, M., 2006. Management Accounting. London: Sage Publications ltd. Hansen, D. R. And Mowen, M. M., 2006. Managerial Accounting. New Jersey: Cengage Learning. Hofstede, G. H., 2003. The Game of Budget Control. London: Routledge Khan, M. Y. And Khan J., 2006. Management Accounting. New Delhi: Tata McGraw-Hill. M. 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Managerial Accounting: Tools for Business Decision Making. London: John Wiley and Sons. What are the Beyond Budgetting principles?. BBRT - Beyond Budgeting Roundtable at http://www.bbrt.org/beyond-budgeting/bb-principles.html APPENDICES APPENDIX A Line –Item Budget Program Based Budget APPENDIX B Sample Cost Map Read More