Benefits and Drawbacks of Traditional Budgeting Procedures - Case Study Example

Benefits and Drawbacks of Traditional Budgeting Procedures The most established budgeting procedure is prepare revenue, cost, profit, investment, and cash flow targets for a 12-month basis, drawing from a 5-year plan (Oliver, 2000). Environmental changes which have taken place after a plan has been made, and actual achievements during the recent past, are taken in to account during budgeting. Control, coordination, and feedback are the 3 primary advantages of such an elaborate budgeting system (Oliver, 2000). The budget serves as a kind of navigation tool, which lets people at all levels of the organization know the direction in which an enterprise is headed, relative to a plan. Senior management cannot take corrective steps in time unless a budget is available. This is how an elaborate budgeting process keeps an organization on track. Coordination is the second gain of detailed budgeting because organizations consist of departments and functions which are dependant on each other. The outputs and deliverables of staff functions are especially important and direct inputs on which line functions rely. The expectations and predictions of line functions in turn, affect capacity planning by staff functions. A budget serves as a forum for coordination, so that all parts of an organization work in unison towards shared goals. External stake holders such as suppliers may also be involved in a budgeting process (Dickey, 1992). The third advantage of elaborate budgeting systems is that of feedback, and perhaps the most important. Budgeting allows top management to appreciate the ground realities at the periphery of its structure, and gives an opportunity for people who are in direct and routine touch with market and environment realities to contribute their perspectives to their employers. Budgeting, in this sense, is not a procedure to be carried out in isolation, but is an instrument of great social interaction within an organization (Dickey, 1992). There are variations within the standard template of a detailed and formal budgeting system. Some management teams prefer a top-down process in which they specify minimal goals which are to be achieved. These refer to growth, profitability, and image in organizations which work for profit. Other organizations prefer to allow the lowest levels of hierarchy to propose opportunities around which a budget can be made. This approach relies heavily on scanning the environment by people who are in touch with customers, the distribution chain, and with competitive moves. It is difficult in real life to have an elaborate budgeting process which is entirely top down or developed from the bottom to the higher echelons of structure. The budgeting process tends to be iterative in nature, with various levels and branches of organization in negotiating dialogue with each other, before consensus on targets can be obtained. This iterative process of budgeting leads to one of its main criticisms about drawbacks. Budgeting can be an expensive and time consuming process, which can take a substantial part of personnel capacities. An excess of deliberations about the future can also distract attention and focus from short-term operational pressures. A second important limitation of formal budgeting relates to the uncertainties of a dynamic environment (Hope and Fraser, 2003). Conditions in which a budget has been prepared can change to such an extent that the accepted targets become irrelevant. The budget then loses its sanctity as a navigational tool, because it can no longer provide meaningful leads on how an organization fares. Budgets become invariably linked with individual performance appraisal matters. It is but natural to reward people who achieve or exceed accepted targets, and the reverse also applies, though in lesser degree in case targets are not met. Target achievement generates high expectations in terms of the people involved (Hope and Fraser, 2003). There are 2 consequences of this: firstly, people tend to build as much slack as they can in to target definitions, and resist taking on ambitious challenges in the interest of the enterprise. Secondly, the organization may end up rewarding people for achieving goals which have become irrelevant in changed circumstances. Such limitations of a formal and conventional budgeting system have resulted in the development of a number of modern variations in the classical template. First, some organizations adopt Zero Based Budgeting, in which the focus is on targeting activities rather than numerical goals (Shim and Siegel, 1994). The allocation of resources is linked to the activities which are chosen for a particular planning period. The organization generates a large number of activity proposals, from which a final set can be chosen. Zero Based Budgeting has been used more by government arms than by companies which work for commercial gains. The system creates instability in an organization because existing departments and functions have to justify their essential continuance. However, the system can produce results for new teams, and leads to productivity gains. Another variation of traditional budgeting which is used by many successful corporations relates to Adaptive Processes (Hope and Fraser, 2003). The advantage of this variation is that it shortens the planning cycle, and allows teams to respond to environmental changes. The emphasis is on setting goals with high degrees of stretch, and linking them to individual remuneration decisions. This form of budgeting can yield high value addition in the short-term, but may not be sustainable over long periods of time. It can also generate intense and unhealthy competition between individuals within an organization. Some form of budgeting is essential for effective delegation (Cullen and Broadbent, 2003). Organizations will become chaotic if there is no formal and recorded plan on the basis of which operational decisions can be taken. Professionalism of management is not possible without some degree of budgeting. Budgeting also creates incentives for innovation, and stimulates people to excel (Simons, 1995). However, it remains a matter of finding the right balance between preparing a useful operational tool, and creating a bureaucratic imposition which only wastes precious resources, especially that of employee time. Budgeting and its form is therefore a top management prerogative (Dickey, 1992). Design of Effective Budgeting Design for the Nuevo Since the Nuevo does not have the baggage of an established budgeting bureaucracy, it can use the experiences of other organizations as enumerated in the previous section, to build an optimal system which addresses its specific needs, and avoids known pitfalls of the process. Environmental scanning (Dickey, 1992) will be an important part of budgeting during the early years of the Nuevo. This phase is more important in Strategic Planning than in short-term budgeting, but will need special efforts as the Nuevo is new to the process even as part of the Comodo Group, and because Manchester is such a dynamic city. A second key element of budgeting at the Nuevo, should relate to the explicit enunciation of detailed assumptions. This is to make the budgeting process relevant in the uncertain environment of the hotel business (Hope and Fraser, 2003). Though Manchester has enjoyed rapid growth, it is also the site of many new hotels. The euphoria of demand created by events such as the Commonwealth Games is unlikely to last, so the Nuevo has to be sanguine about its revenue forecasts. Assumptions related to the security situation in the U.K. and with respect to inflation and industrial relations, should also be taken in to account. The Nuevo will be better placed to deal with discontinuities if it elaborates budgetary assumptions, and reviews such assumptions periodically. Key ratios should be an important concern of budgeting at the Nuevo (Cullen and Broadbent, 2003). Room occupancy, profitability, and working capital management will be some of the functional areas for which targets should be set in terms of key ratios. This approach will also help the new hotel management think and function cohesively as a team. Key ratios are normally targeted and evaluated based on historical trends, but since the Nuevo is a new hotel, the targets can be fixed based on information in the public domain about other hotels in Manchester, or on the basis of Comodo's internal data on its North American properties (Cullen and Broadbent, 2003). However, the most important component of budgeting at the Nuevo should be the establishment of a standard costing system. The restaurants and the bar will be typical examples of defined cost objects (Cullen and Broadbent, 2003), though this is not an exhaustive list. The concept of cost objects is crucial for budgeting profitability. Setting standards for direct costs and finding equitable ways of apportioning indirect costs will be other major concerns of a standard costing system for the Nuevo. Capital budgeting will not be important for a new property, but the budgeting process should provide for it nevertheless. Expansion and maintenance will be concerns in future as the hotel establishes a presence in the Manchester market. It will also help the Comodo Group use management expertise of the Nuevo to plan for further forays within the European mainland. Suppliers of major resources such as labor, food ingredients, fabric ingredients, and hygiene components, should be involved in the budgeting process (Dickey, 1992). This may yield some cost efficiencies, and it will certainly help to avoid any nasty surprises on the cost front! Budgeting can extend in to systems of annual and quantity contracts which will ensure timely supply of essential materials and services for the Nuevo to maintain quality standards, and will also provide strong foundations for the standard costing system (Shim and Siegel, 1994) The Nuevo should use a 12-month period for budgeting, with a system of exhaustive quarterly reviews (Kemp and Dunbar, 2003). This may strike the right balances between the advantages of budgeting, and the dangers of planning eating in to execution time. It may be best to start the budgeting process every autumn, after the peak arrivals of the summer are over, and to schedule completion before the start of a new calendar year. Since both the Nuevo and even Comodo are new to budgeting, and since the hotel staff has come in from diverse backgrounds, it will be best to de-link budgeting from performance appraisal (Hope and Fraser, 2003). However, this can only be an interim measure, because rewards and recognition must ultimately be on the bases of the achievement of agreed targets. Memo on Budget Control System for Comodo To: Mr. R. Campana From: The Nuevo, Manchester Date: January 2007 Reference: Budget Control System This refers to a proposal to establish a budgeting system for the Nuevo, which can also be used later by all hotel properties of the Comodo Group. We believe that budgeting will help us achieve better levels of performance. The process will also help other properties of the Comodo Group, especially prospective ones in Europe. Here is a summary of the main points: 1. Budgeting requires the commitment and time of top management; we cannot make it work on our own. The project report, on the basis of which you decided to invest in Manchester, should form the basis of a recurring Strategic Planning process. Budgetary control will flow from the long term plan. 2. A broad-based environmental scan, detailed lists of sensitive assumptions, goals specified in terms of time, cost, quantity, and quality, and detailed activity plans with identification of responsible people, are qualitative parts of an effective budget, which matter as much as tables with matrices of numbers. 3. The budget should also consider balance sheet items such as fixed assets, working capital, liabilities, and cash flow. These may not be important as long as the Nuevo is new, but will matter as we establish ourselves and dream of expansion, as well as encounter maintenance issues. 4. A standard costing system, with identified cost objects, should give a frame within which we can plan for profitability. A hospitality business is vulnerable if it seeks to excel in service without concern for true and full costs. 5. Though budgets would be linked to individual performance appraisal, this should be kept in abeyance during the early years of team development at the Nuevo. We need confidence in our abilities to project environmental trends, and to build a reliable database of historical achievements before budget targets can be tied to rewards and remuneration. 6. The budget period should follow the calendar year, with provision for detailed quarterly reviews. The exercise, including a review of the long-term (5-year) Strategic Plan, should commence each autumn, with completion before the end of the calendar year. This will strike a harmonious balance between planning needs and our loads of routine work. Detailed sections follow on each of the summary points listed above. This memo is based on references listed at the end of the document, but have not been cited in accordance with intra-office communication norms. All planning activity including budgeting serves as opportunities for productive communication within organizations. The new team at Nuevo needs to understand the business priorities of the Comodo Group, and we also want a forum at which we can raise our concerns, and voice our ideas on what the enterprise should do. We do understand the given direction of excelling in service for both the business traveler and the tourist segments. However, there are many connotations of such broad concepts which we would like to discuss. How much for example, should we sacrifice margins in order to satisfy customers There are many segments such as economy travelers whom we cannot target as a 4-star property: what is/should be our segmentation policy Many of us at Nuevo have diverse backgrounds, and a planning and budgeting exercise would be a ritual to which we would look forward, especially as it would give all of us at Nuevo to interact with you directly, and outside the pressures of our everyday responsibilities. We have seen the table of figures which represent the first year of the investment appraisal. However, we would like to discuss the assumptions under which they were made, and consider if some of the goals need to be changed in response to new environmental developments. You will agree that a series of coordinated actions alone will ensure that the numbers are achieved: therefore, we need an opportunity to discuss action plans amongst ourselves. Housekeeping capacity for example, will depend as much on the projections of our sales functions, as the number of rooms we have: we can plan our own capacities based on the room occupancy which we hope to achieve. Finally, we worry about responding quickly to sudden changes in the Manchester business environment. Hopefully, these changes will be positive ones, but they could also be unpleasant ones which require us to curtail spending for example. Therefore, we need to list the assumptions behind the numbers explicitly and in detail. Overall, the qualitative parts of a budget matter, and we cannot interpret your directions by reading tables alone! We do not need to worry about either new construction or repair at the Nuevo today, but these issues will inevitably arise over time. The budget exercise should be an occasion to plan for the essential maintenance of our physical assets, and we can use it to propose some productive new acquisitions as well. We might like to add a fleet of limousines for example, to take guests on tours around Manchester, and for airport transfers as well. Plumbing, drainage, renewable energy, and waste management are examples of new ideas which we may get if the annual budget takes us through the gamut of fixed assets addition possibilities. Similarly, we can ask for more liberal credit terms from volume suppliers as we grow, and we need to watch our cash flows, especially during the lean winter season, as we pile up inventories of big ticket items such as rare wines. Overall, the balance sheet side of things needs as much attention as sales, costs, and profits, during annual budgeting. The bar and restaurants are double edged swords for our profitability: we cannot grow without establishing top customer satisfaction levels there, but also run the risk of cash losses, if we do not have full cost information on dishes and drinks. Further, it is dangerous to keep large elements of fixed costs unallocated because they may give cost objects false ideas of their contributions: all costs should be allocated, though we have to discuss and agree on the bases. These concepts will be as important for our service departments as for revenue-generating outlets. Our material bill will grow over the years, and we would spend significant sums of mundane things such as milk, meat, linen, and alcohol. We have to set standard rates for each year, establish consumption norms, and improve productively from year to year as well. We cannot achieve any of this, and may even start making losses in real terms, unless we adopt a standard costing system. It could be around 3 years before we develop a reliable forecasting system to back our budgets. We have also to rely on new recruits to provide us with realistic targets. Neither overly ambitious targets nor ones which are easy to exceed will serve our best long term interests. That is why we should defer linking budgeting to systems for individual rewards and remuneration. However, this should be something to achieve over time, and it can also evolve in to a method of comparing employees in comparable positions in properties across the Comodo Group. Finally, we have to run a hotel and not just play with budgets! A good balance between the benefits and costs of budgeting could be to restrict the process to autumn when our arrivals will be relatively low, and to have a New Year's budget ready before anyone thinks of a break for the festive season. We should schedule detailed reviews at the end of each March, June, and September, with the third one marking the start of a new budget exercise. We can send detailed forms and tables if you approve of this proposal for a budgetary control system in principle. Best wishes and regards from your Nuevo team! References Cullen, C. and Broadbent, M. 2003 Managing Financial Resources, Elsevier Dickey, J. 1992 The Basics of Budgeting: A Practical Guide to Better Business Planning, Thomson Crisp Learning Hope, J. and Fraser, R. 2003 Beyond Budgeting: how managers can break free of the annual performance trap, Harvard Business School Press Kemp, S. and Dunbar, S. 2003 Budgeting for Managers, McGraw-Hill Professional Oliver, L. 2000 The Cost Management Toolbox, AMACOM Div American Management Association Shim, J. K. and Siegel, J. G. 1994 Complete Budgeting Deskbook, CCH Tax and Accounting Simons, R. 1995 Levers of Control: How Managers Use Control Systems to Drive Strategic Renewal, Harvard Business School Press Read More