The Role of Budgeting - Essay Example

A CRITICAL EVALUATION OF THE ROLE OF BUDGETING ………………………….. College ……………………………… ……………….. Word count: 2225 Table of Contents Table of Contents 2 Introduction 3 Budgeting and Its Relevance 3 Traditional Budgeting, Better budgeting and Beyond Budgeting 4 Pitfalls of Traditional budgeting 4 Better budgeting 5 Beyond Budgeting 8 Evaluative Conclusion 9 References 11 Books 11 Journals 13 Bibliography 14 Introduction Budgeting has long been playing a pivotal role in management account for projecting the financial impact of future operations of an organisation, however recently it has become a matter of considerable debate and criticism (Libby and Lindsay, 2010, p. 56, Hansen, Otley and Vander Stede, 2003). The perception that traditional budgeting has become irrelevant due to rapid changes in contemporary business field has been a major drive that inspired the ‘Beyond Budget’ movement (Dugdale and Lyne, 2010). The argument that budgeting system in an organisation results in nothing more than dysfunctional behaviour has initially been proposed by Hope and Fraser (2003) as part of the Beyond Budgeting Round Table (BBRT). This report is a review of relevance of budgeting in contemporary business contexts and an attempt to suggest which one among ‘better budgeting’ or ‘beyond budgeting’ will be effective to the CFO of Halfords Group plc. This report is prepared to submit to the CFO as he asked me to review literatures and prepare a report based on ‘budgeting- lost relevance’ after he participated in a conference that made him concerned about the matter. Budgeting and Its Relevance In finance and accounting, budgeting is a formal plan expressed in monetary terms and is prepared in a current financial year to provide managers and other stakeholders with an estimate of the anticipated costs and revenues for the next financial year (Chandra, Menon and Mishra, 2007, p. 264). Traditionally, budgets served a number of useful purposes such as 1) planning annual business operations, 2) coordinating various activities in the organisation, 3) communicating these plans to various responsibility managers or departments, 4) motivating managers to achieve desired organisational goal, 5) controlling all activities in the firm and 6) evaluating managers’ performance (Drury, 2006, p. 426). Because of that budgeting looks both forward and backward, it identifies resources that the company is likely to generate and the need in its near future to serve as a measure of current and past performance of department and individual managers (Fabozzi and Drake, 2009, p. 334). Why budgeting has been traditionally considered as an effective strategic tool for management accounting was that it was nothing but a plan relating to future and it helped management take various critical decisions pertaining to strategic planning, budgetary planning and operational planning (Walker, 2006, p. 305). Budgeting has also played a very significant role in strategic and operational planning thereby to become a component of systems and practices that geared to organisational coordination and development. It was considered as a technique for cost-engineering as well (Chapman, Hopwood and Shields, 2011). Traditional Budgeting, Better budgeting and Beyond Budgeting Pitfalls of Traditional budgeting From literatures in the area, it is clear that there are three concepts about budgeting; traditional budgeting, better budgeting and beyond budgeting (Weber and Linder, 2005, p. 21, Weber, 2011, p. 127). Traditional budgeting has been proving to be wasteful and ineffective (Schmidt. 1992), a broken tool (Jensen, 2001), a matter of the past (Gurton, 1999) and an unnecessary evil (Wallander, 1999). Neely, Bourne and Adams (2003, p. 23) have clearly illustrated and outlined around 12 factors that proved weaknesses and ineffectiveness of traditional budgeting in today’s business contexts. They are- 1) Budgets are hardly strategic and therefore they are often contradictory (Kaplan and Norton, 2001, Bunce and Fraser, 1997, p. 26). 2) They concentrate on cost reduction, but not on value creation. 3) They constrain responsiveness and flexibility, so they seem to be barriers to change (Ekholm and Wallin, 2000, p. 521). 4) Budget adds little value since they are bureaucratic. 5) They consume considerable time. 6) They are updated too infrequently. 7) They are based on unsupported assumptions. 8) They encourage dysfunctional behaviour. 9) They strengthen vertical commanding. 10) They never reflect the merging network structures. 11) Budgets reinforce departmental barriers rather than encouraging knowledge share. 12) They make people feel undervalued (Neely et al, 2003, p. 23) To summarise, traditional budgeting fails to deliver results basically due to that it adds limited value to the management of business. According to economic perspective, the benefit of an effort should at least outweigh its costs including money and time spent on it. Literatures including Neely et al (2003, p. 22) stressed that budgeting has not only become too time consuming and costly, but also too unresponsive to today’s competitive and turbulent business contexts. Budgeting itself is not a waste or ‘relevance lost’, but its practicability in today’s dynamic business environment has become a matter of concern among academicians and researchers due to many factors. This consensus among literatures has inspired widespread debate regarding whether better budgeting or beyond budgeting is acceptable. Better budgeting It is very important to analyse and identify whether better budgeting or beyond budgeting will be useful and relevant for a firm. The modern thoughts about better as well as beyond budgeting stemmed from Schmidt’s (1992) work titled ‘Is it time to replace traditional budgeting?’, Gurton’s (1999) research titled ‘Bye Bye Budget- The annual budget is dead’ and Wallander’s (1999) findings in his work ‘The budget- an unnecessary evil’. Marginson (2013, p. 14) argued, based on critical review of relevant literatures, that modification and adaptation is possible and therefore better budgeting is more preferable to complete obliteration of budgets. He used the term ‘repairing the budgetary process’ to refer better budgeting. As he defined, better budgeting is an all-encompassing concept that encapsulates a range of ideas (Marginson (2013, p. 15). Why academicians thought about ‘better budgeting’ was that the problems with budgets were more to do with how they were used. Budgets have potential to be extremely useful if they are used appropriately (Libby and Lindsay, 2007, p. 50, Horngren,, Stratton, Sutton and Teall, 2004). Some researchers thought to consider Activity based budgeting, Zero-based budgeting, Value based management, Profit planning and Rolling budget and forecasts etc as major reforms in budgeting as effective techniques to make ‘budgeting’ works even in turbulent business conditions. Activity Based Budgeting Activity based budgeting is newly emerged approach to budgeting which builds on well-established ideas such as activity-based costing (Marginson, 2013, p. 15). Activity based budgeting is a powerful analytical tool (Phillips, 2011, p. 9) that enhances the accuracy of financial forecasts and increasing management understandings (Pieter and Kevin, 2007, p. 38) . It is particularly valuable in measuring and assessing indirect costs since it separates indirect costs in to individual costs (Baker, 1998, p. 132). Cokins (2006, p. 217) explained why Activity based budgeting will be an effective strategy to better budgeting. He noted that traditional budgeting tends to extrapolate the level of resource spending for each spending line form spending of past periods, but activity based costing recognises that the need for resources originated with a demand pull triggered by end-users. Zero-based budgeting In relation to better budgeting concept, zero based budgeting is not accurately an alternative solution to overcome all shortcomings of traditional budgeting, because zero-based budgeting is also found to be enormously time consuming (Marginson, 2013, p. 15). In ZBB, budget decision makers have to prepare next year’s budgets after reviewing all programs from scratch (Ryu, 2013, p. 65). It is because, zero based budgeting focuses on thorough evaluation and re-evaluation of a firm’s planned as well as current activities, programs, units etc to determine whether each one should be continued or not (Dropkin, Halpin and Touche, 2011, p. 91). Zero-based budgeting has been introduced as an attempt to overcome limitations of incremental budgeting (Drury, 2006, p. 375). As Sahaf (2009, p. 344) noticed, traditional budget is based on previous year’s budget whereas zero based budget starts at zero budget level every year and therefore it seems to have more accuracy and effectiveness. Rolling Forecasts and Budgets A rolling budget is typical forecasts that can help management maintain constant forward looking between periods of 12 to 18 months. As compared to traditional budgeting, rolling forecast budget is claimed to have advantages such as 1) frequent occurrence of planning and constant planning ahead, 2) easy updating of changes to budgets, and 3) maintaining a connection with longer time horizon (Hansen, Mowen and Guan, 2007, p. 252). Value based management and profit planning Both value based management and profit planning are also considered as techniques of better budgeting. In value based management, all expenditure plans are evaluated as project appraisals and are assessed in terms of shareholder values. Profit planning is a typical planning and assessing the extent to which a firm’s responsibility is related with a view to generating sufficient cash and creating economic value (Marginson, 2013, p. 15). Value based management provides investment certainty, competitive advantage, credibility and innovations (Abram and Hawkes, 2005, p. 110) Beyond Budgeting A large numbers of literatures including Libby and Lindsay (2007), Moeini (2007), Bogsnes (2008), Hudson (2012), Hope and Fraser (2013) deeply illustrated the concept of beyond budgeting. After widespread debate on the relevance of budgeting in modern business times, some businesses attempted to use budgetary control and certain techniques such as activity-based budgeting or zero-based budgeting etc as means of ‘better budgeting’, whereas some other firms attempted to manage without budgets. Beyond budgeting is thus a movement that argued that budgeting is a bigger barrier for firms to compete in the unstable market contexts and that therefore they should fully ignore budgeting (Broadbent and Cullen, 2012). Moller and Chaudhry (2012, p. 280) stated that companies are far from fully abandoning budgets, even though it is a hot topic and concern among practitioners. In 1970s, Svenska Handlesbanken, one of the largest banks in Sweden, eliminated budgets altogether and produced better results of improved returns on equity than any of its direct competitors. This has been one of the most critical empirical evidences for the potential of beyond budgeting. Beyond budgeting is to fully abandon budgetary contracts and accompanying ex-ante performance targets (Marginson, 2013, p. 16). As Hope and Fraser (2013, p. 29) stressed, the principle of beyond budget offered a new coherent management model assuming that front-line managers are able to regulate their own performance metrics. Decisions are taken locally within a specific and clear governance framework that is based on certain principles and values. Beyond budgeting is a radical alternative to traditional budgeting and is best suited to highly dynamic environments since it uses specific coordination concepts and forecasting as well as motivational tools (Weber, 2011, p. 127). The notion of Beyond Budgeting has stemmed from the Beyond Budget Round Table (BBRT) established in January 1998 by CAM-I in Europe. According to the BB Round Table, beyond budgeting is a set of principles that enables a firm to adequately manage its performance and overall business activities without depending on budgetary control system. This system therefore promotes decentralization of its various decision-making processes within the firm (Monden, 2007, p. 76). The Beyond budgeting notion assumes that a certain organisational-level vision is materialized in to strategic plan and this strategic plan will be used as channel for preparing mid-term operational plans (Monden, 2007, p. 76). Dugdale and Lyne (2011, p. 181) emphasised that beyond budgeting is not just a recommendation to fully abandon budgeting, planning and forecasting, but it suggests that budgets are replaced with systems for forecasting, planning and resource-allocation that move away from annual and financial reporting cycle. It also allows management to evaluate performance on after-the-event comparison with that of competitors or comparable business enterprises. Dugdale and Lyne (2011, p. 187) suggested that an important characterisation of the beyond budgeting recommendation is that all organisations that adopt beyond budgeting should also adopt pooled structures and organic management methods. Evaluative Conclusion This report has critically reviewed the relevance of budgeting based on various literatures and compared and contrasted features of traditional budgeting, better budgeting and beyond budgeting. It is widely accepted that traditional budgeting has almost become a waste and ineffective (Schmidt, 1992) due to dynamic and rapid changes in the business landscape. Many businesses have followed better budgeting and they proved results whereas there are some other businesses, especially after the success story of Svenska Handlesbanken in 1970s, that adopted beyond budgeting and proved results (Lindsay and Libby, 2007). Better budgeting suggests repairing the budgetary control process with newer strategies such as activity-based budgeting, zero-based budgeting, rolling forecast etc. Beyond budgeting, in contrast, is a notion that argued that budgeting itself is a bigger barrier for firms to compete and therefore firms should fully ignore budgeting. This report recommends better budgeting as most effective option for CFO of Halfords Group plc due to the strategic relevance of certain budgetary techniques such as activity-based and zero-based budgeting. This report has highlighted that, in economic perspective, the outputs of an effort should at least outweigh its costs and time spent on it. Based on (Libby and Lindsay, 2007, p. 50) this report has also highlighted that budgets still have potential to be extremely useful if they are appropriately used. But, what budgets have long been benefiting firms in terms of planning, financing, spending, timing, competing, comparing and so on cannot be fully ignored. Since the issue is not related to mere budgeting, but related to how they are being used, this report firmly suggests the CFO to strategically use most relevant and appropriate techniques of budgeting such as zero-based or activity-based budgeting. In short, this paper would kindly recommend the CFO of Halfords Group plc to use ‘better budgeting’ rather than thinking about ‘beyond budgeting’. References Books Abram, J and Hawkes, P, 2005, The Seven Myths of Customer Management: How to be Customer-Driven Without Being Customer-Led, West Sussex, Englan, John Wiley & Sons Bogsnes, B, 2008, Implementing Beyond Budgeting: Unlocking the Performance Potential, Hoboken, NJ, John Wiley & Sons Broadbent, M and Cullen, J, 2012, Managing Financial Resources, Third edition, Burlington MA, Routledge Chapman, C.S., Hopwood, A.G and Shields, M.D, 2011, Handbooks of Management Accounting Research, Volume 2, Amsterdam, The Nederland, Elsevier Cokins, G, 2006, Activity-Based Cost Management in Government: Second Edition, Vienna, VA, Management Concepts Press Dropkin, M., Halpin, J and Touche, B.L, 2011, The Budget-Building Book for Nonprofits: A Step-by-Step Guide for Managers and Boards, Second edition, San Francisco, USA, John Wiley & Sons Drury, C, 2006, Cost and Management Accounting: An Introduction, Sixth Edition, Bedford Row, London, Cengage Learning EMEA Dugdale, D and Lyne, S, 2010, Budgeting Practice and Organisational Structure, Burlington, Elsevier Dugdale, D and Lyne, 2011, Beyond Budgeting, ed, Abdel -Kader, M.G., Abdel –Kader, M.G.G.A, Review of Management Accounting Research, Kirby Street, London, Palgrave Macmillan Fabozzi, F.F and Drake, P.P, 2009, Finance: Capital Markets, Financial Management, and Investment Management, New Jersey, John Wiley & Sons Hansen, D, Mowen, M and Guan, L, 2007, Cost Management: Accounting and Control, Sixth edition, Mason OH, USA, Cengage Learning Hope, J and Fraser, R., 2003. 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