The Role of Budgeting in the Current Economic Climate - Essay Example

Critically discuss the role of budgeting in the current economic climate, taking into consideration what is often referred to as dysfunctional behavior emanating from this practice. Budgeting has become an important concept in the present day business scenario. The term budgeting is sometimes used as an alternative for ‘command and control’ (BBRT - Beyond Budgeting Roundtable, 2012). Initially the concept of budgeting was designed for the senior executives in an organization to control the activities in the organization directly from the business head. It acts as a management tool by which the financial health of the company can be controlled (Banović, 2005, p. 3). The benefits of budgeting include that of forecasting the future performance of an organization, addressing its developmental issues, promoting cohesion amongst the different departments and also predict any possibility of unforeseen expenses (The limitations of Budgeting, 2006). However, there are several limitations accrued to such a concept of traditional budgeting. This paper tries to address the role of budgeting in the current economic climate and the dysfunctional behavior that emanates from this practice. Budgets have been incorporated as financial plans in the corporate firms in the 1920’s. It has been accepted as an important part of their central planning and corporate system. Through the system of budget the managers of a company can co-ordinate the allocation of resources on one hand while tap and evaluate the expenditures on the other. This facility of this system has made the budgetary practices to remain unchanged throughout the decades. Yet, the managers and administrators have not failed to notice various dysfunctional behaviors associated with the system (Banović, 2005, p. 1). In its course of action, a company might encounter several unpredictable events which require rapid responsive action. But the prevailing budgeting process does not provide such space for immediate action. It is a quite detailed structure and is also expensive one. Besides, the budget is made under some assumptions. But with the change of the economic conditions with passage of time, the validity of the assumptions gets over. This creates confusion and sometimes involves much rework. Problems with the traditional budgeting system Any budgeting system has three major roles, viz., “planning, motivation and evaluation” (Banović, 2005, pp. 4-5). Hence there are chances of three types of conflicts to arise. For the effectiveness of a budget, the planners are supposed to assess the company’s functioning capabilities and therefore they make an optimistic budget. They are under pressure to create a plan that would merge the targets desired to be achieved with feasibility of achieving the desired performance. This leads to the setting of more attainable targets thereby under using the available resources to the fullest extent. It causes lack of motivation among the employees. Secondly, the level of motivation might conflict the evaluation standard in the company. For the evaluation of performance certain rigid standards are maintained. This may not take into the consideration of unforeseen or uncontrollable incidents. Thus, while on one hand the detailed knowledge about the evaluation standard might make the employees take it for granted at work for the fulfillment of the desired level, on the other hand, the occurrence of some uncontrollable incidents would not be accounted for the system and reflect a faulty judgment of a lesser performance. Finally, a minor conflict might arise in lieu of the differences between the realistic assessment of the future prospects by the planning personnel and the need to get rid of the unfavorable environmental factors from the budget that goes for evaluation purposes. However this conflict is not a big one since adjustments can be made as required after the budget period ends (Banović, 2005, pp. 4-5). Besides, the budgets are formulated on the basis of the functions of the different departments of an organization. The goals and policies in many cases do not strongly relate to the corporate strategy making. However in today’s world, success is driven by appropriate strategy and faster response rather than a not so fool proof budget. The authority put upon the practice of following budget tend to hinder innovations. The cost structure estimated by the cost budget generally take into account the income and expenditure of the previous years. It does not delve much into forecasting the behavior of the variables in the future. When a budget is prepared beforehand, it takes into account the performance level of the employees in the organization and the targets are set accordingly. This does not give the space to the employees to maximize their effort. They work only up to the minimum requirement to achieve the target. In this case the company foregoes a part of the extra output that it could generate. On the other hand, sometimes the company sets aggressive targets in front of its workers. The workers might employ unfair methods to meet these targets putting the company’s reputation at risk (BBRT - Beyond Budgeting Roundtable, 2012). Impact of non-transparent budgeting The problems that such a budget practice encompasses sometimes become major problems in the management of the organizations. Compared to the number of people engaged in the planning department, less number is engaged in the strategy making procedure. It creates a “top-down process” (BBRT - Beyond Budgeting Roundtable, 2012) in which the management at the upper level formulates the budgeting procedure with least involvement of the individual operating units. The levels below the headquarters receive the budget and simply adhere to it. In such a case, the information at the source is not available symmetrically to all the employees of the organization (Banović, 2005, pp. 9-10). The methods of cost-estimation and target setting incur huge costs. Yet, the outcome does not have enough transparency. The entire decision making power is entrusted into the hands of the few policy-makers. This has its own implications. Too many trade–offs are made between the “long-term value creation” (BBRT - Beyond Budgeting Roundtable, 2012) and the need to achieve short term results. The accountability structure maintained in the organization makes the operations too rigid and lack of new initiative. Also, it sometimes leads to unnecessary or unethical activities to please the superiors. Need for transformation of the budgeting system: Beyond Budgeting Model With a stress on speed and flexibility, the suitability of the traditional budget has come under debate. The budget which is designed to handle long term complex problems, cannot serve the purpose of the managing small failures with preciseness. In many developed organizations a team of planners is maintained who would be responsible to learn and innovate rather than control the actions of the other staff. This leads to cost cutting to huge extent and provides a steep competition for their rivals. Observations by several researchers have helped to figure out the problems existing in the budgeting process. In this economic climate, several companies have felt the need for modification in the traditional budgeting system. This modification can come in the form of repairing certain specific loopholes in the system or a total makeover in it. In January 1998, “The CAM-I Beyond Budgeting Round Table (BBRT)” (Hope & Fraser, 2001, p. 3) was established in response to the rising dissatisfaction with traditional budgeting. Some of the 33 companies that have formed the collaborative organization, BBRT, include “UnileverBEstfoods, Deutsche Bank, Diageo and BT Group” (Leitch, 2003). The officials of this organization recognized the companies who had abandoned budgeting and outlined their best practices. The common set of principles have been adopted to build the framework of the beyond budgeting model. People are the priceless asset of any business organization. Beyond budgeting refers to the release of people from the top-down process and enable them to satisfy the customers and beat the competition consistently by making profitable usage of the knowledge resources available in the organization (Hope & Fraser, 2001, p. 5). The benefits enjoyed by the companies that have forgone the traditional budgeting process enjoy several benefits. With less time being spent on “unhelpful budget activities” (Leitch, 2003) the saved time can be spent making analysis on the decisions and forecasts and using them to steer the business in the right direction. These companies can be more responsive and focus on customer satisfaction. For decades budgeting has been seen as the key element of the internal control system of any organization. “Annual fixed target setting” (Leitch, 2003) has been prominent in almost every company’s annual report. Budgetary control in short refers to the process of management involving setting of targets, “measuring variances between the original targets and actual outcomes” (Leitch, 2003) and directing people towards reduction of those variances. Now, when this method of budgetary control is eliminated from the annual report few other things take its place. The trends of the company’s performance are monitored by the “Key Performance Indicators” (Leitch, 2003). Information is made available widely and asymmetrically so that nothing can be hidden or covered up. Devolution of decisions is allowed through a more transparent framework of principles. Performance is judged in hindsight by making comparisons with both internal as well as external competitors. It encourages the managers to think about the effectiveness of their plans in a variety of situations. This leads to better forecasting and improved risk management which makes shocks less frequent. In such companies the support functions are made more centralized while the customer facing units are decentralized. Besides, when the companies adopt adaptive planning, they review their targets frequently through the year in response to the different events that it comes across, instead of revising the company’s direction annually as happens in case of fixed targets. This ensures that the shareholder’s investment in the company shares is being taken greater care off. Thus the trust of the people is strengthened, something the traditional budgeting process fails to do. Risk Management Risk management is a process in which people manage potential future outcome apart from some benchmark outcome which is a planned outcome, which is sometimes referred to as the most likely outcome. Since the most likely outcome is almost certainly different from the actual outcome, it is sensible to anticipate the most likely outcome and try to manage it. a formal risk management mechanism is present in almost all companies that complies with the corporate governance regulations. But they also manage risk informally or formally outside that prescribed process within other management bodies. While traditional budgetary control deals with unforeseen future occurrences by reacting to them and trying to bring outcome back to the preplanned desired level, risk management deals with such happenings by anticipation and taking action in advance. This has made risk management become increasingly important and a highly desirable attribute in any organization’s administration. The Beyond Budgeting model is based on the concept of time saving by not using budgetary control and reallocates it towards a more adaptive planning. The BBRT helps the companies to learn from the best practices of the different organizations around the world. This encourages them to share necessary information, past successes and experiences so that they can move beyond the system of command and control. They move towards the formation of adaptive and ethical enterprises and showcase healthy competitive performance (BBRT - Beyond Budgeting Roundtable, 2012). Risk management can add to the model of beyond budgeting in three ways, i.e, “empowerment, action planning, and forecasting” (Leitch, 2003). The management team at the top of an organization has a legitimate right to look into the plan of action of the business departments even when they have handed over the power to them under the policy of radical decentralization. They mainly look into whether the thought process of the business units match with their own thought process. Also, they consider the conclusions that have been drawn and discuss whether any improvement can be made upon those. These people, on being seniors, possess valuable experience which they can use to provide beneficial suggestion and different angles of risk assessment. However, the team comprising of senior staff does not give such propositions in the form of instructions to be mandatorily followed by the individual business units. These are suggestions that are provided for the junior level staff to consider and act accordingly so that the performance of the company can be improved upon. This is empowerment of the individual business units. Apart from that, in order to improve the action plans, the concept of risk management provides added advantage. With the plan of following the path of beyond budgeting the companies are aiming at something which would go even beyond immediate responsive action to any incident. This can be done by anticipating prospective outcomes and take action in advance so as to modify their impact. Uncertainty is an inevitable part of any decision made about future outcome. Unlike traditional budgeting system where original objectives are set as single points or evaluators of performance, Beyond Budgeting incorporates the method of forecasting in which a range of probability distribution is stated about the likely outcome. Uncertainty is not suppressed in this rule rather is represented explicitly in the probability distribution (Leitch, 2003). The problem of dysfunctional behavior Research on budgeting has found three mains of budgeting research; economical, sociological and psychological. When individual behavior is in conflict with the objectives of the organization, then dysfunctional behavior occurs (Hansen & Mowen, 2010, p. 388). It has been revealed that fixed performance contracts, based on a centralized control system and absence of trust, act as a primary cause of dysfunctional behavior that we come across nowadays in the organizations. The organizations are victims of performance trap that arises from a not so efficient budgeting system. The impacts of dysfunctional behaviors include phenomena like budget slack, budget padding, “participation in budget setting” (Banović, 2005, p. 19) and other budget games that cause damage to the organization’s financial health. The two topics, “participation in budget setting” (Banović, 2005, p. 19) and budget slack have emerged from the behavioral facet of budgeting research and ideal solutions to these problems have not been found. It has been noticed that some organization in spite of having sound technical budgeting witness detrimental social-psychological happenings related to budgeting. A study by the Controllership Foundation has revealed that excessive pressure to meet the budget targets has resulted in “stress, interpersonal conflicts, and distrust” (Banović, 2005, p. 19). These factors lead to the problems of poor communication, lack of effort and gaming. Under the budget pressure the employees unite against management and create an atmosphere of tension in the workplace. Strict accountability makes some of the officials to find minor faults in the employees under his supervision and highlight them to his superiors. The lack of cohesion makes the supervisors to be engaged in the well-being of their respective departments and be oblivious to the cause of the entire organization. Another important reason behind dysfunctional behavior is that the supervisor tends to use the budget to express their own ways of leadership not considering the importance of involvement from the business units at operation level. By de-centralization of the control system, the problem of dysfunctional behavior can be cured to a great extent as has been shown by the first movers in this path. Conclusion Business leaders as well as investors want to enjoy a sense of control over the business outcomes. Every company that maintains a healthy growth path considers risks while they make major business decisions. The expected security could have been provided by the budgeting system through its centralized planning. But the concept of beyond budgeting proffers a welcome alternative. The ultimate objective is to construct a management model which is “coherent, simple and integrated” (Hope & Fraser, 2003, p. 194). Research is still on in this sphere and more can be added to the element of risk management in the model of Beyond Budgeting. 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(2003), Control without budgets, internalcontroldesign, available at: http://www.internalcontrolsdesign.co.uk/bs2003no3/index.shtml (Accessed on December 11, 2012) 7) Hope, J. & Fraser, R. (2001), Beyond Budgeting Questions and Answers, balanced-scorecard, available at: http://www.balanced-scorecard.de/docs/Beyondbudgeting3.pdf (Accessed on December 11, 2012) 8) Hansen, D. R. & Mowen, M. M. (2010). Conerstones of Cost Accounting. Cengage Learning 9) Hope, J. & Fraser, R. (2003), Beyond Budgeting: How Managers Can Break Free from the Annual Performance Trap. Harvard Business Press Read More