The Traditional Budget Is a Rigid Tool and Should Be Discarded In Practice - Essay Example

The traditional budget is a rigid tool and should therefore be discarded in practice Introduction Budgetary control styles are fundamentally affectedby both the internal and external factors including business previous year performance and its competitive strategy (Vander-Stede, 2000). And this budgetary control is a significant tool of management control (Ryan, 2007). However, despite their usefulness for management, there are inbuilt limitations to the traditional budgeting which make it hard for many organizations to avail their maximum and effective utilization of the organizational capabilities. Till this point of time, traditional budgeting has been used for achieving organizational goals and objectives. However, due to the introduction of new concepts, such as activity-based budgeting and activity-based management, organizations have been given an opportunity to avoid the inherent limitations to the traditional budgeting by switching over to the activity based budgeting process. In the following parts of this essay, first traditional budgeting has been defined and elaborated as well. It is followed by the segment “critical evaluation” in which limitations of traditional budgeting along with benefits of activity-based budgeting have been provided. Before the conclusion part, a passage relating to the external pressure and the influence of capital markets on the budgetary process has been included. Traditional Budgeting Traditional budgeting refers to incremental budgeting in which previous year budget is taken and an increment of 10 per cent or more is added to the figure of previous year budget. In this type of budgeting exercise, indirect costs, such as heating and lighting, administration expenses, maintenance cost, are mostly included and these are allocated to the products and services (Griff, 2014). For example, if the marketing department budgeted $80 million in the previous for carrying out the marketing and advertising activities, and in the current year, a 10 per cent increment is added to the previous year’s marketing budget, which will bring $88 million for the marketing advertisement activities. This activity represents the process involved in the traditional budgeting. In this regard, it is important to highlight that the traditional budgeting is based on the traditional system of costing in which certain assumptions are normally followed by the management accounting. First, it is assumed that all costs are consumed by departments; hence, they will be subsequently allocated to products which indirectly consumed the costs. Critical Evaluation While allocating the indirect cost, the products in the higher quantity and the products in lower quantity are over charged and under charged respectively (Griff, 2014). Consequently, this process has various ramifications for product profitability. For example, if a total of 2000 units of product A and 500 units of product B will be produced in a particular period and it is expected that product B will generate the higher profit when it is compared with the profitability associated with the product A; and the management is required to make a decision in which it is forced to only produce a total 2000 units. Subsequently, the management decides to produce only product A as it will generate the maximum number of units. Consequently, this will indicate that the profitability was not the rationale behind this management decision instead the maximum number of quantity attracted the management attention. At the same time, it will also consume the higher quantity of costs associated with the product A. Reliance on previous year data is one of the major limitations in the traditional budgeting (Lalli, 2012). In the traditional budgeting, the management uses the previous year data or information for developing the next’s budget. This type of process is filled with many flaws as every year considerable changes takes place in technology, prices of products, demand and choices, social, political, economic and financial issues. And each year does not come to reflect the continuity in the previous year’s trends and inclinations instead every year changes occur and they put their effect on overall demand and supply of all products which are produced under the framework of traditional budgeting. The traditional budgeting provides inadequate management information about the level and type of services required; the potential advantages and disadvantages of the required services and specific resources essential to carry out the process of production (Steiss and Nwagwu, 2001). In other words, it can be deduced that the traditional budgeting even does not take into account the internal factors which are highly essential for producing products. Additionally, based on the above information, it can also be inferred that the traditional budgeting has no unequivocal framework highlighting the contribution of services required for generating a certain amount of units. In these days, it has become an established fact that the human activities, such as services, have become an essential part of production. Furthermore, it also indicates that the traditional budgeting does not account for other resources which are highly significant for generating products. At the same time, traditional budgeting process does not take into account the cost-benefit analysis of products which are going to be produced. Profitability has been a very important aspect for organizations as they always endeavour to know how much a product shares its part to the overall profitability. And organizations do not work for providing free social services to society instead they are primarily based on the profit motive without which they are reluctant to produce products by incurring costs. Consequently, it is highly essential that organizations should know the profitability of products. However, in the traditional budgeting process, only focus is given to the cost side in which only costs are considered by adding a particular amount of addition to the previous year figure. Moreover, the entire process of traditional budgeting involves limited consideration for developing the next year budget. Generally, budgeting is a very crucial activity as it encompasses both planning and control for carrying out the process of budgeting. However, in the traditional budgeting process, the management undermines and undervalues the process of contemplation in which reasons and benefits and subsequent effect on productivity, performance, profitability and other internal and external factors are completely ignored. And it looks that the incremental budgeting process is like a number game in which no heed is required for justification for adding or reducing a particular amount in the previous year’s budget figure, reflecting that in such organizations where the traditional budgeting is adopted, the process of budgeting is a sub-valued activity in which even no consideration is needed only adding or reducing a particular percentage from the previous year budget figure. Lack of choice mechanism is also an understandable limitation inherent to the process of traditional budgeting (Steiss and Nwagwu, 2001). Changes and their effects on every management decisions are certainly unavoidable. Keeping this view in mind, the traditional budgeting does not provide any alternative choices that can be considered for. More specifically, the traditional budgeting activity mainly believes and promotes the historical trend in which each year similar products, costs and budgeting procedures will be considered and followed along with a certain level of addition or reduction in their previous year’s level. In contrast, in today’s dynamic business environment, the organizations are required to have alternatives that can be used for accommodating any changes that make the initial choice meaningless. However, some authors highlight the benefits of the traditional budgeting. For example, Wildavsky (2001) reflects that despite so much criticism on the traditional budgeting process, this management technique is comparatively easy as it makes calculation simple and understandable as well. for supporting this perspective, it has been argued that if the previous year budget has obtained its budgetary objectives besides saving a considerable time and energy, the same benefits can also be availed in the subsequent year as well (Wildavsky, 2001). Budgetary bias is an inbuilt limitation to the traditional budgeting. Budgetary bias or slack refers to a budgetary process in which overstated cost and understated revenue are included in a budgetary process (Horngreen et al., 2009). And there exists both positive and negative slack which also affects the budgetary control and budgetary activity as well (Riahi-Belkoui, 2002). As the traditional budget is affected by the budgetary slack, it does not require much attention and effort from the budget managers (Dutta, 2009). Additionally, employees do not prefer to take interest in the budgetary process as they consider it a time wasting activity (Cokins, 2001). Kaplan introduced Activity-Based Costing including Activity-Based Budgeting, Activity-Based Cost Management and Activity-Based Management (Otley, 2001). This invention serves as an alternative to the traditional budgeting and conventional costing system that has been in existence and in practice for last many decades (Otley, 2001). Activity-based budgeting involves determining output first and allocates resources for creating that output (Hansen et al., 2009). On the other hand, in the traditional budgeting no such overhauling process is carried out. Additionally, the activity-based budgeting purely focuses on costs of activities instead of the costs of departments which are normally followed in the traditional accounting (Rich et al., 2012). In other words, the activity-based budgeting does not overhaul the departments instead it is more interested to highlight the contribution and usefulness of individual activities which incur cost. Moreover, when further comparison with activity-based budgeting with the traditional budgeting is made, it can be further extracted that the former is more actionable and understandable (Hilton et al., 2008). Also, traditional budgeting relies on standard costing whereas the activity-based budgeting relies on the activity-based costing (Toit et al., 2007). External Pressure Traditional budgeting does not take into account the external independent factors. For example, the external environment is highly uncertain and complex as well. This uncertainty is common in generating revenues, in social, economic and political issues and most importantly changes in stocks markets as these factors are not considered by the traditional budgeting (Griff, 2014). For example, a manufacturing unit plans to assemble 40,000 auto spare parts for the coming year. And based on this estimation, the marketing and advertisement department, sales department and purchase department have also estimated their budgets for the same year. However, due to decreased demand of auto spare parts and increased market price of the auto parts, only 30,000 auto spare parts were sold in that year. and costing will include 40000 units not on 30000 units .In other words, a loss of 10,000 auto spare parts along with additional cost consumed by the marketing and advertisement, sales and purchase department clearly highlight that the traditional budgeting has failed to accommodate the external changes and their influence on the internal generation of units. More recently, the emphasis has been given to increase the use of knowledge in manufacturing environment along with enabling service type environment; and this has mainly caused by the increased influence from the capital markets, representing the shareholders for organizations, for improving their budgetary allocations and provides effective control to their budgeted estimations (Ryan, 2007). However, such external pressures are not going to be easily incorporated in the budgetary processes as still many organizations are too much relying on the use of the traditional budgeting. On the other hand, the use of activity based management and its attached subsequent applications have largely enabled the organizations to switch over to this costing system capable enough to enable them to avoid the effects of the traditional budgeting process. Conclusion Traditional budgeting has inherent limitations. First, it is purely based on the concept of addition or reduction in which the previous year’s budget is either added or reduced for developing the subsequent year’s budget. Additionally, this type of budgeting activity has budgetary slack issue which enables the budget developer to provide easy and achievable budgetary targets. The traditional budgeting does not use the cost-benefit analysis for assessing the usefulness of certain budgetary targets besides heavily relying on the use of previous year data. Moreover, the external considerations are not included while developing a traditional budget. Numerous external changes such as change in political, economic, social and financial aspects, directly affect the budgetary targets and decisions. In order to avoid the inherent limitations of the traditional budgeting, the use of activity-based budgeting is needed as the shareholders and capital markets have become more concerned about the budgeting process and its subsequent ramifications for overall performance of organizations. References Cokins, G. (2001). Activity-Based Cost Management: An Executive’s Guide. New York: Wiley. Dutta, M. (2009). Cost Accounting: Principles and Practice. New Delhi: Pearson. Griff, M. (2014). Professional Accounting Essays and Assignments. United States: Miracel Griff Publication. Hansen, D., Mowen, M., & Guan, L (2009). Cost Management: Accounting and Control. Ohio: South-Western. Hilton, R.W., Ramesh, G., & Jayadev, M. (2008). Managerial Accounting: Creating Value in a Dynamic Business Environment. 7th ed. New Delhi: Tata McGraw-Hill. Horngreen, C., Sundem, G., Stratton, W. O., Schatzberg, J., & Burgstahler, D. (2009). Introduction to Management Accounting. 14th ed. New Delhi: Pearson. Lalli, W.R. (2012). Handbook on Budgeting. New Jersey: Wiley. Otley, D. (2001). Extending the boundaries of management accounting research. British Accounting Review, 33, pp.243-261 Riahi-Belkaoui, A. (2002). Behavioural Management Accounting. Connecticut: Greenwood Publishing. Rich, J., Heitger, M., & Hansen, D. (2012). Cornerstones of Financial and Managerial Accounting. 2nd ed. Ohio: South-Western. Ryan, B. (2007). Budgeting, the individual and the capital market: a case of fiscal stress. Accounting Forum, 31, pp.384-397 Steiss, A.W., & Nwagwu, E.O.C. (2001). Financial Planning and Management in Public Organizations. New York: Marcel Dekker. Toit, E.D., Hopkins, A., Oosthuizen, A., Qua-Enoo, G.A., & Smith, C. (2007). Fresh Perspectives: Cost and Management Accounting. Cape Town: Pearson. Vander-Stede, W. A. (2000). The relationship between two consequences of budgetary control. Accounting, Organizations and Society, 25, pp.609-622 Wildavsky, A. (2001). Budgeting and Governance. 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