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

Introduction A formal attempt to describe the budgetary control is to consider it as a process that involves planning, coordinating organizational activities and controlling organizational departments. The idea is to accomplish certain pre-specified organizational goals by incurring the least possible expenditure (Buckley and McKenna, 1972). The extensive use of budget in corporate organizations is rooted in the fact that it is a comprehensive tool for monitoring organizational activities and addressing critical factors in business (Otley, 2001). The concept of using models of traditional budget is now under extensive debate owing to the restrictions that they impose on managers. The main proponents who describes the idea of budget as a highly rigid one complains that discarding the budget for a corporate organization will ultimately change the organization from being a central hierarchy to a well developed network that can more readily adjust itself to the market forces. In order to explore this argument, factors which cause researchers to challenge the concept of formal budgets in the organization are discussed. The impact of capital markets on organizations and the redundancy of the budgetary controls are to be focused. Discussion One of the biggest supports of strict budgetary controls can be found in the works of Otley (1978) who had established that maintaining strict budgetary control is not essentially expensive for an organization. This is because; focusing strongly on the budget ultimately results in obtaining stipulated results. Others who have supported the notion of strict budget control in an organization are of the view that formal budgets are likely to perform in an efficient manner only when the external environment is relatively stable and there are no fluctuations (Hansen, Otley and Van der Stede, 2003). The business environment is no longer stable and is actually shaped by interaction of multiple forces which are dynamic and are constantly evolving. The interactions of business organizations have increased with the capital market. Money flows from the capital markets into the projects of any organization and the project in turn generates income for the firm. The money that is generated by the organization is used by the firms in order to repay the loans and provide returns to the shareholders. This makes the firm liable to the capital market. The concept of creating capital budgets is related to investing of the firm’s surplus in projects which have a net present value. However, the concept of market timing is related to benefits that can be accrued by firms in case there is wrong pricing by investors (Govindarajan, 1989). In a research that has been conducted by Froud, Johal and Leaver (2006), certain factors have been noted which highly emphasize the role of the capital market in business enterprises. He noted that in the new era both human assets and technology have become highly mobilized, and loyalty that shareholders had towards the organization are no longer reliable. Under these circumstances having a budget plan for a time horizon of one year can be treated as rigid and outdates. Riley (2000 cited in Power, 2007) has noted that under these changed circumstances organizational budgets should be treated as a type of communication strategy between the capital markets and the organization itself. Capital markets no longer demand companies to very high performance standards regarding their dividends but their ability to earn higher value on future. This is because ability to earn higher value is directly related to the future share price of the company (McSweeney, 2006). This sentiment has been strengthened in the works of Allen (1998) who had pointed that fast changes that occuring in business environment made traditional budgetary mechanism useless. The capital markets have become highly demanding and this requires business to be more accountable and report in a timely and accurate manner to explain the deviations between actual and forecasted values. A significant amount of external pressure comes from the expectations of the shareholders. Shareholders have become highly interactive and they demand immediate information on the key performance indicators (Ryan, 2007). Another concept which has become very important in today’s time is the concept of budget slacks. Originally budget slacks has been described as “sources or efforts” that are unlikely to have immediate outcomes on the organization (March, 1988). In this regard, the research conducted by Van der Stede (2000) is highly informative as it has focused on interaction between the short-term outlook that managers have and the budget slacks. The work of Van der Stede (2000) had followed the framework of the influential paper that was used by Hopwood (1972). The findings of Van der Stede (2000) suggests that the type of budget mechanism that is used by organizations are largely dominated by two main factors namely the way in which the business have performed in the past and the competitive strategy that is followed by the management. Results from his study have clearly shown that the overall performance of a business enterprise is positively affected if it does not resort to very strict controls of budget. This suggests that creating slacks in the budget and the long-term business strategies of managers are not completely incompatible. The works of researchers like Wallander (1999) had shown that budgetary tools were important for an organization because they were effective in addressing impressive returns on equity. Over the years the alterations in capital markets have changed the competitive scenario that are being faced by business and the information that is being provided by budgets are no longer significant. Samuelson (1986) echoes the idea that has been propagated by Wallander (1999) by saying that the life cycle of products and services has become relatively shorter in the present context and it is no longer relevant to follow the annual budgets as it has a long time horizon and underlying assumptions may change during the specified time period. Traditional budgetary controls of organizations do not have provisions to accommodate the ongoing changes and this causes the major problem. The research conducted by Daum (2002) has shown that traditional budgets often prevent the managers to take corrective actions when the conditions in the capital market changes. The research conducted by Hope and Fraser (2003) had pointed out three main factors which often makes budgeting a difficult issue. Firstly, the process of preparing the budget is a lengthy one and it does not add value to the organization per se. Secondly, while the budget mainly focuses on the internal strengths and resources that an organization has but it does not concentrate on the external forces and this makes it a weak management tool. Finally, budgets prepared on the basis of fixed contracts are not reliable because they do not focus on the consumer demands. Most importantly changes in the economic conditions and conditions of entrepreneurship have put increasing importance on information that is circulated in the capital markets. Traditional models of budgeting and financial statements published on traditional data fails to capture subtle changes in the market and this is particularly problematic (Dechow, Hutton and Sloan, 2000). In today’s world, it has become mandatory for the business organizations to monitor the performance of the organization against premeditated objectives and provide greater analytical insights that can drive the decision making process. This is required to create a positive image of the firms in the capital markets. The pressure is further intensified by the pressures that are imposed by regulatory body who wants greater transparency in the information that is being reported (Ajinkya and Gift, 1984). Numerous examples are abound regarding the fact that strict budgetary controls are particularly bad and can lead to total collapse of an organization. For instance, the case of WorldCom can be cited as a spectacular example where the excessive control in the form of organizational control perpetuated into the fall of the organization. In case of WorldCom the corporate governance of the organization had focused heavily on the fact that every member should be able to do their job by limiting themselves within the budget. Other examples include that of Enron and Barings Bank which have followed strict budgetary controls but were not able to maintain their position in the market. In a recent article that has been published in the Harvard Business Review it has been purpose that the concept of budgeting is almost self-defeating because in an attempt to track the changes in the market traditional budgeting mechanisms actually makes the frontline employees powerless, delays sharing of useful information and finally reduces the speed with which companies can react to the changes (Hope and Fraser, 2003). A natural question comes to the mind that if companies are finding the use of traditional budgets non-useful then how can the situation be improved? One of the popular approaches that are now being followed by the company is setting long-term goals which will depend on factors like return obtained from the capital. Researchers have observed that it has become the imperative of companies to set some useful key performance indicators like customer satisfaction, flow of cash, quality of products, cost ratios and the profits recorded by firms (Hope and Fraser, 2003). A leading example in this case would be the Borealis which is a petrochemicals company based in Vienna have set its long-term goal to reduce the fixed costs. Some researchers are also of the view that the use of key performance indicators is a process of self-regulatory approach for the employees who works in the lower levels which improves overall efficiency of the organization. Examples of few companies who do not prepare budgets any longer but have still managed to outperform their rivals are Svenska Handelsbanken and Ahlsell (Hope and Fraser, 2003). These companies have abandoned the system of budgeting but have been able to respond to changes in the market trend and this has allowed them to improve their customer satisfaction. Ekholm and Wallin (2000) has suggested that one of the alternatives for companies is to adopt a method of “rolling forecasts” which is a highly flexible process and involves continuous process of updating key performance areas. In such methods the management mainly devises three main areas which are planned namely setting of reasonable targets, devising flexible performance indicators and optimal resource allocation. Major oil companies in Norway have abandoned their traditional budgeting techniques and moved to a relatively new concept called beyond budgeting. The focus is to integrate the best practices of the finance and the human resource departments, to enhance their responsiveness in accountability to the shareholders and improve their image (Østergren and Stensaker, 2011). The most prominent benefits of following this type of organizational policy are that the investors can know what to expect of the company and they can trust their money with them. Conclusion The changing economic times coupled with the forces of globalization have greatly altered the ways business enterprises operate. In this regard, it has been found that the traditional wisdom of creating elaborate budgets on a yearly basis is not only feasible but also not desirable. This entails that the use of stringent budgets should be immediately changed by organizations. Changes in the capital markets cause high anticipation among the investors and they expect a certain degree of transparency in the process of reporting of the firms. Successful companies in the contemporary era like Norwegian oil companies, Svenska Handelsbanken and Borealis have abandoned their process of annual budgeting and replaced this system by a flexible form of target setting approach best described as rolling forecasts which have provided them with considerable amount of benefits against their competitors. The most important requirement for organizations in the present era is to become more accountable to the external stakeholders and traditional budgets are unable to account for changes in the market. So, if firms continue to invest in elaborate budget plans then it is unlikely for them to retain confidence of stakeholders ultimately resulting in bankruptcy. Reference List Ajinkya, B. and Gift, M., 1984. Corporate managers’ earnings forecasts and symmetrical adjustments of market expectations. Journal of Accounting Research, 22, pp. 425–444. Allen, D., 1998. Variations on a theme. Management Accounting, 76(9), pp. 58–60. 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