Accounting and Managment - Research Paper Example

1. Introduction You don't need a survey to tell you that finance executives don't like budgeting, but what the research does show is just how much. Making a budget is an exercise in minimalisation. You're always getting the lowest out of people, because everyone is negotiating to get the lowest number. There are a number of reasons why budgets are so disliked and add so little value, a few of which are outlined below: TASK 1 Time consuming: Some larger entities believe that their budgeting process can take up 20% of senior management's time, and take up to 5 months to complete. Stephen Hansen 2003. Within the public sector, political decisions also have to be made on how to raise and allocate the resources. Coombs & Jenkins (2002) Costly: For a better idea of the real cost of budget preparation, consider a company where 160 employees devote time to some aspect of budgeting. At an average cost of approximately $105,000 per employee, the company s annual cost of budgeting is nearly $17 million. Van der Stede (2003) Are irrelevant to today's environment: Budgets are developed and updated too infrequently. In today's turbulent business environment, the budgeted numbers could change daily and, as a result, the budget would be out of date before the financial year has even begun. (Barr, p38) Inflexible: Budgets are too reactive and inflexible and are a barrier to change. There are very few companies that actually update their budget during the fiscal year, purely because it is too complex and time consuming. Management and governments also spend very little time each month working on strategy, as most time is spent on data collection, reconciliation and accountability for public funds. Niskanen (1971) Internally focused: Jeremy Hope and Robin Fraser (2003) argue that budgets focus on cost reduction and not value creation. Budgets focus on internally generated targets that are comfortably achievable by you, but appears difficult to your superior. This breeds sub-optimalisation and does not promote growth of shareholder value. Production oriented: According to Stefan Sering and Maria Goldbach (2002), the traditional budget was developed in the manufacturing era where production costs and revenues were predictable, whereas today, an event such as 9/11 can change the way you do business at the drop of a hat. Concentrate on numbers: In the form of incrementalism-where the previous year's appropriation is the starting point for budget formulation, with negotiations focused on increments or decrements, state budgets. It is quite evident that while making budgets, the emphasis is on numbers and cost cutting. Aaron Wildavsky (2001). Does not include non financial information: The budget structure does not reflect changes in the company's organization and processes, and people were budgeting many costs largely under someone else's control. Hope and Fraser (2003) argue that front line managers are unable to regulate their own performance and financial planning processes. And therefore individual behaviours are not better aligned with corporate strategy. They don't reduce costs but protect them. This comes from the age old "use it or lose it" mentality. Staff knows that if they don't use a budgeted expense, it will get pulled from the next year's budget as management sees it as unnecessary especially in the public sector. Any unused balances are cut from the next annual budget. Brimson, Antos and Collins (1999). They encourage managers to play games with it. Budgets can encourage 'gaming' and perverse behaviour. Finance managers are more than familiar with "managing the slack" and making the budget "presentable" to the board. This, however, creates a culture of dishonesty and can lead to greater troubles such as fraud. Jensen (2001) They are results oriented. According to Hansen and Mowen (2006), when budgets are resource driven rather than output driven, then managers concentrate on resources and may fail to see the link between resources and output. When the need arises for cost cutting they make cuts on things like research and innovation which are important. They create an effective floor for costs. Out of precaution, few managers ever spend substantially less money than their budget allows, especially when budget relies heavily on historical expenditure as mainly seen in government budgets. Wanna, Jensen & de Vries (2003) Traditional budgets over emphasize variance analysis. In highly unstable environments, it is not surprising that actual outcomes do not fit one-year-old budget data, so the time to search for the reasons of variances afterwards might better be used elsewhere. Jacobs (2003) They reward mediocrity and punish risk-taking. If budget attainment instead of absolute success is rewarded, then a manager will try to maximize the possibility of meeting the budget instead of maximizing the company's shareholder value. Ingram, Albright & Hill (1997). Budgets are bureaucratic and hinder creativity. Front-line employees are bound to top-level decisions, even if they see that these are already obsolete. They cannot pursue their own ideas. Niskanen (1971) TASK 2 Working with budgets as practiced in most corporations should be abolished. That may sound like a radical proposition, but it's merely a step in a long running battle to change organizations from centralized hierarchies towards developed networks. Most of the other networks are in place. Firms have invested huge sums of money in quality programs, IT networks, process re-engineering and a range of management tools including balance scorecards, activity accounting, etc. But they are unable to realize the new ideas, because the budget, and the command and control culture it supports, remains predominant. Beyond Budgeting (BB) is an alternative that is more adaptive and devolved. It defines a set of principles that guides leaders towards a new management tool that is lean, adaptive and ethical. The BBRT (Beyond Budgeting Round Table) was developed in 1998 by Thomas Boesen and Bjarte Bogsnes in response to growing dissatisfaction, indeed frustration with traditional budgets. The BBRT community successfully addressed 3 major questions: 1. Is there an alternative to budgeting Yes 2. Is there a better management model Yes 3. How should it be implemented This is our main focus now. Because of the above questions, Fraser and Hope came up with the 12 principles of beyond budgeting. Leadership Principles Customers: To focus everyone on improving customer outcomes, not on hierarchical relationships. Organization: To organize as a network of lean, accountable teams, not around centralized functions. Responsibility: To enable everyone to act and think like a leader, not merely follow the plan. Autonomy: To give teams the freedom and capability to act; do not micromanage them. Values: To govern through a few clear values, goals, and boundaries, not detailed rules and budgets. Transparency; Promote open information for self management; do not restrict it hierarchically. Process Principles Goals: To set relative goals for continuous improvement; do not negotiate fixed performance contracts. Rewards: To reward shared success based on relative performance, not on meeting fixed targets. Planning: To make planning a continuous and inclusive process, not a top-down annual event. Controls: To base controls on relative indicators and trends, not on variances against plan.. Resources; to make resources available as needed, not through annual budget allocations. Coordination: To coordinate interactions dynamically, not through annual planning cycles. When the Beyond Budgeting Round Table (BBRT) was established over ten years ago its vision was to find steering mechanisms that could replace budgeting and help to make organizations more adaptive to change. But its members quickly realized that management processes (the way we set goals, strategy, plans and budgets, allocate resources, coordinate actions, and measure, reward and control performance) with budgeting at their core were not neutral in terms of management thinking and behavior. In fact, these processes were designed to enable leaders to command and control the actions of front-line people. Head office did not want managers to think or act on their own. In fact, they didn't want any surprises. So if leaders now wanted managers to be more responsive, innovative and ethical, what did they need to change The answer was not about fixing a few problems. It required a new way of thinking about management. It meant designing a new coherent management model. Over the past ten years studies have been made about many organizations that have changed their management models and built organizations that are not only more responsive, innovative and ethical but also operate with lower costs and consistently beat their peers on a wide range of indicators (what we call 'beyond budgeting' organizations). When common threads were looked at, it was seen that their leaders had adopted a clear set of guiding principles underpinned by innovative management processes. These two elements were in harmony with each other and were in stark contrast to the traditional 'command and control' model that most organizations still use today. While many of the early cases had visionary leaders with deeply held beliefs who had implemented these models from the inception of the business, others had brought in such leaders to turnaround their failing organizations. More recently, the 'beyond budgeting' community has spawned many transformation cases and the authors of this principle have been learning with their leaders what actions are required to change management models. There is of course no 'one-size-fits-all' recipe but there are clear guidelines that successful transformation cases have followed. Some of the success cases are Toyota, Nucor Steel, Southwest Airlines, etc Clear Purpose They all have a clear purpose that is greater than short-term shareholder value (though they create lots of that as well). They operate with simple structures, flat hierarchies and peer-to-peer networks. Everyone can see the same information at the same time. Front line teams are trusted to analyze and interpret information (that is totally transparent) and make decisions. The management control bureaucracy has been dismantled as information is now integrated into the work of front line teams. There are no negotiated targets as everyone is striving to improve their performance relative to their peers or some other benchmark. They satisfy customers at the lowest cost and generate minimal waste. And accountability and rewards are shared around the whole organization. Everyone is in the same boat heading in the same direction. Failure to understand and emulate success Competitors have repeatedly tried and failed to understand and copy the success formulae of these organizations. In a recent IBM study, 65 percent of the world's top corporate CEOs declared that due to pressures from competitive and market forces, they plan to radically change their companies in the next two years. But most will repeat the same mistakes as before. They will focus on 'fixing' the parts rather than the whole. They will spend huge sums on project-driven change initiatives supported by tools and IT systems that will fizzle and then fade. Few will understand and copy what is truly innovative about these organizations - their management models. The actual framework for implementation of the Beyond Budgeting model is described on the basis of figure 1. As shown in the following diagram, the new Borealis management system delivered the capabilities of the traditional annual budget (inner box) while also providing a much broader set of capabilities 1. Rolling Forecasts Rolling forecast was used to replace the traditional high level financial and tax planning. Each quarter, Borealis generated rolling forecasts for the next five quarters to give a clear simple picture of anticipated financial performance with regular reviews. The concept of rolling forecasts takes up an idea from production planning: to plan only the next period of time in detail, whereas later periods are planned rather roughly. In the words of Paul R Niven: 'managers are more likely to support rolling forecasts since they provide them with much needed flexibility in taking advantage of new opportunities that arise. Often an organization will spot an opportunity mid year, but the set in stone budget, which has already allocated every penny of discretionary spending, won't allow for the funding of what could turn out to be a competitive advantage for the firm.' This is one of the key advantages of rolling forecasts. Also they are a powerful device of coping with an increasingly uncertain environment. As seen in the case of San Diego Zoo, which had to divert resources from other programmes, in order to combat Newcastle disease that threatened the birds in the zoo. Paul R Niven (2006) However, difficulties arise, as soon as these forecasts are also used to assess individual performance (problem of gaming behavior). Other disadvantages of rolling budgets are: Rolling budgets are time consuming and expensive as a number of budgets must be produced during the year. "Managers are required to be constantly planning, re-evaluating and revising to meet the established goals,'" Alexander et al (2009). The volume of work required with each reassessment of the budget can be off-putting for managers. Each revised budget may require revision of standards or stock valuations which is time consuming. According to Colin Drury (2008), rolling budgets create uncertainty for managers because they are constantly being reviewed. 2. Balanced Scorecard (BSC) The BSC models financial as well as non-financial measures, their connection among one another and their relation to vision and strategy. Borealis used the BSC to communicate strategic objectives and measures to employees. Furthermore, it emphasis strategic learning and an overall feedback process. The benefits of the BSC are as follows: It encourages employees to set personal objectives that would be linked to corporate strategy. Rather than communicate corporate performance through budgets and variances, the company now tracks performance against key performance indicators related to the business. In the words of Kaplan and Norton (1992), "The balanced scorecard does not have the control bias that traditional measurement systems have. It emphasizes strategy and vision, not control. The balanced scorecard approach is consistent with the concepts of cross-functional integration, customer supplier partnerships, global scale, continuous improvement and team accountability". Before the balanced scorecard was established, one of the key ways of determining whether a particular strategy was working was to use financial measures, but these usually reflect the results of past actions and say very little about future performance. By complementing these financial measures with measures from the perspective of the customer, internal business, and learning and growth, a firm can track its progress towards meeting its objectives and future performance goals better using the balanced scorecard. Allan Afua (2009) But as soon as it is misused as a budget replacement (by performance contracts on certain figures in the BSC), it is subject to the same sort of problems as traditional budgeting (especially gaming and calculated under-estimation of realistic goals). Other problems experienced by organizations using BSC's are as below: The BSC is not a quick fix: it takes considerable thought to develop an appropriate scorecard for example the organization has to first come up with a comprehensive strategy. "An ill defined strategy produces a vacuous scorecard. While communication can commence within a short time, the complete implementation should be staged" Dr. Robert Davies The BSC is a set of measures not a strategy. In the words of Allan Afua: "While it enables managers to track the performance of a strategy, it does not say what the strategy is a how it could be improved. The framework says very little about the activities that are driving a firm's performance and why the activities are indeed responsible for the performance." 3. Controlling fixed Costs (Activity Based Budgeting-ABB) Under the former budget process, Borealis controlled capacity-related (fixed) costs through budgets and variances for each expense line item. Borealis replaced the budget line-item expense and departmental cost controls with activity-based budgeting (ABB). The basic logic in support of activity-based budgeting models is that the costs and benefits of various activities can be most clearly seen where the activities are undertaken. Baker (1998) Activity-based budgeting models allow both the local leadership and the central administration to envision both budget opportunities and potential budget threats. For example, according to Paul N. Courant, Associate Provost of the University of Michigan, if a school is losing enrollments, an activity-based system calls the problem to everyone's attention immediately. Activity based Budgets according to Jan de Sutter (2004), are a detailed understanding of an organization's costs, increased control over expenditures, and an improved understanding of the links between processes, activities and costs. It also encourages a healthy discussion of issues and cost drivers during budget reviews. It's interesting to note that most of the potential problems with activity-based budgeting derive directly from its strengths as below: The idea of this concept is convincing, but as many companies found it even difficult to implement activity-based costing, few took the step to introduce the more complicated system of ABB. This type of budgeting requires implementing the steps of activity based costing which are quite complex and difficult to put in place.Venkataraman (2008) By providing support for activities that are directly attributable to individual units within the organization (Courant 2000), there exists the possibility that activities where such attribution is difficult or contested will be under-supported. Many vital parts of the organization may not possibly survive based on revenues that they generate directly. 4. Decentralized investment management Under decentralized investment management, Borealis eliminated centralised capital budgets and gave decision making and control to the managers and employees who were closest to the marketplace and customers. Small investments could be approved by the division, plant and function that proposed the project. Borealis tracked the cost of these small investments as a component of the twelve-month moving average of activity-based costs. Medium sized investments had to exceed a hurdle rate that corporate management set each period in accordance with the financial projections from the five quarter rolling financial forecast. Investment level Hurdle rate % The largest investment projects were approved centrally by the executive board. The benefits of this method are discussed as below: It encourages diversification, across managers, of strategies used and it also generates alpha to exploit the skills of specialist active managers with superior knowledge of a particular asset class. Sharpe 1981, van Binsbergen et al (2009) It also induces yardstick competition among multiple managers and brings benefits of higher effort levels exerted by these managers Shleifer (1985) One problem identified with this method is that decision objectives of employees and customers may not be identical to those of the headquarters or top management. B.Obel and J.V Weide (1979). Task 3 The New Castle local government waste management service has not implemented beyond budgeting because the local government still operates on the traditional annual budgets and methods of financial forecasts. Policies and plans are very much centralised and divided by the Central government. Resources too are controlled and allocated by the Central government. Below we discuss the beyond budgeting model in relation to the local council of Newcastle in four parts: Non financial Indicators Controlling Fixed Costs Rolling Forecasts Investment Management The Balanced Scorecard can be used to communicate strategic objectives and measures to employees using the illustration below. STRATEGY PERSPECTIVE OBJECTIVES MEASURES In order to achieve efficiency, the council has made sure their budgets don't run in deficits and that the money allocated to each project is used specifically for that project. When they are preparing the annual budgets, the council tries to minimise the council tax payable as much as possible. This in turn ensures a workable budget. It is evident that Newcastle local council' s performance is good compared to other local governments, which leaves the central government satisfied with use of public funds and also the people of Newcastle are relatively happy with its performance and efficiency. When we look at the strategy of achieving quality, the objective is to ensure that the bins are hygienic, garbage doesn't spill and that it's not infested with vermin. The council has come up with a measure of using trucks that have sensors. If the bin is too heavy or if rubbish is spilling over, the garbage won't be picked up. Also to ensure clean bins, the council recommends bio-degradable refuse sacks to the end users. This ensures that the bin collectors are satisfied with the quality of service. To meet the strategy of timeliness, the objective is to be quick at garbage collection, damping and replacement of empty bins. The council has come up with a bin collection calendar such that the end users know the collection dates beforehand. They also estimate the demand by asking people to sign up for the service, and therefore supply of bin collectors id sufficient to meet the demand. Because of this, the bin collectors are able to do a timely job. Also the bins have been divided into categories and sizes to meet the need for disposing off different types of garbage. They also have different bin sizes for different end user household sizes. In order to meet the strategy of ensuring that a bigger percentage of people benefit, the council can use such measures as the RSS online feedback so that people can write in direct and raise their issues online. Training camps can be organised to sensitise people on this service and how to use it. There is also the Special Collection Service in place to help those who miss their garbage collection schedules for one reason or another. The council also has in place the Assisted Lift Service to ensure that even the disabled or the incapacitated people, who may not be able to move their bins, actually receive the service. 2nd Part As far as controlling fixed costs is concerned, the Council continues to maintain its system of cash limited budgeting. The main feature of this is that directorate budgets are set entirely at estimated outturn level for pay and prices. The other important feature of this budget regime is that directorates are allowed to carry forward over/under spends on cash limits and trading accounts. To explain how costs are analyzed and allocated we shall take an example of salaries. The Value for Money Framework is used and it describes the principles used to assess value for money in order to price contracts. To assess 'value', they examine costs in the context of the benefits offered by each service. This balance will be different in every case. What they agree to pay will inevitably be influenced by local, political and market conditions, and by interests beyond the immediate facts of each case (e.g.: a need to preserve diversity in the market). Therefore, whilst comparison with similar services is useful for high level planning, price negotiations must be undertaken on a service-by-service basis. Rather than conducting a purely 'scientific' analysis of costs across service groups, they make individual assessments, taking in qualitative information and stakeholders' judgments. Basing on the above, it is evident that this analysis is subjective because it isn't possible to attach a price to 'value'. However, there has been a certain move towards activity based costing through recycling. BAN waste suggested to the council to sort and sell recyclate materials. This would have enabled the council to be directly in charge of the benefits as well as the costs. However, the above suggestion received criticism and R Nichols from Neighborhood Services felt that the suggestion was not a core Council activity and would be a risk for the Council to undertake. 3rd Part. In financial forecasting, traditionally the council uses annual financial forecasts and reports. It is based on the incremental approach with the comparison or starting point being last year's budget updated for inflation or growth. The financials are done at once covering the whole year and reviews are also done annually. Also it's important to note that over/underspends are carried forward to the next financial year. Rolling forecasts are a projection into the future based on past performances, routinely updated (on quarterly basis) to incorporate data. This type of forecasting has not been adapted by local government authorities because of the following reasons: Lack of commitment to change and the unwillingness of management and in particular, the finance function, to loosen central control over the budget process. It requires a huge commitment in time and resources, as well as willingness to let go of the comfort zone of well known processes and procedures. The legal requirement to produce a budget is also a reason why local council is still using the traditional budget. The presence of financial regulations which largely restrict the wirement (transfer) of funds from one budget heading to another. Also the fact that the local council is an agent of central government through whom policy is implemented, keeps them from developing their own accounting system. An attempt at incorporating rolling forecasts is illustrated with the recycling vs. Landfill project. Taking an example of LATS (Landfill Allowance Trading Scheme, forecast were made over 15 years with regular review of performance in reaching the targets set by statutory government or EC for recycling and diversion of land fill. Figure 2 Biodegradable municipal waste (BMW) Image from: www.newcastle.gov.uk/.../ns/recycling/strategies/WasteManagementStrategyandActionPlan2005.pdf - 2009-05-18 The figure shows how the Council is projected to perform against these LATS targets. From the figures, we realize that this project would produce bad results. Part 4 To understand investment management in Newcastle local council, we look at the organization structure. There are 5 major departments: The Chief Executive Office, Adult & Culture Services, Children's Services, City Service, and Environment and Regeneration. Each of these has sub divisions with directors, heads and executives in charge of different programmes. There are 78 elected councilors who decide upon the overall policies and set the budget for the different projects each year. This shows us that organization is project based and decentralized. However, as far as resource allocation is concerned, the central government is in control therefore this particular element of the council is highly centralized. All investments by the council are done through procurement procedures. Let's analyze the procurement strategy of the council to understand its investment management. Governance arrangements are in place to provide leadership and clear direction to all procurement/investment activities as below: Image from http://www.newcastle.gov.uk/wwwfileroot/cxo/procurement/ProcurementAppendices.pdf There is guidance in place on financial thresholds and regulation as below: Total Value Procurement Route Documentation Requirements Up to 5,000 Seek at least three quotations unless inappropriate -ensure good value for money is obtained. The successful quotation if oral must be confirmed in writing. All payments must be made and all Orders processed via the POP system. 5,000 to 20,000 Obtain at least three minor quotations. Quotations may be obtained orally, although officers may decide to seek three Written Quotations (if, for example, there is a detailed specification for the Contract). The selected Minor Quotation, if submitted orally, must be confirmed in writing. The successful firm must pass a risk assessment All payments must be made and Orders processed via the POP system. 20,000 (if not Minor Quotations) or 20,000 to 139,983 (if not Tenders) Seek at least three written quotations. Quotations must be sought by written means and submitted by a certain date. Quotations must be invited by, and returned to, Corporate Procurement Team, unless agreed otherwise by Assistant General Manager (Procurement) The complete list of documentation required to undertake the procurement is stated at PPR 3.15 which must be checked and dispatched by the AGM (Procurement) unless he agrees otherwise. All Orders must be processed and payments made through the POP system. A Completion Statement must be sent to the AGM (Procurement). 20,000 to 139,983 (optional) or 139,983 and above (essential) Seek a minimum of five tenders. Quotations must be invited by, and returned to, the Assistant General Manager (Procurement), unless agreed otherwise by Assistant General Manager (Procurement) The complete list of documentation required to undertake the procurement is stated at PPR 3.19 which must be checked and dispatched by the AGM (Procurement) unless he agrees otherwise. Officers must seek approval from the Legal Services Procurement Team if the EU Rules apply. The successful firm must pass the risk assessment requirements unless exempt under PPR 2.6. There must be a Formal Contract in place before the firm commences work. All Orders must be processed and payments made through the POP system. A Completion Statement must be sent to the AGM (Procurement). Any Value over 5,000 NEGOTIATION WITH ONE FIRM - follow PPR 3.21 to 3.27. The firm must pass the risk assessment and there must be contractual terms in place before the firm commences work. Officers must first ensure that any negotiation with one firm complies with EU Rules (and seek legal advice to this end) and complete an Authorization to Negotiate form. The firm with which negotiation takes place must pass the risk assessment requirements unless exempt under PPR2.6. All payments must be made and all Orders processed via the POP system. A Completion Statement must be sent to the AGM (Procurement) if over 20,000. PPR= Procurement Procedure Rules Image from: http://www.newcastle.gov.uk/wwwfileroot/cxo/procurement/ProcurementAppendices.pdf The Council has an investment strategy of achieving zero waste by treating waste as a resource and not a problem. The plan was to cut landfill to 50% by 2006/07 by expanding recycling and composting activities. This strategy had short, medium and long-term investment challenges. There are Government and EU national targets for reducing the amount of waste disposed off via landfill and increasing the amount recycled. As seen in the figure 2 discussed under Part 2, from 2010 to 2020 the Council could face significant LATS penalties if more is not done. Current national projections suggest that the cost of waste management to councils will approximately double within the next 10 years, implying that further investment will be unavoidable. In the figure below, we analyze the council's bids for external funding for the above investment requirements. Figure 3 Image from: www.newcastle.gov.uk/.../ns/recycling/strategies/WasteManagementStrategyandActionPlan2005.pdf - 2009-05-18 Key future funding opportunities from the Government are likely to be: The Recycling Performance Reward Grant, The Waste Resources Action Programme, Waste Implementation Programme New Technologies Fund (WIP) and Private Finance Initiative Funding. References 1) Abandoning traditional budgeting. By Oldman, A.; Mills, R.; Management Accounting: Magazine for Chartered Management Accountants, Nov99, Vol. 77 Issue 10, p26 2) Accountancy: Business Budgeting - Evolution or revolution, 13 October 2000, European Intelligence Wire, p. 60 3) Beyond budgeting. By Hope, Jeremy; Fraser, Robin; Management Accounting: Magazine for Chartered Management Accountants, Jan99, Vol. 77 Issue 1, p16 4) Beyond budgeting... By Bunce, Peter; Fraser, Robin; Management Accounting: Magazine for Chartered Management Accountants, Feb97, Vol. 75 Issue 2, p26 5) Beyond budgeting... 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