Budgeting a global perspective

What is Budget

A budget (derived from old French word baguette, purse) is a quantified financial plan for a forthcoming accounting period. In other terms, a budget is an organizational plan stated in monetary terms.

Budgeting is a control tool used by management developed to facilitate management in implementation of its strategies, control expenditures, undertake measures to increase revenue, plan about investments of surplus cash and arrange sources of finance to meet future obligations.

Types of Budgets: There are various types of   techniques used by organization to develop budgets with their pros and cons.

• Static/Fixed Budgeting:This technique sets inflexible(fixed)objectives for the forthcoming accounting period related to target revenue and expenses. This technique does not adapts to subsequent events and environmental factors that can affect the achievability of predetermined objectives. Thus this technique introduces rigidity and is only suitable in stable environments with very slow pace of change.
• Flexible budgeting: This technique involves setting different targets related to revenues and expenses considering various environmental factors that may be present in future and will impact the outcome for the period. This technique is more complex but is more compareable to actual outcomes for the period.
• Zero based budgeting: This technique challenges previous assumptions and estimates. It involves a vast study of factors every time a budget is set. As it involves determination of outcomes that management wants and then allocation of resources to achieve those outcomes. This approach is more relevant to service sector organizations.
• Incremental budgeting: This technique involves development of budgets based on experience adjustments to budgets of previous accounting periods. It is incremental on approach and involves experience adjustments to previous assumptions and estimates. It does not encourages detailed evaluation of factors and thus does not provokes for improvement.
• The rolling budget: It involves extension of budget to cover a similar period on expiry of a similar period so that at all times the length of period covered by a budget remains constant. It involves considerable level of resources and effort and thus it is least efficient.

Why to develop budgets

                               Budgeting is an important management tool that gives the organisation control over its future as it forces the organisation to plan for the future and avoids firefighting.It enables management to achieve its strategic objectives.The technique has following benefits:

• Planning orientation: The process takes management away from its management of operational matters and forces it to think long This is the principal advantage of budgeting as it enables the company to shape its future.
• Profitability review: It enables the management to identify the areas which are generating cash for the company and those which are milking out cash from it thus operating at loss. Thus it enables management to make important strategic decisions.
• Assumptions review: The process involves evaluation of key management Assumptions about the company. Thus company is able to adjust and adapt to environmental factors and change management style as required.
• Performance evaluation: Company is able to review its performance by comparison of actual results with budgeted outcome. Thus it enables management to identify problem areas that need improvement and those areas that are fundamental and core areas for business success. Management can then adjust its plans or take corrective actions.
• Funding planning: Management is enabled to identify its financing requirements for future and thus management can arrange sources of finance to meet its financial obligations as they arise.
• Cash allocation: Management is able to identify its surplus cash resources and hence can devise suitable investment strategies.
• Bottleneck analysis: Management can identify bottleneck resources and devise suitable plans to deal with those bottle neck resources either by capacity extension or adjusting production schedules.
• Coordination and communication:Budgeting process involves and thus improves coordination and communication between departments.It thus creates alignment between interdepartmental objectives with the aim of achieving overall strategic objective.

Budgeting in Modern Buisness environment

As early as 1992, the famous guru of management, Peter Drucker, wrote in The Wall Street Journal: "Uncertainty—in the economy, society, politics—has become so great as to render futile, if not counterproductive, the kind of planning most companies still practice: forecasting based on probabilities."

Modern day business environment is very unstable and pace of change is very rapid. Technology, law and order situation, innovation, competition are the factors leading to a continuous change in business environment. Traditional budgeting involves setting budgets for 12 months period which is not suitable in modern business as now a days business needs to be adaptive and flexible as opposed to rigidity to combat with the pace of change. Modern business requires a system that needs to be more flexible and adaptive to business environment and more flexibility is to be enjoyed by operational core so that timely actions can be taken to keep the business in competition.

Despite the reasoning behind these limitations, Hope and Fraser (1997) report that 99% of European companies use formal budgeting procedures, this figure is likely to remain high even today. In addition, a survey of US organizations by Libby & Lindsay (2007) revealed that over 50% of senior managers felt businesses could not cope without budgets and that they were imperative to success. Managers also believed that despite the associated time and costs budgets were adding value to a company. Ekholm & Wallin(2010) feel the annual budget is not dead yet, but it is past its peak and has lost usefulness and become outdated.

How Budgeting can cope with modern buisness requirements

Modern day business strategist are introducing a new concept named as “Beyond Budgeting, to cope with the rapid pace of change and unstable business environment.

The Beyond Budgeting Round Table (BBRT), a network designed to transform the traditional budget system, studied 14 companies without budgets or almost without budgets and from this they produced 12 guiding principles to Beyond Budgeting:

1. Measure performance against the competition, not internal targets.
2. Motivate employees by empowerment.
3.  Delegation to divisional managers allows them to take responsibility.
4. Give operational managers independent access to resources.
5. Create customer focused teams.
6. Provide transparent information sharing across the organization.
7.  Set targets on external benchmarks.
8.  Rewards in line with beating the competitors.
9. Allow managers to be involved with strategy planning.
10. Grant management access to local resources.
11. Coordinate the internal use of resources.
12.  Performance measurement information should be available freely.(Daum, 2002)

Other responses of the supporters of the budgeting process is to use better budgeting techniques. Better budgeting techniques are more flexible and adaptive as they introduce areas like flexible budgets, roll forward budgets, zero based budgeting. These techniques adapt to business environment, question previous assumptions and estimates, are adjusted frequently with shorter time periods, involves the input of operational core in setting up budgets and carrying out frequent performance evaluations.

Budgeting and behavioural aspects

As budgets are to be implemented by humans the success of the budgeting process can be significantly impacted by human factors. We need to worry about how the budgets are set, the targets set are they “SMART, what happens if budgeted targets are not achieved, the attitude of senior management towards budgets, political factors involved, will employees be held responsible for factors beyond their controls, compensation related to the achievement of budgets, how to reconcile the pressure to achieve short term goals with ambitions for long term goals.

A budget is a target and aiming towards a target can motivate employees, encourage team work, create goal congruence(by linkage of compensation and rewards with achievement of organization’s objectives).Employees have different perceptions of targets but it is thought that if (a)targets are too low employees will not be motivated to work hard(b)targets are too tough or unachievable employees can be demotivated as they believe that they are going to fall short of targets set for them. So the objective is too set targets that can motivate employees to work hard to achieve objectives that are balanced neither too tough nor too low.

 The relationship between budget difficulty and actual performance is typically represented in the picture attached below:

• ¤ When the budget is very easy, actual performance is low. It has been pulled down by the low demands made of employees.
• When the budget is very difficult, actual performance is low. Why try when you are doomed to failure?
• ¤ When a budget is set at the level of the expectations (the best estimate of what performance will actually be), employees are likely to perform as expected.
• If a more difficult aspirational budget is set, employees will try harder, and if the budget is judged just right then their actual performance will be at its maximum, though often falling short of the
  
  budget.                              

Thus budgets need to be carefully designed to be source of motivation and goal congruence rather than being demotivating factors.

Participative or Authoritative

There are two main approaches towards setting up budgets each suitable in different circumstances.Participative budgets involves input from employees while setting up the budgets while on the other hand authoritative budget is a top down approach where senior management develops the budgets and simply communicates the budget to employees regarding what they are expected to achieve.

Participative budgets: This technique involves discussion among employees and management about the targets to be set for forthcoming period.As employees are involved there is likely to be ownership of targets et and thus motivation to achieve those objectives.

This approach is only relevant where employees have the required skills to participate and give their inputs related to development of objectives.

Authoritative budgets: This technique involves little or no involvement of employees in setting up budgets.Senior management develops budgets and informs lower level employees about targets to be achieved.

This approach is suitable where lower level employees are not qualified enough to participate in the development of objectives.

 Conclusion: Budgets are a tool used by management to control the use of resources and monitor expenditures and revenues for forthcoming accounting period.They assist management in achieving its strategic objectives.However to be successful in modern buisness environment they need to be carefully developed to be effective.Budgets need to be developed carefully to enable the organisation to cope with modern buisness environment and act as a motivating factor for employees.