Budgeting: Discussing Various Methods

Abstract

This paper discusses the various budgeting models namely the traditional budgeting model, the zero based budgeting model and the activity based budgeting model.

The paper discusses the advantages and disadvantages of each model, and gives a suggestion on the business environment under which each model would be most appropriate.

The paper also gives a conclusion whether any of the models is superior to the others.

Discussion of various budgeting models

Traditional budgeting model

Ann Irons notes that the traditional budgeting model, also known as the incremental budgeting approach, is a method of budgeting where managers adjust previous year’s figures for growth and / or inflation, plus or minus any significant changes in expected results, so as to come up with the current year’s budget. This method is the most common among financial institutions.

There are several ways of carrying out the traditional budgeting model but there are two extremes, which are:

The bottom-up approach

Under this approach, a central department reviews and consolidates budgets that have been prepared by unit managers. This central department suggests modifications which are discussed and considered before the final budged is drawn.

The top-down approach

Under this approach, an initial budget with targets for each unit is prepared by a central department, and then expanded into a detailed budget by unit managers.

Regardless of the approach adopted the performance levels that are considered achievable by unit managers usually differ from the expectations of senior management at the centre, bringing about a planning gap that may take a lot of time to eliminate, but this has to be achieved through negotiation, otherwise the unit managers may disown the budget.

Joshi, PL, Jawahar Al-Mudhaki; Wayne G Bremser note that most companies in Baharian use the traditional budgeting model.

Benefits of traditional incremental budgeting

Traditional incremental budgeting has the following advantages:

1. It is easy to prepare and understand.
2. It is less costly because it does not require any special software, and also does not consume a lot of time.
3. It promotes consistency within the organization since the same system is used, thus reducing conflict among the managers.
4. It is easy to trace any changes to their causes.

Gregory Nolan notes that it is important to replace annual budgeting with frequent performance forecasts, because traditional budgeting has the following weaknesses:

1. The traditional annual budgeting is a painful process, and is a headache to every manager involved.
2. The traditional annual budget has a short term focus, and lacks the long term vision.
3. The traditional annual budget has the pain of bottom-up and top-down.

The traditional annual budget is based on the general ledger, and fails to budget profitability.

The traditional budgeting model is more appropriate for organizations which operate in a stable environment.

Zero Based Budgeting

Accounting for management.com notes that Zero Based Budgeting is a budgeting technique which requires managers to justify all items on their proposed budgets, regardless of whether the same items have been on previous years’ budgets and actual expenditure.

Zero based budgeting is more appropriate for organizations which operate in a stable environment, particularly nonprofit organizations such as governments and charitable organizations.

Strengths of zero based budgeting

Michael LaFaive notes that Zero based budgeting has several advantages, such as:

1. Zero based budgeting results in reduction of costs and improved services, since all costs must be justified.
2. zero based budgeting Makes the managers more aware of the limited resources that they are budgeting for at the time when they are developing budgets;
3. zero based budgeting ensures that the managers do not feel that they are entitled to increase costs in the budget, thus making them strive to improve operations at minimum cost;
4. When reviewing the budget, it gives more meaning to budget discussions;
5. zero based budgeting ensures that resources are allocated on the basis of needs and potential benefits from those needs, thus resulting in efficient resource allocation;
6. zero based budgeting minimizes the occurrence of inflated forecasts, since all requests must be justified;
7. In organizations where output cannot be easily quantified, such as in the service industry, this approach to budgeting ensures that only expenditure which adds value to the organization is endorsed;
8. zero based budgeting motivates employees by giving them the responsibility of coming up with their proposed expenditure and justifying the same;
9. zero based budgeting ensures that communication within the organization is effective, and that every member is working towards the same objective;
10. zero based budgeting ensures that no resource is wasted, and that obsolete operations are not funded;
11. Zero based budgeting encourages managers to identify areas where costs can be reduced outsourcing some operations at lower costs.

Limitations of zero based budgeting

The following are the disadvantages of zero based budgeting:

1. Zero based budgeting makes the budget preparation exercise more expensive and time consuming;
2. Zero based budgeting may be seen as an overreaction since it provides a solution that is too radical for the problem.
3. Zero based budgeting needs a great level of commitment by all involved to ensure that it is done properly; otherwise it may worsen the problem.
4. Zero based budgeting may discourage activities which cannot be easily justified, but which are very crucial for the survival of the organization, such as research and development.
5. If this technique is not clearly understood by all managers, its implementation may not succeed. This means that the organization has to spend some resources on managers’ training before the system can be implemented.
6. The technique may not be appropriate for large organization since it involves a lot of documentation, and summarizing the information may lead to loss of vital data.
7. Managers who are naturally extravagant may still overspend, thus wasting the efforts of their colleagues who are honest.

Zero based budgeting is appropriate for organizations operating in all environments, whether stable or dynamic.

Service-level budgeting

This is a modification of the zero-based budgeting technique, which bases the level of expenditure on the services to be performed.

Instead of spending a lot of time on justifying expenditure requirements that the organization cannot operate without, as is the case with zero-based budgeting, Service-level budgeting starts at a base that is higher than zero, such as 80 % of the current level of expenditure. Additional requests beyond the set level would then have to be justified. Funds can also be allocated to new projects so long as they are justified.

Activity based budgeting

Eric Flamholtz notes that Activity based budgeting refers to allocation of resources to activities based on the proportion of costs incurred by each activity in every function of the organization.

Islam Majidul and Jeffrey Kantor note that most organizations in China are moving towards the Activity based Management, which includes Activity based budgeting and Activity based costing.

Strengths of Activity based budgeting

Teresa Aira notes that Activity based budgeting has several advantages, such as:

1. Activity based budgeting is very easy to understand.
2. Activity based budgeting facilitates decision making by managers based on facts.
3. Activity based budgeting promotes projects which offer the best returns, while denying resources to projects which do not add value to the organization.
4. Activity based budgeting enhances accuracy of budgeted information on each activity which requires resources.
5. Activity based budgeting encourages entrepreneurship among managers by allowing them to manage the level of reinvestment in their respective areas. This ensures that the competitiveness achieved by the organization is sustainable.
6. Activity based budgeting enables the organization to set justifiable prices.
7. Activity based budgeting minimizes allocation of resources to activities which cannot be traced to any specific product.
8. Activity based budgeting enables managers to identify ways of improving each segment of the organization.
9. Since the primary focus is on the products, Activity based budgeting improves customer satisfaction.
10. Activity based budgeting enables managers to understand each segment of the business.
11. Activity based budgeting encourages teamwork among all employees.

Limitations of Activity based budgeting

The disadvantages Activity based budgeting are as follows:

1. Activity Based Budgeting may be very costly to Implement and maintain because it can only be run on special software for Activity Based Budgeting, and in order for it to succeed, all managers need to be trained on its operation.
2. In order for it to work, people must have a thorough understanding on the drivers of their budget, thus requiring a lot of time to set up.
3. Activity Based Budgeting requires an accurate estimation of activity volume by everyone involved, otherwise the allocations will be wrong.
4. Managers may be de-motivated by Activity Based Budgeting because it gives them large volumes of information which they are required to understand in order for the system to work.
5. It may introduce unhealthy competition for resources among the managers of different units.

John Edwards, Trevor Boyns & Mark Matthews note that most companies in the British iron and steel industry have adopted the Activity based budgeting model.

Activity based budgeting is appropriate for organizations operating in all environments, whether stable or dynamic.

Beyond Budgeting Model

Juergen Daum notes that the traditional budgeting model no longer contributes to effective planning nor controlling, since market conditions are no longer stable, competitors are neither known nor are their actions predictable, decisions can no longer be made at corporate headquarters, prices no longer reflect internal costs, strategy and product life cycles have become shorter, customers a wide variety of products to choose from, and good stewardship is no longer the priority of shareholders.

Russ Banham notes that breaking free of the old planning and budgeting mentality and involving employees at all levels in building a new foundation for sustainable improvement, is a must for organizations that wish to compete effectively in the changing business environment.

In order to achieve this, an organization needs to do the following:

• Develop quick response to threats from competition, new opportunities, and varying customer needs.
• Employ and develop the best employees who can take full control of their areas.
• Innovate new solutions to problems and come up with new ideas that can be implemented to develop new streams of income.
• Achieve the same or higher operational efficiency at lower costs.
• Understand every customer and make maximum regular sales to each customer, by making sure the customer only buys from other organizations products that we don’t sell.
• Maximize the shareholders’ wealth, such that they prefer to invest in the organization compared to other organizations.

Budgeting barriers

An organization may find it hard to achieve the above, due to the following reasons:

Fast response can be hindered by budgets

An organization that is restricted to rules, procedures, budgetary controls fixed annual strategies and budgeting cycles may find it impossible to quick response to changing environments. This is because with such constraints, the management is not free to act locally so as to respond to the changing environment.

Attracting and retaining talented employees can be hindered by Budgets

Entrepreneurial leadership and risk taking are not encouraged by rigid plans and budgets, and as a result ambitious employees feel less challenged and deprived of personal development in organizations which adhere to such budgetary controls.

Innovation can be discouraged by budgets

When budgets are the only tool for performance appraisal, managers stop thinking about new ideas and only strive to achieve what is already in the budget. Unrealistic Standards normally de-motivate workers. If standards are lower than what workers can reasonably achieve, then they would only achieve the low standards. On the other hand if standards are too high, the workers will realize that it is impossible to attain them. This will result in frustration, and they will not even try to achieve any standards.

Operational excellence can be hindered by Budgets

Once the budget has been prepared, managers tend to only think about implementing it, thus forget about further measures which can be taken to reduce operating costs so as to spend less than the budgeted costs.

Budgets do not encourage close relationships with customers

Salespeople whose main aim is to achieve targets that are set in the budget usually do not care about whether customer needs are met or not. Their main aim is to achieve the sales level that is set for them in the budget.

Sustainable competitive corporate results can be hindered by Budgets

Setting unattainable targets in the budgets may raise the shareholders’ expectations, which may force the managers to take drastic measures that may not be good for the organization in future, just to temporarily satisfy the shareholders’ expectations.

The Beyond Budgeting Model is designed to overcome the barriers of the traditional budgeting model. The model aims at to promoting flexibility and adaptability within the organization so that local managers are self-confident and are free to think differently, make rapid decisions, and collaborate with colleagues both internally and externally on innovative projects.

Roger Stewart notes that the framework for implementing the Beyond Budgeting Model has twelve principles.

Some of the Principles are concerned with the performance management climate at your company, while others are concerned with the processes of performance management.

1. Self-governance:

Allow managers to make fast effective decisions by cultivating in them clear rules and boundaries instead of rigid rules and bureaucratic procedures.

2. Performance responsibility:

Always employ people who have customer service at heart.

3. Empowerment:

Ensure that the managers who handle customers directly have the necessary power to make decisions as need be.

4. Structure:

Enhance communication at all levels of the organization to ensure that information travels fast within the organization.

5. Coordination:

Ensure that all processes within the organization work towards achieving customer satisfaction. This would ensure that all systems move in the same direction for the common good of the organization, as opposed to satisfying individual interests.

6. Leadership:

Challenge managers to increase performance significantly and to achieve beyond expectations.

7. Goal setting:

Set relative targets that are on a range of key performance indicators and external benchmarks, and that are not pegged on measures and rewards, so as to encourage ambition among local managers, and also encourage them to pursue goals that are strategic as well as financial.

8. Strategy process:

Allow managers to come up with new ways of satisfying customers, even if it means developing new products. When managers bring new ideas, they would strive to see those ideas work because the success of such ideas would give them a lot of satisfaction.

9. Anticipatory systems:

Always forecast the future and act in advance so as to overcome foreseen problems and also take advantage of foreseen opportunities. This would ensure that you have ready solutions for problems that are likely to be encountered, so you are not taken by surprise when the problems actually occur.

10. Resource utilization:

Let the managers who are directly involved in the operations make decisions regarding investments and resources, instead of tying such decisions to the annual budgeting cycle. This would ensure that managers are free to act appropriately at the right time, and would also ensure that decisions are only made only when it is necessary. Strive to achieve efficient resource consumption so as to continuously reduce costs.

11. Measurement and control:

Establish open information systems that quickly provide all managers with information about the controls that you have established to provide actual results, leading indicators, and rolling forecasts. This would make implementation easy because all managers will be able to use the system.

12. Motivation and rewards:

Use relative measures to evaluate performance, and encourage employees to perform well in teams, as well as individually, so as to ensure that all employees are working towards the same goal. Relative measures of performance include comparing the performance of the managers to those of competitors on key performance variables.

Advantages of beyond budgeting

1. Its clear governance framework persuades front-line teams to accept of local decision making;
2. It improves performance;
3. It ensures that the organization achieves sustainable competitiveness;
4. It encourages managers to be more innovative, and increases the organization’s responsiveness;
5. Leads to value creation and reduction of waste, which means reduction of costs;
6. Improves customer satisfaction, which means more business and more income;
7. It leads to ethical behavior due to the openness in the information culture.

Peter brownell notes that accounting data is very important for performance evaluation.

Stephen Hansen, David Otley & Wim Van der Stede notes that the main limitation of beyond budgeting model is that it advocates for evaluation of organization and / or their managers by comparing their performances with those of competitors on key performance variables. This makes it very difficult to implement for most organizations.

Beyond budgeting is suitable for all organizations, whether they operate in stable or dynamic business environments. Organizations which operate in dynamic business environments however find this technique to be more appropriate than other budgeting techniques.

Mitchell Max notes that the following four key business needs have driven the leading financial services organizations based in North America to change their planning and forecasting processes:

1. They have felt the dire need to make more accurate forecasts
2. They have felt that it is important to have their focus driven by exemplary performance in business
3. They have realized that they need to be more agile and respond faster to changes in the business environment
4. Their Chief Financial Officers have felt that they need to get more value from the planning and budgeting process.

Mitchell Max notes that the organizations which have adopted the Beyond budgeting have achieved great success.

Conclusion

Jeremy Hope and Robin Fraser note that no model is superior, but each model has its own merits and demerits.

Every organization should decide on the model to use based on their circumstances, especially the business environment in which they operate.

For organizations which operate in a stable business environment, any of the models can be used. Such organizations should therefore consider other factors when deciding on the model to adopt.

For organizations which operate in a dynamic business environment, the beyond budgeting model would be most appropriate.

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