Bank of Bhutan
Year 2012
Year 2012
This
essay will examine the various methods which can be used as basis for the
preparation of the budget and identify the primary strength and weakness of
these methods, assess whether improvement proposed for budgeting together with
those that relate to ‘Beyond Budgeting’ are likely to enhance the effectiveness
of the planning , controlling and evaluation needs of organisation.
Budget
is plan expressed in monetary terms covering future time period based on a
defined level of activity. Horngren et
al (2008) described budget as an integral part of management and controlling
systems that aim at promoting, coordination and communication among subunits
within the company. It also provides a framework for judging/rating performance
and which acts as motivational factors for managers and other employees.
According
to Davila and Foster (2007, cited in Robyn King et al 2009) budgeting has been
identified as a management accounting tool that enhances financial planning and
performance and improves organization’s efficiency. Planning decisions help
managers in achieving the goal of an organization and control comprises taking
actions that implement the planning decisions, providing feedback that will
help future decision making ( Horngren
et al 2006).
Budgeting
has been the dominating instrument for management control in organizations. Otley
1994 suggest that there are examples which show highly successful firm
utilizing budgeting as a planning and controlling tools.
Paul
M. Collier (2006) suggest that budgeting provides the ability to implement
strategy by allocating resources in line with the strategic goals, assist
coordination and communication between units, motivate and evaluate managerial
performances and provide means to
control activities.
Four
methods are being used by the organization as a basis for the preparation of
the budgets, either as the principles on which all the budgets are based, or
particularly for the functional budgets as the administration budget.
Functional department which support the main operations of the organization may
not be so dependent on sales levels. Budgeting in non- profit making
organization also requires a different approach, as starting from forecast of demand may not be
appropriate.
Following
methods are being used by the organization as a basis for preparation:
1. Incremental
budgeting
2. Priority-based
budgeting
3. zero
base budgeting
4. Activity
based budgeting
Incremental Budgeting
Incremental
Budgeting is mostly used in commercial organization and in public sector. It
takes previous year’s budget as base and adds or subtract certain percentage on
it usually adjusting for inflation. In some cases the previous year’s actual
costs may be used as starting point, rather than the budget particularly if the
actual cost were lower than the budgeted one.
This method has number of advantages. It is
stable and change is gradual and planned, manager can operate their department
on a consistent basis. The system is relatively simple to operate and easy to
understand and change in impact can be seen quickly. However, it is not free of
weakness and has a number of criticisms. It assumes activities and method of
working will continue in the same way, giving no incentive for developing new
ideas. There is no cost control incentive and spending up to budget is
encouraged so that next year level of budget is maintained. The budget may
become out of date, and longer relate to the level of activity or the type of
work being carried out. The priority for resources may have changed since the
budgets were set originally. There may
be ‘budgetary slack’ built in to the budgets, which is never reviewed – this
means that managers have overestimated their requirements in the past, in order
to obtain a budget which is easier to work to, and which will allow them to
achieve favourable results.
In
priority-based budgeting, funds are allocated in line with organisation’s
strategy. The allocation of budget would change if there is changed in
organization’s priorities as per its strategy focus (Paul M. Collier 2006). Under
this method budget are allocated to projects rather than to responsibility centers.
This method has the advantage of comparing changes in resources with the
resulting cost and benefits.
Zero-base
budgeting
Zero-base budgeting identifies the costs
to be incurred to implement the strategies and achieve target goals, as if it
is fresh start of new organization unit without prior history. It takes the
opposite view: instead of assuming everything will continue as before, the
focus is on achieving the organisation’s objectives in the most efficient way. The basis of this method
is that entire budget centres start with a zero budget allocation and then
builds up budget proposals at different levels of activity which will be reviewed
by the senior management. It is unlike in traditional budgeting, where existing expenditure levels form
the baseline for discussions about future expenditure. Like in all budgeting
techniques, it is designed to be used in setting levels of future expenditures.
This method has advantage over other
methods because budget holder regularly review all the activities that are
carried out to see if they are still required (Paul M. Collier 2006). It focuses
the use of resources on achieving the organisation’s objectives. The
budget centre managers have to re-evaluate in detail the cost effectiveness of
the working methods and results achieved in their departments. The
new projects are compared with existing work so that innovation is encouraged
rather than assuming existing activities must continue.
Allocation of resources is linked to the achievement of results. Wastage
and budgetary slack should be eliminated, because budgets which
are not cost-effective will not be given funds. Planning and budgeting
is combined into a single process when the decision packages to be
funded are chosen.
However, disadvantage is that it requires more extensive work than
incremental budgeting. It compels the managers to justify their outlays on a
regular and systematic basis in the context of future plans and strategy rather
than on the past performance. An incremental approach is most likely to be
applied to discretionary costs, as it is these costs that have no demonstrable
relationship with volume or activity measures. The Zero-base budgeting approach
requires all activities
to be justified and prioritized before the decision to allocate resources is
taken by management. It is also criticized, because the
process itself is very complex and therefore costly to operate.
By separating different activities, links between them may not be allowed for,
leading to an uncoordinated approach. Short-term benefits may
be emphasised in the decision packages, to the detriment of long-term
planning. The
process of judging and prioritising the decision packages may be extremely
difficult and it may be affected by the internal politics of the organisation,
so that it is not really objective.
Activity base budgeting is concerned
with activity based costing (Paul M. Collier 2006). These include
activity-based costing, activity-based management and activity-based budgeting
(ABB). The logical thrust behind all is that cost control and management should
focus on the outputs of a process rather than on the inputs to that process.
ABTs are, arguably, most
applicable to service-sector operations, the public sector, the not-for-profit
sector and indirect costs in a manufacturing environment.
The traditional approach
to budgeting presents costs under functional headings, that is, costs are
presented in a manner that emphasises their nature.
Strength of this approach is that it provides a clear framework
for understanding the link between costs and the level of activity. Using the
traditional approach, many of the costs listed under traditional functional
headings might simply be considered 'fixed'. However, research often shows
that, in the long run, few costs really are fixed. If one can identify
appropriate 'cost drivers', then a very high proportion of costs reveal
themselves to be variable.
The weakness of this approach is that it gives little indication
of the link between the level of activity of the department and the cost
incurred. Johnson and Kaplan (1987) argued that it failed to keep pace with new
technology and became subservient to the needs of external financial reporting.
The flexible budget
helps to ensure for comparing the actual results with the budget for a period
to monitor against realistic targets.
Whereas fixed budget is
one that remains unchanged regardless of the actual level of activity. In
situations where activity levels are likely to change and there are a
significant proportion of variables costs, it is difficult to control
expenditure satisfactorily with a fixed budget.
A flexible budget can help managers to make more valid
comparisons. It is designed to show the expected revenue and the allowed
expenditure for the actual number of units produced and sold. Comparing this
flexible budget with the actual expenditure and revenue it is possible to
distinguish genuine efficiencies.
According to Paul M. Collier (2006) there are
two approaches that can be applied while preparing budget. Budget may be top-down budget or bottom-up budget. Top-down budget begin with the sales forecast and
using the volume of sales, predict inventory levels, staffing and production
times with capacity limitation. The advantages of top-down approaches are their
speed and straightforwardness. The disadvantage is that the methods look to the
past as a guide, rather than to future goals Also, budgets tied to sales
figures mean that a company’s promotional budget will decrease if sales
decrease—but in fact increasing the promotional budget may be precisely what is
needed in order to remedy declining sales. Bottom-up
budgets are developed by the managers of department based on current spending
and agreed plans, which then totaled up to the corporate total.
Improvement
proposed for budgeting
In the modern context, the process of establishing a budget is an
intelligent exercise in business planning wherein alternative means of achieving
given objectives are identified and evaluated.
ZBB, PPBS and ABB are probably most applicable to costs which
contain a substantial discretionary element and as such they are most commonly
encountered in service departments of commercial operations, the public sector
and the not-for-profit sector. However, organization has to face
number of challenges in terms of depending solely on budgets for management
control. They restrict responsiveness and are often a barrier to change and
they concentrate on cost reduction instead of value creation (Ostergren & Stensaker
2008, John & Ngoasong 2008). As a response to such criticism, it has been
suggested by Hope and Fraser (1997, 2000 and 2003) cited in Ostergren &
Stensaker 2008 to drop the budget all together by moving to “Beyond Budgeting”
as their new approach to management control.
The beyond budgeting model
focuses on six principles that link the often disparate decision streams of
strategic planning, budgeting, and performance management. It is hard to argue
with the notion that resource allocation on the whole will be more effective
when these areas are coordinated. The ideas in Beyond Budgeting are getting
some play, as many companies are seriously considering scrapping budgeting.
Hope and Fraser (2003) argues that beyond budgeting is an alternative, coherent
management model that enables companies to manage performance through processes
specifically tailored to today’s volatile marketplace. Based on the decision –
making needs of front- line managers, the firm can create set of adaptive
management processes that replace centrally controlled, predetermined goals
with self- regulating, relative competitive benchmarks and transfer the power
and decision making authority from the center of the Organization to the front
line. Hope and Fraser (2001) states that the root of planning and budgeting
problem is organization being considered as machine for making money, as
opposed to complex human organizations that have a life of their own, that
evolve over time, and that constantly adapt to the changes in the environment.
Beyond budgeting connects these ideas of the organization as a human network
with different ways of managing performance within an organization.
Performance
Flamholtz
(1983) argues that budgeting in an organization is a part of planning system
but not equivalent to the whole of control system because they lack critical
component like evaluation – reward system which is a mechanism for performance
assessment and administration of rewards. Otley (1999) further states that
performance measures are to influence managerial behaviors, so that managers
have the knowledge and motivation to act in the organization’s best interest.
Lower cost
Hope
and Fraser (2003) states that low cost is also a feature of beyond budgeting
process. By removing the cost of the budgeting process and eliminating the
entitlement mentality that traditional budgets create, front- line managers can
spend less when they need less while safe in the knowledge that they will be
provided greater resource should they need them. There is no place for fix
performance contract and remote control management. Leader need to place more faith
responsibility and trust in their operating people. The result will be a
management model that offers a unique source of competitive advantage.
It
has been argued by Ostergren and Stensaker (2008) that three separate processes
were introduces as budgets were removed. They are; a) Target should be
strategic and based on high ambitions.
b) A greater focus on the big picture. c) Focus on the possibilities and flexibility.
Target should be strategic and
based on high ambition
When
the budgets are basis for target setting, targets are controlled by the
budgets. Separating target setting from planning and resource allocation made
it possible to set target irrespective of available resource. With higher
ambitious goal, target setting was performed at higher level in the
orgationsation than when compared with budgetary controlled (Ostergren and
Stensaker 2008).
Greater focus on big picture has
become important
Once
budget were removed, the focus was on the big numbers instead of details. This
shortened the time available for decision on resource allocation. The criteria
for allocation resources also forced organization unit to look beyond their own
unit and focus on the big picture.
Increase focused on possibilities
and flexibility.
This
rule is based on new dynamic resource allocation. Instead of allocating
resource once a year, Beyond Budgeting employs a dynamic resource allocation
process and the department obtains financial resources continuously (ostergren
& Stensaker 2008).
Conclusion
Horn
et al (2003) contend
that budgeting is incremental, consumes many months and thousands of hours of
staff time, ignores performance, and leads employees to focus on the wrong
targets at the expense of customer service, overall corporate goals and value
creation. Budgeting is also seen as a regime that regenerates itself, as being
cumbersome, and as one of the few administrative functions that technology
hasn't done much to improve. Even corporate debacles such as Enron and WorldCom
are being blamed in part on budgetary incentives that promote a
"gaming" and a "massaging" of the numbers
As
a response to such criticism it has been suggested by Hope & Fraser (1997,
2000 and 2003) cited in Ostergren & Stensaker 2008 to drop the budgeting
practice and move to Beyond Budgeting as their new approach to management
control system. It would appear to be more fruitful to develop the
possibilities for each model by seeking deeper understanding as to the mechanisms
and processes which underlie the application of each model in highly successful
companies.
Therefore,
beyond budgeting and balance scorecard proposed for improvement of budgetary
control method will definitely enhance the effectiveness of the planning,
control and performance evaluation of organization’s by broadening performance
measurement systems and integrating financial and non- financial issues.
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