Aysel Salahova

1102978

Assignment for BE162

Financial Decision Making

Budgeting: Yesterday, Today, and Tomorrow

January 2012

Introduction

Historically budgeting was one of the most important functions in management. While

being more short-term oriented rather than long-term it includes both planning and control

aspects of the management. A budget can be understood as a description of management’s goals,

plans and objectives that covers the whole organization in terms of money (Shim, J.K., Siegel,

2005). Master budget, operational and financial budgets, cash budget or cash flow forecast, fixed

budgets, flexible budgets, zero- based budgets, activity –based budgets, incremental budget and

others are the most common budget types used by organizations. Budgets are the means that

managers use to assign responsibility and coordinate resource allocation throughout the

organization, evaluate performance and also to motivate employees by setting targets with

appropriate rewards and penalties.

Much has been written about different aspects of budgeting including its impact on

employees and managers (Schiff and Lewin, 1970; Marginson, and Ogden, 2005), performance

evaluation (Imoisili, 1989; Otley, 1989; Fisher, et el., 2002), relevance of budgets for modern

organizations (Wallander, 1999; Ekholm and Wallin, 2000; Hope, and Fraser, 2003; Libby, and

Lindsay, 2010 ) and it’s possible implications in today’s changing business environment (CIMA,

2004; Daum, 2002; Marginson, Ogden, and Frow, 2006). Some researchers think that, traditional

budgets have lost their relevance in today’s competitive environment and they no more reflect

changes in organizations’ business processes (Schmidt, 1992; Wallander, 1999). Moreover new

and more sophisticated and flexible management techniques are developed that can replace

conventional budgets. Whereas other researches undertaken in this area show that, budgets can

be and are still used by organizations from different industries all over the world (Ekholm, and

Wallin, 2000; Libby, and Lindsay, 2010). In the following paragraphs both economic and social

significance of budgeting in today’s organizations will be critically analyzed referring to

different researches done in this area.

Economic Significance of Budgets

In recent years budgeting was criticized a lot for being divorced from strategy and

protecting rather than reducing costs (The Beyond Budgeting Round Table, 2012). Critiques of

budgeting argue that, it is an “unnecessary evil” (Wallander, 1999) which is “broken” (Jensen,

2011), too inflexible, outdated (Gurton, 1999) and time consuming (Daum, 2002). According to

Hope and Fraser budget targets provide meaningless information to investors and their

abolishment can result in better relationships with capital markets (Hope, and Fraser, 2003). It

seems that budgeting is losing its usefulness as a managerial technique giving its place to rolling

forecasts, balanced scorecards and etc. Beyond Budgeting is a modern management philosophy

that explains reasons and benefits of using alternative techniques to control and evaluate

performance in organizations. After the introduction of The Beyond Budgeting Round Table

(BBRT) – a research and learning network of companies that wish to transform their

management system in 1997 the trend to transform traditional budgeting has even increased.

BBRT provides more radical rather than adaptive solutions to the problem introducing new

leadership and Performance Measurement Principles (CIMA, 2004). The list of companies that

replaced their budgets with more developed managerial tools is quiet diverse now, including

companies from different industries such as banking, pharmaceutics, furniture retailing, food

production, computer and truck manufacturing, and etc. (Hope, and Fraser, 2003).

However surveys undertaken among the biggest companies in Finland (Ekholm, and Wallin,

2000) showed that despite the growing criticism majority of organizations were still using the

budgeting as a main planning and control tool of the organization. According to it, among 144

companies that took place in the survey almost 86% were still using the budgets either

unchanged or in slightly adopted version. Research concluded that along with the ones that were

using rolling forecast instead of budgets the companies that were using budgets also strongly

agreed to criticism of budgeting seeing it too rigid and unable to signal changes in the

environment. The interesting fact was that almost 68% of the firms didn’t want to abandon

budgets completely; instead of it they were using rolling forecast and budgets together. The

similar surveys were also conducted in North America (Libby, and Lindsay, 2010), and England

(Lyne, and Dugdale, 2004). The results of the both surveys support Ekholm and Wallin’s

findings showing that the statement that the budgets are not fully dead and irrelevant is quite

reasonable. Moreover the study conducted in North America was much broader and covered two

countries. For example, the number of respondents in Libby and Lindsay’s survey was 558

including companies from both USA and Canada which was four times bigger than the sample

size in the previous research. In contrast to recent criticisms of budgeting companies stated that

they would continue using budgets because the benefits were outweighing the costs and the

budgets were successfully used to promote the strategies of the firms (Libby, and Lindsay,

2010). Another survey conducted among 44 firms in England found that majority of financial

and non-financial managers were satisfied with budgeting and disagreed to the statements that it

was de-motivating and unrealistic while accepting that it was too time-consuming (Lyne, and

Dugdale, 2004). All three researches support the fact that despite of rising criticism budgets are

still adding value to the management of organizations. Rather than abolishing their use

companies are trying to change and adopt it to modern dynamic business environment. Modern

budgets tend to pay more attention to activities, customer satisfaction, and long-term strategies

aimed to increase shareholders’ wealth.

Different characteristics of organization such as its size, structure, industry, competitive

strategy, and even extent of centralization have an impact on its use of budgets. A research

conducted by Van der Stede and Hansen (2004) among 57 managers investigated potential

reasons of why companies prepare budgets. According to his research operational planning,

performance evaluation, communication of goals and strategy formation were proposed as the

four main reasons and their separate relationships with budgeting were empirically tested.

Results showed that, larger organizations with traceable resources used budgets more for

performance evaluation whereas the companies with divisional structure more for strategy

formation (Hansen, and Van der Stede, 2004). Another important finding of the research was

that it was impossible to satisfy the performance of the budget for all four reasons

simultaneously. For example, use of rolling budgets could help to improve the performance of

budget in the operational planning but at the same time it decreased the effectiveness of the

budget for performance evaluation. Extent to which budgeting is used also depends on the

competitive strategy deployed by the company. Companies that use differentiation strategy tend

to use budgeting more than those with cost-leadership strategy (Simons, 1990). These

contradictory relationships highlight the importance of unique approach to budget setting in

every organization. For example, for the companies that are faced with strategic changes budgets

should be more interactive and participative (Abernethy, and Brownell, 2005).

Another point raised by the opponents of budgeting is about the slack built into the budgets.

The logic behind this argument is that managers intentionally build slack by understating the

revenues and overstating the expenses of the company. They also don’t incorporate account

internal improvements of the business processes, and learning curve effects in to the budget

information (Schiff, and Lewin, 1970). Schiff and Lewin estimated that this slack could even

reach 20-25 % of budgeted operating expenses of the company. Historically, role of participative

budgets in slack creation was debatable topic. For example, according to Lukka (1988) more

participative budgets give manager much more opportunities to create additional slack. In

contrast other study showed that budgetary slacks could be avoided by more participative

budgeting because the main reason of them was pressure that came from rigid targets set by top

management and also hedge against uncertainty (Onsi, 1973). Similar to the findings of Onsi

Schiff and Lewin also found that, slack created in the divisional level was much more difficult to

detect and prevent. They proposed that special budgetary reviews should be conducted in

successful years of operation by neutral parties such as outside consultants or MBA students

trained in management in order to detect budgetary slacks. Their findings stress out the fact that

management by exception is no longer relevant in modern business environment. Organizations

should focus on more regular review of budget variances rather than doing it at the end of the

year. Redesigning of budgets rather than dismantling them is required in order to solve the

problem between budgets and innovation (Marginson, Ogden, and Frow, 2005). Marginson and

his colleagues argue that, better budgeting is not necessarily means beyond budgeting.

Apparently traditional budgeting should be transformed to reflect the changing structure of

today’s modern organizations. In order to maintain its economic significance it is crucial for

budgets to wider its control framework (Marginson, Ogden, and Frow, 2006), take into account

non-financial measures along with financial measures, and have a broader long-term focus. This

is the only way it can confront uncertainty in modern business environment.

Social Significance of Budgets

As stated in previous paragraphs organizations use the budgets as both control and

performance evaluation tools. Thus they affect both the controller and controlled persons. Along

with economic aspects budgets have important social impact on managers, employees and their

behavior. In the preceding paragraph some social aspects of budgeting in modern organizations

namely: impact on employee motivation, budgeting games, and impact on employee behavior

will be critically evaluated.

Critiques argue that in modern organizations budgets are no longer motivating employees

and even make them feel themselves undervalued (CIMA, 2004). This statement is quite logic if

we take into account the fact that, targets in the budgets are coming mostly from managers.

Managers are able to play the targets for their favor, in other words put them too attainable

intentionally not incorporating developments in manufacturing processes and learning effects

and other improvements into them. This in turn will have a negative impact on employees’

motivation and their willingness to improve. However there is evidence that, successfully

implemented participative budgets will enhance employee motivation (Becker, and Green,

1962). In contrast to imposed budgets participatory budgets will be more accurate and realistic as

subordinates have more detailed and updated information about the business processes than top

management (Nouri, and Parker, 1998). Thus more realistic budgets will result in targets neither

too loose nor too tight and increase employees aspirations towards achieving them. Participative

budgets also have an impact on performance of employees. Researcher findings regarding this

impact are quite contradictory while some of them being positive (Brownell and McInnes, 1986;

Becker, and Green, 1962), and others negative (Stedry, 1960). Study by Brownell and McInnes

(1986) found empirical evidence of strong positive relationship between participation of

employees in budget setting process and their on-job performance. However due to controversy

in findings this topic is still debated by academicians and researchers.

Budgeting games can be described as different strategies attempted by participants of

budgeting process in order to obtain desired budget. Because budgeting process has game-like

nature (Hofstede, 1968), it is natural that managers will try to develop different techniques for

attaining the numbers reflected in the budgets. These techniques differ according to the type of

budget used, leadership style of superior bodies (Collins, 1978) and also cultural attitudes of

managers. Collins (1978) has identified four patterns of games played by managers which are:

economic, time, devious and incremental games. His studies revealed the fact that managers with

positive attitudes towards budgeting were mostly using incremental, time, and economic patterns

of games, whereas managers with negative attitudes preferred devious pattern. The

characteristics of budgets also have an impact on games played by managers. Imposed and top-

down budgets tend to cause more stress among the managers while causing more gaming. When

it comes to the reasons of budget games, it can be assumed that managers play with numbers in

order to accomplish their own personal goals rather than organizational goals. This statement can

be linked to one of the most important criticisms of budgeting in modern organizations which is

the fact that “budgeting encourages ‘gaming’ and perverse behavior” (CIMA, 2004, p.7). Since

budgets are used as tools to measure and evaluate the performance of managers the latters will be

always attracted by rewards and threatened with penalties set in these budgets. These attractions

and threats define the reasons why managers play with the numbers and sometimes even

demonstrate unethical behavior. Some of the most common gaming strategies used by managers

are moving revenues/costs to future or past, entering into informal agreements with

customers/suppliers or other parties, virement – recording an expense under the wrong headings

(Proctor, 2009) and etc. The effect of these budgets games can be very serious for the

organizations because they result in false information for superiors and top management. The

information that is not true and faithful has no value for decision-making or results in wrong and

not efficient decisions. However, in modern management research the source of gaming

problems is somehow moved from budgeting itself to the way in which employees and managers

are paid in the organization (Jensen, 2003). According to Jensen (2003), if the patters of pay-

schemes are changed, it is quite possible to overcome gaming problems in budgeting. He

proposes to transform bonus schemes of managers into more linear ones where the bonus will

not depend on the targets reached by managers. Employees will lose their incentives to cheat if

they will be rewarded for their accomplishment rather than ability to hit targets (Jensen, 2001).

The case study of multinational company- Astoria which operates in the technology industry

supports this argument. The company was using the innovative beyond budgeting techniques for

performance evaluation called “performance measurement process” (PMP) (Marginson, Ogden,

and Frow, 2006). Marginson and his colleagues noted that the company had developed its pay-

scheme from traditional into more innovative where performance evaluation was separated from

bonus payment system.

Budget games also can evolve from the desire of different parties to use particular budgets.

Differences in type of organizations and some physiological factors may affect the employees’

acceptance of imposed budgets. Conflicts of interests always arise in the process of enforcement

of budgets. If refer to the case of Danish Theatre (Christiansen, and Skarbaek, 1997) it can be a

good illustration how managers, employees, government and other officials were engaged in

budget “games” in order to protect their interests. Even the employees from different

departments had diverse attitudes towards the budget that was going to be imposed. For example,

artist had a negative attitude towards implementation of budgeting because they thought that

management and other were suspicious of their performance quality. Whereas tailors were quite

happy with it as it would save them of designer’s uncertain actions and demands and also secure

a fixed working hours (Christiansen, and Skarbaek, 1997). Resistance of artists was an expected

outcome if we consider that, their personal goals and organizational goals were conflicting in this

case. Although in the end budgeting was adopted in the theatre, it took almost 15 years to reach

this outcome. It is worth to note that note the original version of the budget was implanted and

several amendments were made to the plan during 15 years. The case about Danish Theatre

highlights two issues regarding implementation of budgeting or any other management

accounting techniques. First, it is crucial for the budget to be accepted by the participants.

Otherwise it will never work and even will result in poorer performance because of decreased

motivations and organizational commitment. Especially, in today’s business environment where

employee empowerment and knowledge sharing are important for efficient and effective

operating of organizations. Second, the budget that is going to be implemented should be

consistent with organization’s objectives and culture since it enforce other structural changes

(Christiansen, and Skarbaek, 1997) and redesign of accounting system.

Conclusion

So far we have analyzed both economic and social aspects of budgeting in modern business

environment. It can be concluded that views about budgets are quite contradictory today. In one

extreme some researchers blame budgets for being reasons of breach in corporate ethics (Hope,

and Fraser, 2003). They even show too tight budgets as potential reasons for failure of

companies such as WorldCom, Enron, and Barings Bank (Hope, and Fraser, 2003). On the other

hand budgets are considered as irreplaceable tools of control in the organizations even nowadays.

However it should be noted that economic and business environment is changing rapidly and

new techniques that can be used in planning, control, as well as performance evaluation are

needed. Organizations from different sectors of economy, in different countries of the world

accept the criticisms of budgeting and the fact that it is losing relevance. However they actively

work for improvements by adding new features and removing factors that enhance rigidity and

inflexibility. Thus rather than abandonment complete transformation of budgets and budgeting

process is a main issue waiting for solution.

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