Traditional Budgetting Essay

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Traditional Budgetting

Essay: “Traditional budgeting is counterproductive in today’s fast paced and highly competitive environment. Instead of tinkering with current budgeting systems, managers would be better off abandoning budgeting altogether – that is, companies should move beyond budgeting.” Discuss

Introduction

In the worsening economic conditions we live in today the question of the efficiency of budgets is constantly being discussed. “The usefulness of budgets has generated much recent discussion and debate. Though budgets are useful for coordination, communication, and performance evaluation, many people consider them the cause of gaming and earnings manipulation by managers, time-consuming and costly to develop, and a barrier to change.”(Murray-Lindsay and Libby, 2007) Van Mourik (2006) states, “Research suggests that 80% of companies are dissatisfied with their planning and budgeting processes and it has been estimated that these processes use up to 20% of all management time.”

Research completed by Schmidt (1992) states, “In a study of 10 large energy, transportation and banking companies, we found that, on average, the equivalent of 5% of all staff employees were devoted full-time to budgeting activities. At one of these companies, which has a staff-support team of 3,000 employees, 160 employees devote time to aspect of budgeting. “Total budgetary costs in this company “may exceed $20 million a year”. I believe if a company is investing this much time and money in the process they should trust it whole heartedly but alas even a company with that much committed to the process are voicing their concerns at the process. Jack Welch, former CEO of General Electric, is attributed as saying, “the budget is the bane of corporate America.” (Daum, 2002)

There are those that plump for the abolishing of budgets altogether, “Budgeting, as most corporations practice it, should be abolished. That may sound like a radical proposition, but it would be merely the culmination of long-running efforts to transform organizations from centralized hierarchies into devolved networks that allow for nimble adjustments to market conditions.” (Fraser and Hope, 2003)

On the other side of the argument lie those who will openly agree that that the current budgeting techniques are not without their faults but they argue for the adaption of current techniques for the improvement of the company as a whole. “In recent times, headlines have appeared whose controversial nature have gained attention, for example ‘beyond budgeting’ and ‘who needs budgets?’ (Hope and Fraser, 1997, 2000) and which might have great emotional appeal to managers. As we shall see, less controversial and arguably, more appropriate, alternative headlines could be ‘time to change the nature of our budgets’ and ‘time to change how we use budgets’. (Van Mourik, 2006) In this paper I will outline:

1. The problems with current budgeting.
2. The arguments for abandoning budgets altogether.
3. The adaption of current budgeting techniques.
4. Give my thoughts on which is the best way forward for modern day budgeting. Criticisms of Budgeting

Budgets as they stand currently are laden with criticisms. “Our study indicates that the budget process is obsolete given today’s economy, resulting in documents that are time-consuming to produce, of little predictive value, subject to gamesmanship and, quite frankly, out of date by the time they’re implemented.” (Doucet, 2002) “The budgeting process can often be bureaucratic and expensive, budgeting can fail to meet the needs of managers in competitive environments and budget systems can lead to managerial ‘gaming’ of the numbers.” (Lyne, 2004) “Budgeting seems almost totally divorced from the company’s overall strategic direction.” (Bourne, 2004) I feel that a document that is intended to help the company as a whole should at the very least be aligned with the company’s strategic goals. “Good budgeting comes down to trust, integrity and transparency.” (Jackson and Starovic, 2004)

It can be argued that modern day budgets have none of these attributes. Management all seem to be in agreement that there are too many issues with budgets to make them worthwhile. According to Morlidge (2005), “Energy is focused inwards and not outwards. On negotiating targets, rather than on beating the competition. On sticking to ‘plans’, rather than responding to opportunities.” From my research I think Morlidge’s argument is very apt. Organisations are becoming more about beating the budget rather than making profits and beating the competitor. An example is cited in Jensen (2001) where, “The managers of one durable-goods manufacturer, struggling to make their minimum bonus hurdles, announced late one year that they would be raising the prices 10% across the board on January

2. The managers made the price hikes because they wanted to encourage customers to place orders by year-end so they could hit their annual sales goals. But the price increase was out of line with the competition and undoubtedly ended up costing the company sales and market share.” Budget makers should think to themselves how would they react faced with these goals? It promotes self interest over the best interests of the company, basic agency theory. This example leads me to believe that the tieing of budgets to performance evaluation encourages questionable and sometimes illegal behaviour in companies. This behaviour, “in most corporate cultures has become expected of responsible managers and board members.” (Jensen, 2003)

Personally I feel that performance evaluation being tied to budgetary goals is not in the best interest of a company. If a company’s strategic goal is to develop its market share and boost profits then a budget should support these goals not openly conflict with them. “Budgets are created by looking back, when leaders should be looking forward. “ (Ewing, 2006) Modern budgets encourage compliance and not enterprise. The same problems came up again and again in my research and gamesmanship seems to be at the heart of all that is wrong with budgeting. If management are to persist with budgeting I feel it is essential to remove the link between performance evaluation and remuneration.

Abandoning Budgeting

The Beyond Budgeting Round Table has stated, “the only way the inherent contradictions of the budgeting process can be resolved is by scrapping it altogether. It goes on to cite a number of companies that have ‘broken free from the shackles of budgeting and its culture of gaming and misinformation’.” (Bunce, 2004) Is abandoning the budgetary process really the way forward? — Companies such as “Svenska Handelsbanken, Volvo Cars, IKEA, Borealis, Boots, Ericsson, Diageo, and British cider maker Bulmers” (Fraser and Hope, 2000) (Van Mourik, 2006) would all agree it is.

These companies have all abandoned traditional budgeting in recent years and haven’t looked back. Svenska Handelsbanken a large bank in the Scandinavian area abandoned budgeting in the early 1970s. Since their change in philosophy they have outperformed their Scandinavian rivals on nearly every measure. Return on equity, total shareholder return, earnings per share, cost-to-income ratio, and most importantly customer satisfaction. Svenska in the late 1960s was losing customers and underperforming in the banking industry this all changed when they hired a new CEO by the name of Jan Wallander. Wallander only accepted the job on the condition that the bank would dramatically decentralize its operations.

Svenska agreed and set in place a project that would change the face of their company. Nowadays the bank has only 3 organization layers – branch managers, regional managers, and the chief executive. This means the spans of control are very wide, stopping micro management. Each branch is free to set prices and discounts and to decide which products they will sell. The company operates its performance evaluation by putting their 11 regions in competition against each other like teams in a league. This competition is healthy for the business as each region is trying to outdo the other it is only in hindsight that they know how well they have performed relative to the other managers. This leads them to focus on maximising profits at all times rather than playing games with the numbers.

This drastically differs from a budget where management have no incentive but to reach their preset goals. Beating the competition rather than some negotiated budget goes to the heart of the Handelsbanken model. (Hope and Fraser, 2003) (Gary, 2003) (Daum, 2002) (Cleary, 2012) Another example is Ahlsell, a Swedish wholesaler who abandoned budgeting in 1995. Since abandoning budgeting its main lines of business, electrical products, heating and plumbing have overtaken their Swedish counterparts in profitability. They changed their whole outlook on the budgets after suffering a slowdown in business in the early 1990s.

Their organisational structure changed from one central command unit to giving responsibility to a large number of profit centres. Each profit centre competes against each other in the same way Svenska do. Local units have been freed to develop their own approaches in response to local conditions and customer demands. Key Performance Indicators are now used to set goals and impose controls for example the key indicators for the sales units are profit growth, return on sales and market share.

These are all then compared against the competition which again incentivises the units to get the best possible result and not just to meet a target. (Hope and Fraser, 2003) (Daum, 2003) (Paludnach, 2003) From the above examples it is evident to me that company’s who are willing to put in the effort can abandon budgets and succeed. The above companies have not only had success but are leading their areas in most performance measures.

Modifying Current Budgeting

Although the corporate world is aware of the problems associated with budgeting most are set in their ways and feel there is a need for budgeting in all successful companies. “Companies that do without budgeting systems run the risk of being considered poorly managed.” (Jensen, 2003) The alternative to abandoning budgets completely is adapting the current processes to remove the chinks and have processes that are,”introducing new and more accurate financial models capable of linking budgeting to overall strategy. Research from the Accenture/Cranfield School of Management Study states that there is a correlation between companies modifying their budget processes and stock price performance.” (Doucet, 2002) One such modified budget technique is a Linear Compensation Plan.

A linear compensation plan rewards actual performance, independent of budget targets. A manager receives the same bonus for a given level of performance whether the budget goal happens to be set beneath the level or above it. In simpler terms the linear compensation plan rewards people for what they actually do, not for what they do relative to what they say they can do. It removes the incentives to game the system. Managers no longer feel the need to provide inaccurate numbers to the budgetary process in order to low ball their goals. As a result the senior management receives unbiased estimates of what can be accomplished in the future.

For lower level management it means they can stop wasting time spent on trying to game the budgetary system and this time can be dedicated to their real job: maximising the performance and value of their businesses. Removing the problems from the compensation system allows the budgeting process to do what it’s intended to do: provide the basis for good business decisions and enable the effective coordination of disparate units. (Jensen, 2001) (Jensen, 2003) Another option detailed in my research was Multidimensional budgeting (MDB). Multidimensional budgeting converts conventional budgets into formats that are more relevant to management. The main difference between a conventional budget and a Multidimensional budget is the conventional budget is broken down into four separate budgets.

1. The activity budget: This discloses how the company spends on specific tasks and the types of resources it devotes to them. It is useful for management as it enables them to look beyond the general ledger and probe the underlying work the organization performs. 2. The product budget: which states that each activity adds some value to a product for either and internal or an external customer. 3. The customer budget: This is created by matching products with their internal or external customers and shows the total spending proposed for each customer or customer service served by the budgeting entities.

4. The strategy budget: Provides a basis for determining whether proposed expenditures are aligned correctly with corporate, business and supporting strategies. By getting an in-depth breakdown of the processes in the company management can get insights into resource effectiveness and enables them to align resources with corporate strategies and customer needs. MDB can transform a company’s profitability and competitive position. (Schmidt, 1992) These new modified budgetary techniques are great in theory but these techniques may not be suitable for all companies.

Research compiled by Cranfield School of Management states that leading companies these days are applying budgets that: 1. Have an external focus: what matters at the end of the day is their performance against competitors, not their results against an already out of date budget 2. Explicitly focused on strategy: They know that better financial performance ultimately comes from having and maintaining a competitive advantage 3. Use forecasting models, separate from their financial management system: These models are readily adaptable to changes in the business environment.

The company is afforded a higher level of speed and flexibility. 4. Put their efforts into managing future results, not explaining past performance: They realise that endless scrutiny of past results adds little value. Instead they focus on taking actions that really do drive value. (Bourne, 2004) It is clear to me from the above evidence that wholesale changes to current budgetary processes could also be a way forward. The need for budgets in some organizations is evident and this could be a way to please both those who claim the current processes are unworkable and to those that are insistent that the company needs a budget.

Conclusion

From my research in the area of beyond budgeting I feel it is clear to all that budgeting in its current state is no use to anyone. It is full of legitimate problems whether it is the gaming of the numbers, or the vast amount of time that is going into producing; let’s face it, a nearly worthless document. But what is the way forward? –The likes of Svenska Handelsbanken and Ahlsell have shown that organizations can not only function without budgets but can actually go on to thrive. There are then the arguments for adapting the current techniques to deal with the modern day climate. Multi dimensional budgeting and linear compensation plans are just two of the techniques I found in my research and both sound great in theory but not all of these processes will work in every organization.

I believe the way forward to be –adapting the current budgetary processes and continuing with some form of budgeting. The research that the Cranfield School of Management conducted shows me that companies are realising that budgets need to be adapted and the way they see to improve them is to add the four points listed above. The external focus is very important as evaluating a company against its nearest competitors is a much better fit than meeting predefined budgetary targets that were full of dishonest behaviour to begin with.

Professor Andy Neely asserts that, “Firstly, companies can no longer justify the time and effort they invest in the budgeting process; Secondly, budgets have to be much more responsive, enabling nearly real-time tracking; and thirdly, management must understand that budgets cannot serve both as control and motivational devices. Companies that understand this and act on it are posed to enhance credibility and performance.” (Doucet, 2002) I feel with the adaption of the current techniques that all these criticisms, cited by Professor Neely, can be removed and the budgeting process can help lead a business through the tough current economic climate. I leave you with Miles Ewing’s take on the modern budget, it is very similar to my own outlook on the process. “Budgeting can be a powerful asset when leaders build in the flexibility that’s needed in this uncertain economy.”

Bibliography

1. Bourne, M. (2004), “Driving Value through strategic planning and budgeting”, Paper presented at Better Budgeting: A report on the better budgeting forum from CIMA and IACEW, July 2004. 2. Bunce, P. (2004), “The beyond budgeting journey towards adaptive management”, Paper presented at Better Budgeting: A report on the better budgeting forum from CIMA and IACEW, July 2004. 3. Cleary, P. (2012), “Planning & Budgetary Control Systems”, U.C.C Blackboard 4. Daum, J. (2003), Beyond Budgeting on the Move”, Report from the First Annual Beyond Budgeting Summit in London 5. Daum, J. (2002), “Beyond Budgeting: A Model for Performance Management and Controlling in the 21st Century?”,German Newsletter of Controlling & Finance, July 2002. 6. Doucet, K. (2002), “Companies abandon traditional budgets to boost shareholder value”, CMA Management 2002. 7. Ewing, M. (2010), “Is it time to Abandon Budgeting?”, Deloitte Debates http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/us_consulting_AbandonBudgetingDebate_092111.pdf 8. Fraser, R., Hope, J. (2000), “Beyond Budgeting”, Strategic Finance, 4,30 9. Fraser, R., Hope, J. (2003), “Who needs Budgets?”, Harvard Business Review, Feb, Pg 108-115 10. Gary, L. (2003), “Why budgeting kills your company”, Harvard Management Update, May 11. Jackson, C. , Starovic, D. (2004), “Debating the traditional role of budgeting in organisations”, Paper presented at Better Budgeting: A report on the better budgeting forum from CIMA and IACEW, July 2004. 12. Jensen, M.C. (2003), “Paying People to Lie: The Truth about the Budgeting Process”, European Financial Management, 9, 3, 379-406 13. Jensen, M.C. (2001), “Corporate Budgeting is Broken – Lets fix it”, Harvard Business Review, Nov, 95-101 14. Libby, T., Murray-Lindsay, R. (2007), “Beyond Budgeting or Better Budgeting?”,Strategic Finance, 89, 2, Pg 46 15. Lyne, S. (2004), “Beyond Budgeting or Better Budgeting”, Paper presented at Better Budgeting: A report on the better budgeting forum from CIMA and IACEW, July 2004. 16. Morlidge, S. (2005), “Life Beyond Budgets? An implementation story- Beyond Budgeting at Unilever”, Beyond Budgeting by

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