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 managements 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 its possible implications in todays changing business environment (CIMA, 2004; Daum, 2002; Marginson, Ogden, and Frow, 2006). Some researchers think that, traditional budgets have lost their relevance in todays 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 todays 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 didnt 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 Wallins 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 Lindsays 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 dont 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 todays 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 topdown 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 payschemes 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 payscheme 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 designers 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 todays 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 organizations 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.

References
Abernethy, M.A. and Brownell, P., 1999. The role of budgets in organizations facing strategic change: an exploratory study. Accounting, Organizations and Society [e-journal] 24(3), pp.189204 Available through: Science Direct database [Accessed on 10 December 2011]. Becker, S. and Green, D.J., 1962. Budgeting and employee behavior. The Journal of Business [e-journal] 35(4), pp.392-402 Available through: JSTOR database [Accessed on 1 January 2012]. Beyond Budgeting Roundtable, 2012. Beyond <http://www.bbrt.org/beyond-budgeting/beybud.html>. Budgeting [Online] Available at

Brownell, P. and McInnes, M., 1986. Budgetary Participation, Motivation, and Managerial Performance. The Accounting Review [e-journal] 61(4), pp.587-600 Available through: JSTOR database [Accessed on 1 January 2012]. CIMA, 2004. Better Budgeting. [pdf] London: Silverdart Available at: <http://www.icaew.com/en/technical/business-and-financial-management/finance-and-managementfaculty/~/media/Files/Technical/Business-and-financialmanagement/Special%20reports%20archive/sr4_better_budgeting.ashx> [Accessed on 14 December 2011]. Collins, F., 1978. The Interaction of Budget Characteristics and Personality Variables with Budgetary Response Attitudes. . The Accounting Review [e-journal] 53(2), pp.324-335 Available through: JSTOR database [Accessed on 1 January 2012]. Daum, J.H., 2002. Beyond Budgeting: A Model for Performance Management and Controlling in the 21st Century? [Online] Available at: <http://www.juergendaum.de/articles/beyond_budgeting.en.pdf> [Accessed: 20 December 2011]. Ekholm, B. and Wallin, J., 2000. Is the annual budge t really dead? The European Accounting Review [ejournal] 9(4), pp. 519-539 Available through: Business Source Complete database [Accessed on 10 December 2011]. Fisher, J.G., Maines, L.A., Peffer, S.A. and Sprinkle, G.B., 2002. Using Budgets for Performance Evaluation: Effects of Resource Allocation and Horizontal Information Asymmetry on Budget Proposals, Budget Slack, and Performance. The Accounting Review [e-journal] 77(4) pp.847-865 Available through: Business Source Complete database [Accessed on 10 December 2011]. Frow, N., Marginson, D. and Ogden, S., 2005. Encouraging strategic behaviour while maintaining management control: Multi-functional project teams, budgets, and the negotiation of shared accountabilities in contemporary enterprises. Management Accounting Research [e-journal] 16(3), pp. 269-292 Available through: Science Direct database [Accessed on 10 December 2011]. Gurton, A., 1999. Bye bye budget...the annual budget is dead. Accountancy [e-journal] 123, pp.61 Available through: Business Source Complete database [Accessed on 10 December 2011].

Hansen, S.C. and Van der Stede, W.A., 2004. Multiple facets of budgeting: an exploratory analysis. Management Accounting Research [e-journal] 15(4), pp. 415-439 Available through: Science Direct database [Accessed on 10 December 2011]. Hofstede, G.H., 1968. The game of budget control. London: Van Gorcum. Hope, J. and Fraser, R., 2003. Who needs budgets? Harvard Business Review [e-journal] 81(2), pp.108115 Available through: Business Source Complete database [Accessed on 10 December 2011].

Imoisili, O.A., 1989.The role of budget data in the evaluation of managerial performance. Accounting, Organizations and Society [e-journal] 14(4), pp.325-335 Available through: Science Direct database [Accessed on 10 December 2011]. Jensen, M.C., 2011. Corporate Budgeting is Broken-Let's Fix it. Harvard Business Review [e-journal] 79(10), pp.94-101 Available through: Business Source Complete database [Accessed on 10 December 2011]. Jensen, M.C., 2003. Paying people to lie: the truth about the Budgeting Process. European Financial Management, 9(3), pp.379-406. John K . Christiansen, J.K. and Skrbk, P., 1997. Implementing budgetary control in the performing arts: games in the organizational theatre. Management Accounting Research [e-journal] 8, pp.405-438 Available through: Science Direct database [Accessed on 10 December 2011]. Libby, T. and Lindsay, M.R., 2010. Beyond budgeting or budgeting reconsidered? A survey of NorthAmerican budgeting practice. Management Accounting Research [e-journal] 21 (1), pp.56-75 Available through: Science Direct database [Accessed on 10 December 2011]. Lukka, K., 1988. Budgetary biasing in organizations: theoretical framework and empirical evidence. Accounting, Organizations and Society [e-journal] 13 (3), pp.281-301 Available through: Science Direct database [Accessed on 10 December 2011]. Lyne, S.R. and Dugdale, D., 2004. The Changing Roles of Company Budgets. London: CIMA. Marginson, D. and Ogden, S., 2005. Coping with ambiguity through the budget: the positive effects of budgetary targets on managers' budgeting behaviours. Accounting, Organizations and Society [e-journal] 30(5), pp. 435-456 Available through: Science Direct database [Accessed on 10 December 2011] Marginson, D., Ogden, S. and Frow, N., 2006. Budgeting and Innovation. Complements or Contradictions? London: CIMA. Nouri, H. and Parker, R.J., 1998. The relationship between budget participation and job performance: the roles of budget adequacy and organizational commitment. Available through: Accounting, Organizations and Society [e-journal] 23(5/6), pp. 467-483 Science Direct database [Accessed on 10 December 2011].

Onsi, M., 1973. Factor Analysis of Behavioral Variables Affecting Budgetary Slack. The Accounting Review [e-journal] 48(3), pp.535-548 Available through: Business Source Complete database [Accessed on 10 December 2011]. Otley, D., 1989. Trends in budgetary control and responsibility accounting. In: A. Bhirmani, ed.2006. Contemporary Issues in Management Accounting. New York: Oxford University Press, pp.291-307. Proctor, R., 2009.Managerial accounting for business decisions. 3rd ed. Harlow: Prentice Hall Financial Times. Schiff, M and Lewin, A.Y., 1970.The impact of people on budgets. The Accounting Review [e-journal] 45 (2) pp. 259-268 Available through: JSTOR database [Accessed on 10 December 2011]. Schmidt, J., 1992. Is it time to replace traditional budgeting? Journal of Accountancy [e-journal] 174(4), pp. 1037 Available through: Business Source Complete database [Accessed on 10 December 2011]. Shim, J.K. and Siegel, J.G., 2005. Budgeting basics and beyond.2nd ed. New Jersey: John Wiley & Sons, Inc., Hoboken. Simons, R.L., 1990. The role of management control systems in creating competitive advantage: New perspectives. Accounting, Organizations and Society [e-journal] 15 (1-2) pp.127143 Available through: Science Direct database [Accessed on 10 December 2011]. Stedry, A.C., 1960. Budget Control and Cost Behavior. Englewood Cliffs, N.J.: Prentice-Hall. Wallander, J., 1999. Budgeting- an unnecessary evil. Scandinavian Journal of Management [e-journal] 15(4), pp. 405-421, Available through: Science Direct database [Accessed on 10 December 2011].