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1 Inadequacies of Traditional Budgeting Kalaithasan Kuppusamy and Vivi Sumanti Introduction A budgeting process is defined as those procedures and activities undertaken to develop a budget. Langfield-Smith, Thorne & Hilton (2006) write that a budget is a detailed financial plan that covers a specific future period of time, determining the managers targets and summarizing the financial consequences of company operations during that specific period. Since the beginning of the 20 th century, budgeting has become one of the very important management concepts used in planning and controlling mechanism of an organization. It serves the major purpose of forecasting future development of an organization, assisting in planning process, facilitating communication and resources allocation, controlling operations and motivating employees through performances evaluation and incentives (Weber & Linder, 2005). Hence, budgets have been recognized by many organizations as a key element in their management control systems (Libby & Lindsay, 2007). Though, at times, the traditional budgeting process is longwinded, it is still practised and accepted as a necessary evil in companies. However, recently, the traditional budgeting process was subject to considerable criticisms. Many have claimed that budgeting does not always provide a solution to the planning and controlling needs of a business (Langfield- Smith et al., 2006). These criticisms, have nevertheless, lead to two alternative approaches; better budgeting concept, which aim to modify and renew the current budgeting process and beyond budgeting, which has completely abolished budgets and budgeting (Weber & Linder, 2005). CIMA (2010) took the initiative to survey the current budgeting practices among the UK companies to gain evidences about the shift to new budgeting methodologies. The results of this survey are summarized in Table 1. From this survey, it was apparent that the notion of practitioners not being satisfied with the traditional budgeting systems is not largely true. However, there has been some feeble agreement that these traditional systems are only suitable for stable environment and increased decentralization summons a better approach to facilitate better coordination and performance. To a certain extent, there is consensus towards a new 1

2 budgeting approach because of the changing and competitive business environment. This paper aims to provide a condensation of past literature on the inadequacies of traditional budgeting and the new approaches, purportedly, to be the solution to overcome these inadequacies. The paper is structured into two main sections. Firstly, it critically discusses and evaluates the issues related to the shortcomings of traditional budgeting to meet its objectives of planning and control and, secondly, it delves briefly into its purported alternatives, namely, better budgeting and beyond budgeting. The paper continues with a section on past literature and subsequently, a section on the criticisms of traditional budgeting. Next, the new approaches to budgeting are briefly explained. Finally, a concluding section is provided to summarize the salient points in this article. Table 1: Summary of CIMA survey result on budgeting practices in UK (40 respondents) Budget Preparation: 1. All companies prepare budgets 2. Budget process commences between 4 to 6 months before implementation 3. Annual budget is prepared based on a monthly breakdown 4. Variances are done comparing actual with budget and past year result. 5. Budget preparation is structured in line with responsibility centres Managerial Attitude: 1. Most managers concur on the importance of budget for planning, controlling, performance evaluation, communication, coordination and authorization. 2. Time consuming is the only criticism by most managers 3. Non-financial managers were likely to think budgets are unrealistic. 4. A few concerns were raised pertaining to lack of local ownership (top-down budgeting), lack of accountability, the need for better budgeting process and the role of top and operating managers. Budgeting Process: 1. There has been some changes in the last five years, such as, junior management involvement, more detailed analysis and intensification of the use of budgets 2. More sophisticated traditional budgets with emphasis on tighter controls. 3. Utilization of the balance scorecard has improved and greater emphasis on standard costing and variance analysis. Budgeting Behavioural Influence: 1. Budget constraint culture set in profit centres cause some work tension 2. Cost centres are acceptable to budget constraints 3. Profit centre managers emphasize on managerial responsibility and allows unbudgeted spend 2

3 4. A balance of stringent controls and supportive budgeting is required Need for Beyond Budgeting: 1. Lack of evidence that traditional budgets fail in competitive business environment 2. Traditional budgeting still seen as helpful in planning and control 3. Though performance contracts were acceptable, there were many criticisms on incentive-based on budget targets. 4. Budgeting makes companies more profit conscious rather than constrained Adapted from: nning/cid_ressum_budgeting_practice_organisational_structure_may2010.pdf Past Literature on Budgeting Problems In the account of White (1998), traditional budgeting includes a set of common institutions and goals, which has evolved from the 18 th to the 20 th century. One of the very first definitions of budgeting was provided by Aaron Wildavsky (1978; 502 cited in White, 1998), in which he defines budgeting as an annual, incremental, conducted on a cash basis in the form of line items which serves a purpose of accountability, control in many senses, pursuit of efficiency or effectiveness, economic management and planning. Starting from the early of 1920s, budget has become one of the key elements in the management control systems, which was widely used by companies such as, General Motors in the U.S. and Siemens in Germany (Weber & Linder, 2005). Nevertheless, in the mid-20 th century, traditional budgeting process was subject to criticisms. Libby & Lindsay (2007) proposed that despite of the usefulness of budget in planning and performance evaluation, many people have criticised budget as the cause of earnings manipulation, time consuming, costly and barriers to creativity. This finding supports the study by Bunce & Fraser (1997) which found that some of the companies are abolishing budgets and finding better ways of managing. On the other hand, the findings of Pilkington &Crowther (2007) proposed that it is important for organizations to develop some kind of budgetary process for growth and at times, survival. This finding is consistent with the prior study bydzamba (2003) who proposed that traditional budgeting should not be abolished. Also, a recent survey conducted in Europe indicated that whilst most of the companies are ready to change their budgeting practices, they are not willing to do so (Bunce & Fraser, 1997). For decades, concern for budgeting process is becoming more evident while the issues and criticisms on the effectiveness of budgeting remain as a controversial subject. 3

4 Past study done by Leitch (2003) proposed that the communication process in developing budget will normally drag for months and thus, resulting in time wastage. Libby and Lindsay (2007) further agreed on this by stating that senior executives and financial managers spend 20 up to 30% of their time for the budget preparation. This is consistent with the finding by McVay & Cooke (2006). Hence, they believed that traditional budget should be abolished as it is time consuming and result in wastage of resources. Next, study done by Babbini (1999) identified the failure of budget in considering the non-financial factors, such as customer loyalty and product/service quality. This finding was further elaborated by a study done by Libby & Lindsay (1995) which discovered that non financial factors play an important role in the formulation of company strategy. Thus, failure to include these factors will result in an absence of alignment between budget and strategy. Consequently, budgets are claimed to be ineffective as a planning tool (Bunce& Fraser, 1997). In regards to budgeting as a performance measurement mechanism, Hope and Fraser (2003, cited in Libby & Lindsay, 2007) found that tying budget target to incentives may encourage gaming and dysfunctional behavior. To attain a better performance evaluation and to receive the bonuses, managers might modify the budget (Neely, Bourne & Adams, 2003). This will consequently impair the long-run performance of the organization and contribute to company s failures. Criticism of Traditional Budgeting As noted in the review of past literature above, many problems with the traditional budget have been identified. Almost all relates to the much perceived benefits of budgeting such as aiding in planning, facilitate coordination and resource allocation, providing a basis for control, a tool for communication and motivation, and a benchmark for performance evaluation. However, these benefits are now assailable. This section specifically highlights the criticism related to some of these purported benefits. Time Consuming One of the functions of budgeting process is to facilitate communication between managers from all levels and between managers and their subordinates (Langfield-Smith et al., 2006, p. 417). This communication process is apparent in the process of setting the target (goal) for the budget. However, the negotiation or so-called communications process usually 4

5 drags on for months as it involves a huge effort from the finance team and management (Leitch, 2003). The study done by Libby & Lindsay in 2007 indicates that senior executives and financial managers spend 20 up to 30% of their time for the budget preparation. Often, most of this time is spent on calculating, explaining and arguing about the growing variances between the budgeted and actual results (McVay& Cooke, 2006). Thus, traditional budgeting is being criticised as time consuming, while in some of the multinational corporations, the opportunity cost for senior executives to forgo their time would simply mean that billion dollars of sales are forgone. Hence, an organization should ask a further question on whether these significant expenditures would be offset by the value created by the budgeting process. Companies such as Svenska, Ikea, and Fokus Bank have proved that they are successful even without the budgeting process (Leitch, 2003). They argued that traditional budget focuses too much on the financial outputs rather than providing insight into operational requirements. Thus, they believed that traditional budgets should be abolished as it is a waste of time. Instead, the time savings could be used to help the management in analysing the operational requirements and in the strategy development process (McVay& Cooke, 2006). Strategic Alignment and Focus In most of the companies, budgets were designed mainly for the purposes of financial forecasting, managing cash flow and capital expenditure and controlling costs (Bunce& Fraser, 1997). These budgets were developed by accountants from the financial data and chart of accounts and thus, results in focusing merely on managing by figure. However, time has changed and single focus on figure may limit the value of budget in the planning process. In today s business environment, budget as a tool for business planning needs to be dynamic and linked to strategic plans, which means that it should include both financial and nonfinancial indicators, such as sales per customer and number of repeat customers (Thomas, 1998; Anon, 1999; Hope & Fraser, 2001 cited in Langfield-Smith et al., 2006). Also, Babbini (1999) pointed out that budgets failed to measure and take into account factors such as customer loyalty, development of intellectual property, speed to meet customer expectations, employee development and product/service quality. These factors are critical in the success of organization and thus, budgets are claimed to be ineffective as a planning tool. Furthermore, companies are now placing the emphasis of their strategy on managing processes as the cornerstone of value creation (Libby & Lindsay, 2003). To achieve this value 5

6 creation, company strategy often deals with non-financial value drivers. Consequently, budgets as financial representations of firms operational details in terms of costs and revenues are not explicitly linked to the strategy (Libby & Lindsay, 2003). In addition, long term strategic planning and annual budgeting are generally treated as a separate process in companies. As a result, in designing the discretionary activities to accomplish the strategic alternatives, human and financial resources in the budget permit might be overlooked. Consequently, employees at lower level will have little understanding of company s strategy and thus, they are unable to fit their goals to the achievement of company s strategy. Based on reasons, budget does not always provide an ideal vehicle for the management functions which have been piled on to it, such as communication of corporate goals, setting objectives, continuous improvement and resource allocation (Bunce& Fraser, 1997). Again, budgets are claimed to be less effective in planning process, as there is not any clear alignment between strategy and budgeting. This is further supported by the survey done by Robert Kaplan and David Norton (cited in Libby & Lindsay, 2003) which shows that 60% of organizations do not link their strategy and budgeting. Unresponsive to Changes and Uncertainty Leitch (2003) argued that the target (budget) which set in advance, has indirectly suggested a certainty about future events. This is unrealistic and encourages managers to ignore uncertainties. He further argued that managers will not think about how to manage the uncertainties and future opportunities when they were not mentioned in the budget. Thus, he claimed that budgets have blocked good management of risk and uncertainty (Leitch, 2003). Furthermore, Libby & Lindsay (2003) argued that when there is a large variance between the actual and budgeted results, to obtain a realistic budget may require revising the budget. This will be costly and conflict with the motivational and performance evaluation functions of budgeting process. Therefore, relying on budgets which are unrealistic and unresponsive to uncertainties may lead to significant problems for a business. Budgetary Gaming Budget serves as a benchmark to allow a comparison against actual financial results at all levels of a business and thus, enable top level managers to control and evaluate the performance of its subordinates (Langfield-Smith et al., 2006, p. 417). In other word, target is set at the beginning of the period and results are controlled and evaluated relative to this static 6

7 plan. This may encourage gaming and adverse (dysfunctional) behaviour (Neely et al., 2003). Subordinates would expect to received a good performance evaluation and thus, modifying the budget. For instance, to avoid the possibility of top management setting unachievable target and to obtain an easy target, subordinates will then underestimate the profit and overestimate costs (Libby & Lindsay, 2003). Even worse, after meeting this target, managers and subordinates will tend to relax and the company performance will then slow down (Leitch, 2003). Consequently, control mechanism which is based on this target is then claimed by many experts as ineffective and unrealistic. To accentuate its adverse effect, many companies are now using budgets as a tool to motivate their employees, by providing incentives. Hope and Fraser (2003, cited in Libby & Lindsay, 2007) argue that tying budget target to compensation contracts will encourage managers to game the budgets with the wish to receive positive performance evaluation and, therefore, any related bonus. The study done by Libby & Lindsay in 2007 further indicates that to achieve target and obtain bonus, managers will often reduce necessary expenditures such as advertising, R&D and employee training, negotiate easier targets, accelerate sales near the end of the reporting period by offering additional discounts to customers and holding back profits when they are exceeding the target so that it will be easier to meet next year target. Therefore, regardless of the governments and investors effort in promoting honesty and transparency in company reporting, budgets have encouraged managers and staffs to act dishonestly (Anonymous, 2003). Consequently, these actions will impair the long-run performance of the organization and even worse, leading to outright fraud that contributes to company s failures. Barriers to Creativity The performances of managers and their subordinates are evaluated and controlled by budget and thus, their roles, movements and plans are strictly defined, limited and constrained by the single aim to attain the target budget (Pilkington &Crowther, 2007). Therefore, budgeting practice is claimed to limit their creativity, which might be necessary for them to contribute towards value creation for the organizations. 7

8 Alternative Approaches In response to the criticisms towards traditional budgeting and to overcome its limitations, alternative approaches, such as better budgeting and beyond budgeting were developed. Better Budgeting Many companies today are still operating with the traditional budgets. These companies were looking for an evolutionary approach in improving their budgeting process rather than a revolutionary approach on budget elimination (Hope & Fraser, 1997). Thus, their current budgeting process were modified and improved and better budgeting was then emerged as the result of these modifications. Better budgeting focuses and improves the strategic aspect of traditional budgeting by taking into consideration the non-financial key indicators (Marino, 1997). Better budgeting consists of five principal approaches and techniques which are activity based budgeting (ABB), zero based budgeting, value based management, profit planning, rolling budgeting and forecast (Neely et al., 2003). The first two techniques, ABB and zero-based budgeting focus on cost effectiveness and accountability and thus, improve the focus and accuracy of budget (Babbini, 1999). ABB, similar to activity-based costing, recognizes that cost is dependent on the activities of the organization and hence, control is instituted on activity cost drivers. Thus, it is the demand for the activity that will be estimated and cost is budgeted for each unit of activity. ABB emphasizes on cost estimates based on activity terms. Zero-based budgeting sees that every year is completely a new year where its estimates have to be relooked after setting every activity to zero. Justification is done through a cost/benefit analysis. Traditional budgeting projects based on past results or data, though justification is still necessary. ZBB is said to have the most effective allocation of resources.however, these two methods (ABB and ZBB) were seldom used on a regular basis as they tend to require more work than traditional budget (Neely et al., 2003). On the other hand, value based management and profit planning take into account the value creation process but were found to be more theoretical and less practical (Neely et al., 2003). For example, value-based management strictly try to concentrate on key value drivers. Its approach requires management to align a company s overall aspirations, analytical techniques,and management processes to focus management decision making on thekey drivers of value (Koller, 1994). Improved economic earnings are regarded as strategic 8

9 returns that a company should strive to achieve. McKinsey, the consulting company, was promoting this approach in the 1990s since there was a significant relationship between economic earnings and share prices at that time. However, its importance faded and valuebased management is obscurely remembered now. The fifth approach, rolling or continuous budgets and forecasts, appears to be a better regular budgeting approach as it successfully improves the forecast accuracy and overcome the traditional budgeting s time-lag problem (Neely et al., 2003). Rolling budgets have been used in many big companies such as Electrolux and General Electric where their annual master budget is divided in four-quarter rolling budgets (Madison, 2004). When the first quarter of the budget is implemented, a new budget is prepared for the next (fifth) quarter. In this case, the budgeting process is continuous. This enables managers to be efficient in forecasting numbers and anticipate uncertainty quite accurately. Nevertheless, this approach was inferior to markets coordination in a highly dynamic setting (Weber & Linder, 2005). Consequently, none of the above techniques provide a complete and perfect solution. Beyond Budgeting Companies such as SvenskaHandelsbanken, Carnaud Metal Box, Fokus Bank, AB Volvo and Park Nicollet Health Services have eliminated budgets altogether and were now proven to be successful in adopting beyond budgeting approach (Leitch, 2003). Fraser & Hope (2003, cited in McVay & Cooke, 2006) defined beyond budgeting as an innovative and more flexible approach to budgeting that avoids many of the pitfalls of traditional budgeting. CIMA (2007) too, concurred with this definition, reflecting on the literal meaning of the term beyond budgeting, that is to move beyond the traditional budgeting due to its inherent flaws. It is suggested that the traditional budgets should be abolished and make way for more adaptive and decentralised approach such as beyond budgeting. Companies must be more vibrant in view of the changing business environment. Changes such as intense competitions require greater emphasis on intangible assets as value-creating drivers, awareness of shorter product and strategy cycles, and understanding of declining price and margin. As such, focusing on a fixed performance contract like in the traditional budges is not the right option to move forward. This approach aims at ensuring coordination through group and market agreements which will result in a more efficient and effective way of ensuring forecasting, coordination and motivation irrespective of the individual organization (Weber & Linder, 2005). Beyond budgeting may employ a number of approaches to achieve 9

10 its aim of value creation for the organization. For example, the balance scorecard can be combined with rolling forecasts and continuous improvement (kaizen) in order to achieve its value-focused strategy. Fraser and Hope (2003) identified six characteristics of firms that have implemented beyond budgeting. These include a good corporate governance framework, high performance organizational culture, lower level decision making, value-creating responsibility among teams, customer focus and transparent and ethical information system. Target setting based on key performance indicators and not specifically financial numbers, rewards for relative performance and not fixed targets, or availability of resources as per requirement opposing to annual allocation are some evidences of differences in beyond budgeting approach. However, despite of these benefits, most of the companies are still not ready to accept this revolutionary change and thus, they are unwilling to eliminate their current budgeting process (Hope & Fraser, 1997). In the study done by Libby & Lindsay (2007), many companies indicate that budget is indispensable and they could not manage without budget. Also, rather than going for beyond budgeting, these companies chose to improve their current budgeting process and carry on with the status quo. Summary & Conclusion In summary, many have claimed that traditional budgeting process does not always effectively provide a solution to the planning and controlling needs of an organization. Firstly, traditional budgeting was criticised as being too time consuming and thus, indicating a wastage of resources. Secondly, traditional budget is claimed to be less effective in planning process, as it fails to take into account the non-financial indicators, such as customer loyalty, employee development and product/services quality. As a result, there is not any clear alignment between strategy and budgeting. Besides, traditional budgeting is too unresponsive to the changes and uncertainties in today s turbulent environment. Last but not least, as a controlling and performance measurement tool, traditional budgeting is subject to budgetary gaming and thus, results in an ineffective and unrealistic target. This may impair the long run performance of an organization. Also, traditional budgeting constrained the creativity of managers and their subordinates. Therefore, in order to overcome all these limitations, time and effort were spent on developing the alternative approaches; better budgeting concept, which aim to modify and renew the current budgeting process and beyond budgeting, which has completely abolished budgets and budgeting. Nevertheless, neither of 10

11 these alternatives could be viewed as a complete and perfect solution. Indeed, whilst many companies are doing much to improve their performance, the budgeting process remains unchallenged and largely unchanged. References Anonymous (2003), Budgetary health warning issued.financial Management, Vol. 3, No. 1, pp. 4. Anonymous (2007), Beyond Budgeting, CIMA Topic Gateway Series No. 35, Available at: Babbini, C. (1999), Reality check: Is traditional budgeting under siege?,cma Management, Vol. 73, No. 9, pp Bunce, P. & Fraser, R. (1997), Beyond budgeting, Management Accounting, Vol. 75, No. 2, pp. 26. Dugdale, D. &Lyne, S. (2010), Budgeting practice and Organizational Structure, CIMA Research Executive Summaries, Volume 6, Issue 4, Available at: budgeting_practice_organisational_structure_may2010.pdf Dzamba, A. (2003), Financial analysis, planning and reporting. IOMA s Report, Vol. 8, No. 3, pp Hope, J. & Fraser, R. (1997), Beyond budgeting breaking through the barrier to the third wave. Management Accounting, Vol. 75, No. 11, pp Koller, Timothy. (1994), What is Value-based Management? The McKinsey Quarterly, Number 3, Available at: Langfield-Smith, K., Throne, H. & Hilton, R. (2006), Management Accounting: An Australian Perspective, 4 th edn, McGraw-Hill, Australia. Leitch, M. (2003), The dawning of new age: control without budgets, Balance Sheet, Vol. 11, No. 3, pp Libby, T. & Lindsay, R.M. (2003), Budgeting an unnecessary evil, CMA Management, Vol. 77, No. 1, pp Libby, T. & Lindsay, R.M. (2007), Beyond budgeting or better budgeting?, Strategic Finance, Vol. 89, No. 2, pp Marino, S. (1997), Be aware of straitjacket budgeting, Industry Week, Vol. 246, No. 17, pp. 27. Madison, Roland L. (2004), A Closer Look at Rolling Budget, Management Accounting Quarterly, Available at: McVay, G.J. & Cooke, D.J. (2006), Beyond budgeting in an IDS: the Park Nicollet experience, Healthcare Financial Management, Vol. 60, No. 10, pp Neely, A., Bourne, M. & Adams, C. (2003), Better budgeting or beyond budgeting?.measuring Business Excellence, Vol. 7, No. 3, pp Pilkington, M. &Crowther, D. (2007), Budgeting and control, Financial Management, Vol. 1, No. 1, pp Weber, J. & Linder, S. (2005), Budgeting, better budgeting, or beyond budgeting, Cost Management, Vol. 19, No. 2, pp