The Review and Follow-up Process Key to Effective Budgetary Control

Transcription

1 The Review and Follow-up Process Key to Effective Budgetary Control J. C. Cam ill us This article draws from the research finding that the effectiveness of management control systems is influenced more by the manner of administration of the systems than by greater sophistication in their design. In particular, the process of review and follow-up of actual corporate performance in relation to the budget is identified as one of the prime determinants of effectiveness. Guidelines for ensuring an effective review and follow-up process are suggested. J.C. Camillas is professor in the Finance and Accounting area at the Indian Institute of Management, Ahmedabad. His teaching and research interests are in the areas of corporate planning and management information and control systems. He has several articles and papers to his credit both in India and abroad. Budgets have long been accepted as a vital tool for more effective short-term planning and control in organizations. The design of budgeting systems has been the subject of much attention in the area of planning and control. The focus of the existing literature has been primarily on the design of the budgeting process, the executives to be involved in this process, the approach to collecting and reporting of cost and physical performance data, and the linkages between budgeting, corporate planning and the management information function. However, recent research (Bhattacharyya and Camillus) has indicated that what is perhaps more important than the design of a budgeting system, in terms of ensuring effectiveness, is the manner of administration of the system by management. This research indicates that there is no observable relationship between the design of the management control system and the perceived effectiveness of these systems in a sample of organizations where a minimum or "threshold" level of sophistication in design of the system exists.the study indicated that as long as short-term organizational objectives are developed in a formal fashion, departmental costs are identified, the fixed, variable, stepped and discretionary nature of cost items are recognised, and variance reports are generated, further sophistication or refinement in design does not contribute to greater effectiveness of the control system. However, while in general, effectiveness showed no correlation with additional sophistication in design, one particular feature did have a significant association with the perceived effectiveness of the control system. This feature was "the reasons for budget revisions," which is perhaps one of the more important consi- Vikalpa, Vol.1. No.3, July

2 derations involved in the process of comparing and taking action on actual versus budgeted performance (review and follow-up). This finding corroborates the proposition that the review and follow-up process is the key to effective budgeting. This paper, therefore, seeks to identify what makes for an effective review and follow-up process and to suggest measures which would ensure that the process is appropriately designed and implemented so as to enhance the effectiveness of the budgetary control system. In addition to guidelines regarding the process itself, there are certain aspects of the design of the budgeting system which would probably make it more effective. For the review and follow-up process itself the key requirements for effectiveness are : 1. Evaluation of performance against potential. 2. Evaluation of managerial effort. 3. Emphasis on analysis of trends. 4. Collaborative attitude of senior mana gement. Evaluation of Performance Against Potential A common practice in many organizations is to evaluate the performance of a sub-unit of the organization by comparing its performance with that of other sub-units or of similar units in the industry. This practice is justified to the extent that similar units should have comparable levels of performance. The basic fallacy here is the assumption that units are similar. For example, if one takes two identical sub-units in an organization, say two telephone exchanges in a telecommunications organization, the validity of the proposition that these two sub-units are comparable can be tested. Even assuming that the size of the telephone exchanges are identical, that they are located in metropolitan cities, and that the technology is the same, the dimensions along which differences can arise are innumerable. The climatic conditions, the frequency of interruptions due to power failures, the attitudes of labour, the strength of the labour unions, the 2 priorities demanded by the users, the pattern of usage, the effect of vibrations caused by traffic, etc., are some of the valid reasons for performance being different. To take another example, two branches of a bank can be wholly different. One branch may be "deposit heavy" and located in an urban area of declining respectability with no commercial activity of any significance. The other branch could be "advance heavy" and located in a commercial district of growing importance. To compare such sub-units would either demotivate the managers responsible or provide scope for innumerable rationalizations if performance is unsatisfactory. Performance evaluation should always be in relation to the potential available to the unit. The potential for achievement varies, depending on a multitude of factors. It is the effectiveness of the budgeting exercise in approximating the potential available that influences how optimally the organization. is functioning. However, even if the true potential is not identified, it would still be better, from the behavioural point of view, to evaluate managers against their budgeted performance or in other words their commitments in terms of achievement rather than by comparing them with other units of doubtful similarity. In short, performance evaluation of a unit must always be in relation to budgeted performance of the unit and not in relation to the performance of "similar" units. It must be emphasized that comparing the performance of a unit with that of another is not always undesirable. Rather, comparisons are useful at the planning stage to ensure that the most appropriate and effective methods are being employed, that the full potential is identified and exploited, and that the knowledge and advances made by one unit are made available to others. Nevertheless, comparing the performance of two or more units at the evaluation stage is wholly undesirable from both the practical and behavioural points of view. Evaluation of Managerial Effort While performance evaluation, as recommended above, should optimally be in relation Vikalpa

3 to the budget, which in turn is assumed to reflect available potential, a major difficulty is that potential is extremely difficult to determine. Consequently, in terms of performance evaluation, an added dimension needs to be introduced. The commitment made by the manager of the unit at the time of budgeting may not be achieved for a variety of reasons. These reasons need to be classified into two major categories. First, achievement may fall short of commitment because the potential anticipated did not exist or because assumptions made when the budget was developed were found to be invalid later. Second, the shortfall may be due to inadequate efforts or inappropriate decisions made by the managers responsible. Obviously, it is the latter category of reasons for nonachievement of budgeted performance that should concern the superior evaluating his subordinates. To suggest that evaluation should focus not only on the extent of non-achievement of budgeted performance but also on the reasons for non-achievement is neither a compromise nor an indication of the lack of "tough-minded" management but rather a recognition of the reality that it is almost impossible to predict precisely the available potential in most situations. Therefore, it is both necessary and appropriate to evaluate the efforts made by managers to achieve the budgeted level of performance. The resultant culture in an organization where managers are aware that the intensity of the efforts that they put in is a major consideration in the evaluation process is obviously desirable. Emphasis on Analysis of Trends Perhaps one of the most important principles in exercising effective control and ensuring a meaningful review and follow-up process is that of analysing trends rather than "one-time" performance. This principle is one of the basic tenets of the extremely effective control system employed by ITT. Their approach is to focus managerial attention only on those areas where a declining or unsatisfactory performance is indicated by a sequence of two or more reports. Vol.1, No.3. July 1976 Obviously, performance in each month or each reporting period cannot be expected to be identical to budgeted performance. At the same time, performance over two or three reporting periods or two or three months cannot be at variance from cumulative budgeted performance without causing concern and triggering analysis and remedial action. This does not mean that "one-time" variances of a sizable magnitude should be ignored. Managers should, however, be aware of where variations are likely to occur because of inherent difficulties in accurately projecting performance, and consequently they should suitably restrict analysis and reduce the attention paid to variances in such areas. In short, the approach should be primarily one of following trends and indicating to the responsible manager that continuing unfavouraable trends have been spotted. The appropriate actions to be taken if the trends continue is discussed below. Collaborative Attitude of Senior Management The tendency in many organizations is for top management to react strongly to every variance the moment it occurs. However, what is needed at this stage is at the most an indication to lower levels of management that top management is aware of such deviations from budgeted performance. If these deviations continue, top management's responsibility is to arrive, jointly and collaboratively with lower levels of management, at a formal understanding of the remedial action necessary to correct the shortfalls. Unfortunately, though there is a strong inititial reaction, often no further follow-up is undertaken and the tendency is to leave it entirely to lower levels of management to arrive at suitable remedial action. This approach is certainly not in keeping with either the responsibilities that top management should assume or the capabilities, broader perspective, and multifunctional understanding that they can contribute to the appropriate identification of remedial 3

4 action. No doubt, the level of management responsible for the shortcoming should decide what remedial action should be taken, unless of course this level of management displays an extraordinary degree of incompetence. Nevertheless, top management can and should contribute to the process of deciding on suitable remedial action by suggesting further alternatives for consideration and by bringing together different executives who might share a common responsibility for a variance. In short, what is needed is a graduated response to variances, with increasing pressure to remedy the situation if a shortcoming continues. This is distinct from and contrary to the usual practice of over-reaction at the initial stage and a failure to follow-up if the shortcoming continues. Also, the review and follow-up process does not cease when remedial action is identified. It is necessary that a system be formally adopted whereby the implementation of remedial action decided upon is monitored and further remedial action generated if the shortcomings are not overcome. The design of other elements of a budgeting system can also contribute to more effective review and follow-up. For ensuring a better review and follow-up exercise, budgeting systems should be such that : 1. Action plans are incorporated in the output of the budgeting exercise. 2. Contingency plans are developed when preparing the budget. 3. The assumptions that are made by all levels of executives when the budgets are developed are identical. Development of Action Plans In terms of ensuring an effective review and follow-up process, the existence of action plans with certain characteristics is of very great assistance. Budgets have long been viewed as a set of financial statements representing the anticipated consequence of a set of managerial decisions. However, in ensuring an effective review and follow-up process, the management actions and decisions which lead to the expected financial results are of much greater utility and importance than the results themselves. Thus, a budget should, in addition to such financial statements, include : 1. Specific management actions to be taken in the budget period. 2. An identification of the executives res ponsible for carrying out the specific actions. 3. The deadline by which the actions are to be taken. If these three aspects are included in the budget, monitoring of managerial performance is obviously simplified and, more importantly, identification of suitable remedial action is also greatly facilitated. In terms of ensuring that useful action plans are developed, especially in "profit centres," the focus of managerial attention at the time of developing budgets should again shift from the expected profit figure to the means of achieving this level of profits. Thus, the budget should focus primarily on how much each of the following would contribute to an enhanced profit figure : 1. Changes in raw material prices. 2. Cost reduction programmes. 3. Changes in sales prices. 4. Promotional plans. 5. Changes in the product mix. 6. Increase in volume of sales of existing products in existing markets. 7. Tapping of new markets. 8. Introduction of new products. 9. Changes in accounting practices. A similar approach needs to be employed in analysing and specifying through action plans the means for achieving the budgeted performance along other financial parameters. Contingency Plans The development of contingency plans contributes to a more effective review and follow-up process in that the response time for management action in case of unexpected 4 Vikalpa

5 happenings is considerably reduced. There can be two basically different approaches to the development of contingency plans. One is the "single variable approach" and the second is the "scenario approach." The single variable approach focusses on one variable such as sales or orders booked. Contingency plans are then developed to determine management actions to be taken if this variable changes from what was anticipated at the time of developing the budget. The level of sophistication of the contingency plan depends upon management's decision as to the amount of detail desirable in specifying actions to be taken if the value of sales or orders booked exceeds or falls short of expectations. Also, the number of contingency plans to be developed for different values of the selected variable is another aspect which requires a specific decision on the part of management. The scenario approach, in contrast to the single variable approach, focusses on a number of variables which are thought to define the total environment in which the organization is to operate. The usual practice is to develop a detailed and formal understanding of what is most likely to be the environment during the budget period and a somewhat less detailed write-up of the most unfavourable and the most favourable environments that might possibly be encountered during the budget period. The management actions to be taken in the most likely environment would constitute the budget, while less detailed statements of management actions in the most favourable and the most unfavourable environments would constitute the contingency plans. Thus, if the actual environment encountered is at variance from what was expected as the most likely, in either the favourable or the unfavourable direction, management has some understanding of how it can respond to such developments. The scenario approach is somewhat more difficult in practice than the single variable approach but has the advantages of : 1. Ensuring that managerial analyses at the time of developing the budget are more comprehensive and detailed. Vol.1, No.3, July Ensuring that the state of several variables which might influence the organization are formally monitored. The single variable and scenario approaches can be applied to factors internal or external to the organization. A matrix of approaches to contingency planning is therefore possible (Figure 1 ). Contingency Planning Variable Figure 1 Approaches to Type Single Scenario Though four basic approaches are conceivable, in the single variable approach an internal variable is more commonly adopted. At the departmental level, flexible budgeting can be visualized as an example of the internally focussed single variable approach. The scenario approach, on the other hand, is generally developed with a focus on external or environmental variables. Common Assumptions The process of budget development itself can be of significant importance in ensuring an effective review and follow-up exercise. The final budget arrived at should represent a mutually acceptable commitment to achievement in the budget period from the view points of both the superior and the subordinate. The budget should, moreover, be developed on the basis of common assumptions relating to the likely state of critical variables influencing performance in the budget period. The budgeting process should, therefore, ensure that in addition to arriving at a com- 5

6 promise between top management's expectations of performance during the budget period and operating management's assessment of potential available, this compromise should be arrived at on the basis of formally stated and commonly accepted assumptions. Any understanding of what performance is desirable and feasible from the points of view of top management and operating management has no meaning unless a common rationale exists. Any apparent congruence of understanding without a common rationale and identical assumptions would be nothing but happenstance and a sure source of disagreement later if actual performance falls short of the budgeted requirements. Also, if one accepts the philosophy that "plans are conceived in order to be aborted" in other words that plans primarily provide a benchmark which would indicate when actual happenings deviate from management expectations, consequently indicating the need for appropriate management response and remedial action the importance of common assumptions at the budget development stage is enhanced. Thus, to ensure that the review and follow-up- exercise does not occasion differences of opinion but fosters a better understanding of what has gone wrong, it is essential that not only should there be an informal understanding of the assumptions that are the basis for the budget but these assumptions should be clearly and formally stated so as to eliminate or minimize the possibilitiy of disagreements and misunderstandings later. In conclusion, it bears reiteration that the quality and nature of the process of reviewing actual in relation to budgeted performance is perhaps, as supported by research findings, the most important determinant of the effectiveness of budgeting systems. Furthermore, if the design of the budgeting system and the mode of administration of the review and follow-up process incorporate the very simple approaches and principles mentioned, there is every possibility of exploiting the full potential of budgetary planning and control systems. Reference Bhattacharyya, S. K., and Camillas, J. C. "Implementation Problems of Management Control Systems." Ahmedabad: Indian Institute of Management, Technical Report No Vikalpa