PM - Budgeting and control

Contents
Performance Hierarchy ............................................................................................................... 2
BUDGET IMPORTANCE: ........................................................................................................... 2
BUDGETS AT DIFFERENT HIERARCHIES: .................................................................................. 2
BUDGETARY SYSTEM USEFUL IN: ............................................................................................ 2
Master, Functional, Fixed and Flexible Budgets ...................................................................... 3
Participation In Budgeting: Top-Down & Bottom-Up Budgeting ................................................ 4
TOP-DOWN BUDGETING: ........................................................................................................ 4
BOTTOM-UP BUDGETING: ....................................................................................................... 4
Incremental and Zero Based Budgeting ...................................................................................... 6
INCREMENTAL BUDGETING: .................................................................................................... 6
ZERO BASED BUDGETING: ....................................................................................................... 6
Rolling Budgets ............................................................................................................................ 8
Rolling budgets are: ................................................................................................................. 8
Activity Based Budgeting............................................................................................................. 9
Beyond Budgeting ..................................................................................................................... 10
TRADITIONAL BUDGETING: ................................................................................................... 10
DRAWBACKS OF TRADITIONAL BUDGETING: ........................................................................ 10
CONCEPT OF BEYOND BUDGETING: ...................................................................................... 12
BENEFITS OF BEYOND BUDGETING: ...................................................................................... 14
DRAWBACKS OF BEYOND BUDGETING: ................................................................................ 14
SUMMARY: ............................................................................................................................ 14
Feedforward Control ................................................................................................................. 15

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Performance Hierarchy
BUDGET IMPORTANCE:

1) It provides a benchmark for organisations;

2) It allows variance analysis and performance assessment;

3) It allows improved performance based on prior period assessment.

BUDGETS AT DIFFERENT HIERARCHIES:

 Long term planning → Senior management → Plan to develop new products

 Medium term planning → Middle management → Budgeted sales targets

 Short term planning → Junior management → Budgeted material costs

Note: All levels of budgeting are linked. Budgetary system assists all levels of management.

BUDGETARY SYSTEM USEFUL IN:

 Planning;

 Control;

 Motivation;

 Communication;

 Performance assessment.

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Master, Functional, Fixed and Flexible Budgets

Budget
Description
type
Master _ Collates budgets of different business
budget: functions;
_ Consistent with overall financial
statements;
_ Profit or loss account, statement of
financial position and cash flow;
_ Represents an overall budget of
organisation;
_ Not useful for management control.
Functional _ Prepared for each organisation’s
budget: business functions;
_ Sales, material, labour, or overall
budget;
_ Highlight organisation’s structure and
responsibility;
_ Cannot be linked to a business
function.
Fixed
_ Made at the start of the year;
budget:
_ One level of activity;
_ Anticipated levels of sales and
production
Advantages Disadvantages:
_ Not useful in rapidly
_ Benchmark for control purposes;
changing environment;
_ Difficult to incorporate into
_ Highlights organisational potential;
performance appraisal.
Flexible
_ Prepared at the start of the year;
budget:
_ Multiple levels of activity.
Advantages:
_ Budget for multiple levels of activity;
_ Easier to assess the performance.

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Participation In Budgeting: Top-Down & Bottom-Up Budgeting

TOP-DOWN BUDGETING:

A budget can have an “imposed” or a “participative” style, depending on the involvement of

employees.

Top-Down Budgeting is an imposed budget. It is set by senior management and reflects their
overall corporate objectives, and then works down through the different levels of the
organisation, setting appropriate targets to ensure the higher objectives are achieved.

Advantages Disadvantages
_ It is quick, as there is no participation of _ Senior management may come up with
middle or junior management; unrealistic targets,
_ Less staff training is required, meaning which will demotivate other staff and
less cost will be incurred; increase staff turnover;
_ It utilises management’s awareness of _ Budget pressure can result in employees
resource availability; uniting against management;
_ Reduced motivation and reduced
_ Budgetary slack is avoided;
employee satisfaction.
_ More objective or fresher perspectives
may be gained.

BOTTOM-UP BUDGETING:

Bottom-up budgeting is a budgeting system in which all budget holders are given the
opportunity to participate in setting their own budgets. It starts with the personal and
departmental objectives set by junior management, and then works its way up through the
different levels of the organisation, setting appropriate targets to ensure the lower objectives
are achieved.

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Advantages Disadvantages
_ Employee motivation should improve, which _ It can be time consuming and
increases the likelihood of budgetary success; expensive;
_ Junior management will have a more detailed
_ There is a risk that budgetary slack
knowledge of their area and will produce more
may be included;
realistic budgets;
_ Goals set by the junior management
_ It will encourage and improve communication
may not be consistent with the strategic
between departments;
objectives;
_ It should free up senior management time to _ There is a risk of dysfunctional
focus on other important matters. behaviour.

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Incremental and Zero Based Budgeting
INCREMENTAL BUDGETING:

Incremental budget - budget which is based on previous year’s budget or actual results and
adds or subtracts an incremental amount to cover inflation etc.

Limitations:

a) Suitable for stable organisations (commonly used within public sector);

b) Cost control should exist and discretionary expenditure should be limited.

Advantages:
- Easy to understand;
- Time-saving;
- Aids planning process;
- Facilitates operations of departmental
managers;
- Easy to identify changes.
Disadvantages:
- Prior year inefficiencies are carried
forward;
- No incentive to improve on prior year;
- Encourages excessive expenditure;
- Assumes working methods will continue
unchanged;
- Budget may become outdated;
- Does not relate to company’s nature of
work.

ZERO BASED BUDGETING:

Zero based budgeting - budgeting method which requires each cost element to be justified as
though the activities to which the budget relates are being undertaken for the first time or each
activity is approved then there is a zero budget allowance.

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Process:

Advantages: Disadvantages:
- Resources are allocated efficiently; - Time consuming and expensive;
- Budgetary slacks or waste is identified
- Staff training required;
and eliminated;
- Improves understanding of costs; - Difficult to define decision units;
- Increase staff motivation; - Rigid process;
- Commonly used within public sector; - Neglect focus on long term goals;
- Demotivated employees due to
continuous justification.
Note: Incremental budgeting is opposite to zero based budgeting. Companies may apply
bargained or compromised approach: incremental budgeting may be used on an ongoing basis
and zero based budgeting may be applied when required (for example in a period of change or
to some departments exclusively).

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Rolling Budgets
Rolling budgets are:

 Set at the beginning of the period

 Constantly updated and extended

 Extended by adding another accounting period

Advantages
- 12-month budget always exists;
- Reduces uncertainty;
- Improves planning and performance;
- More accurate and realistic budgets.
Disadvantages
- Continuous amendment required;
- Time-consuming;
- Expensiveness;
- Demotivated staff;
- Decrease productivity;
- Increased staff turnover;
- Other important matters may be ignored.

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Activity Based Budgeting
Activity based budgeting is the use of costs as determined by activity based costing as a basis
for preparing budgets. It allows to understand the nature of costs (cost drivers) and focus on
reducing them.

Reduced activity = Reduced overhead = Reduced budget

Cost driver data and related cost driver rate are used as a basis to budget.

Activity based budgeting pro forma:

Cost Total
Department 1... Department n
drivers company
Cost driver rate (OAR) 1 Cost driver rate (OAR) 1 X
Cost x x
driver 1... level of activity at cost driver 1 in level of activity at cost driver 1 in
department 1 department n
Cost driver rate (OAR) n Cost driver rate (OAR) n X
Cost x x
driver n level of activity at cost driver n in level of activity at cost driver n in
department 1 department n
Total
X X X
costs

Advantages: Disadvantages:
- Activity driven; - Complex budgeting system;
- Need to control activities that drive costs; - Staff resistance;
- Highlights non-value adding activities; - Training required;
- Management attention is focused on reducing
- Difficult to identify cost drivers;
costs;
- Detailed accounting data is
necessary;
- Little short term benefit.

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Beyond Budgeting
TRADITIONAL BUDGETING:

Organisations traditionally use budgets as a way of:

 Communicating goals and expectations to management;

 Forming the basis of targets that can be used to assess whether or not an individual has
performed well or badly;

 Encouraging performance in such a way as to meet and beat those targets.

DRAWBACKS OF TRADITIONAL BUDGETING:

There are many issues associated with traditional budgeting, most prominent ones are:

1. Environmental unpredictability:

Environments are generally unpredictable. Budgets are usually set at the start of the period. For
them to be a useful target, the person who sets the budget has to have a reasonable
appreciation what the coming period is going to be like.

However, in a modern environment where the scope of the competition is often in global,
customers are global and technology moves on at an ever-increasing pace, in many cases the
environment for the next 12 months is not stable or predictable enough to derive targets that
are likely to be challenging but achievable. In fact, the targets are likely to end up being set too
high or too low.

Either is de-motivational if a budget is too tough, people give up or if the budget is too easy
people relax. Thus, the very act of setting a target is likely to actually demotivate people in a
changing environment.

2. Time and cost:

Budget is time-consuming and costly to prepare. In a competitive world, careful consideration

needs to be given to whether the benefits of setting budgets actually justify this cost. It also
potentially focuses management on a narrow activity rather than allowing them the freedom to
manage the business more generally.

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 3. Cost control vs. cost reduction:

Budgets promote cost control rather than cost reduction. Provided budgeted costs are met,
this is viewed as a good performance irrespective of whether actual costs could’ve been lower.

4. Threatening quality:

Budgets may threaten quality as budgets are usually expressed in financial terms. The incentive
is, therefore, to reduce costs to beat the budget. However, this may threaten quality if cheaper
alternatives are used that are not considered to be as good by customers.

5. Stifle innovation:

New ideas and opportunities may present themselves during a performance period. If these are
not part of the budget, then they may well be ignored by management even though they might
be good for the overall performance of the business.

6. Dysfunctional behaviour:

Budgets can lead to dysfunctional behaviour. Managers, in their desperate efforts to hit budget
targets, may make all kinds of decisions that are not actually in the best interests of the
creation of long-term shareholder wealth. For example:

 They may focus excessively on the short-term (myopia) – They may cut back on
training and research and development to reduce costs this year and hit profit target.
This is clearly not good for the long-term development of the business.

 They may try to manipulate results to make them look better than they actually are –
This may make senior management unaware of problems.

 They may make decisions to ensure their performance metrics look good – For
example; they may lease an asset rather than buying it to reduce the amount of
investment on the balance sheet. This may or may not have been the best decision to
financially.

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CONCEPT OF BEYOND BUDGETING:

It is fairly safe to say that traditional budgeting has its issues. Hope and Fraser (2003) came up
with an alternative approach known as ‘beyond budgeting’ which suggested that traditional
budgets actually hinder rather than help organisational performance.

Beyond budgeting approach:

Let us consider LearnSignal’s pass rate in this paper, to see how beyond budgeting differs from
the traditional budgeting process.

Traditional budgeting:

 A traditional approach to budgeting for this pass rate might be for senior management to
set a budget of 90% as a target for teaching staff.
 LearnSignal may even incentivise this by offering to pay a bonus based on a pass rate higher
than 90%.
 Part of the problem is setting a target like this is it at the time the budget is set:
 No one knows what the quality of the students is likely to be;
 No one knows how difficult or easy the exam is likely to be.
 So at the time, it is set we have no way of knowing whether 90% target is too high, too low
or about right.

Beyond budgeting:

Let us change our approach here and adopt a ’beyond budgeting’ style:

 At the start of the period management and tutors might have a discussion clarifying ‘what
good looks like’;

 In other words, discussing what should be the dimensions of performance that need to be
given due focus.

 One of those areas might be pass rates. Management and tutors may well agree that pass
rates are an important dimension of performance for LearnSignal.

 We may even discuss an aspirational target, for example, the pass rate was 87% in the prior
sitting, this might give us a feel for what we would hope to beat the future period.

 It’s important to note that no firm target is set out at this point.

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Then, as teaching progresses:

 Gauge the quality of our students together, this may then raise or lower our expectations
for pass rates.

 Management will appraise the tutor’s performance on an ongoing basis in light of what the
unfolding environment shows us.

 When the exam paper is published, again we can reflect on whether the paper was
unusually difficult or easy.

 At the end of the period, we can discuss whether the tutor’s performance was good or
poor in light of the environment as we now know it to be.

 Understanding this environment may well involve benchmarking our performance against
other learning providers.

Beyond budgeting approach summarised:

In short, a beyond budgeting approach runs like this:

1. Jointly decide the dimensions of performance that need to be targeted;

2. Ensure the employee has tools and support they need to do their job;

3. Head office should minimise interference and red tape unless absolutely necessary;

4. Actual performance is appraised in light of the unfolding environment and corrective

action taken on an ongoing basis, this may involve benchmarking.

5. Long-term targets are not used to guide performance or appraise it.

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BENEFITS OF BEYOND BUDGETING:

Benefits of this approach include:

It removes having firm targets which as we have discussed can be de-motivational.

1. It also encourages responsiveness to the environment as it actually unfolds, rather than

trying to adapt behaviour to hit a relatively arbitrary target.

2. Overall, it should encourage the best possible performance in the circumstances.

DRAWBACKS OF BEYOND BUDGETING:

However, there are several drawbacks with the beyond budgeting approach:

 There is a lack of objectivity perhaps given that interpretation of performance is purely

centred on opinion in relation to the environment. This may make performance assessment
too dependent on individuals performing that assessment and their personal views.

 Other stakeholders may require forecast information to help them plan and make
decisions. Often this information is based on budgets. However, in a beyond budgeting
environment it is less likely to be readily available.

 As with any change, there is likely to be resistance from people who prefer the status quo,
change requires resources (time and money) that may be short supply.

SUMMARY:

 Traditional budgeting has plenty of problems which can potentially be overcome by using a
beyond budgeting approach.

 Hope and Fraser originally suggested the idea of beyond budgeting and it has since been
adopted by the ‘Beyond Budgeting Round Table’ (an independent research organisation
that promotes the concept).

 However, beyond budgeting is not without its problems which should be considered before
adopting it as a new approach to Performance management.

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Feedforward Control
A feedforward control is a proactive system of control where potential problems are identified
before they arise. The forecast results are compared to the budget and where deviations are
identified, corrective action is taken to ensure the budget is achieved.

A feedback system compares actual events that have happened with an original budget so this
really is a reactive system of control.

Feedback control example:

Material cost report

Budget ($) Actual ($) Variance ($)

Material 1 X X X/(X) Adverse / Favourable

Material 2 X X X/(X) Adverse / Favourable

Material n X X X/(X) Adverse / Favourable

Total X X X/(X) Adverse / Favourable

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Feedforward control example:

Material cost report

Budget Latest forecast for year Expected variance

($) ($) ($)

Material 1 X X X/(X) Adverse / Favourable

Material 2 X X X/(X) Adverse / Favourable

Material X X X/(X) Adverse / Favourable

n

Total X X X/(X) Adverse /

Favourable

Note: The use of a feedforward control system means that action can be taken to avoid
expected adverse variance arising this year.

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