The strengths and weaknesses of the traditional budgeting Essay Sample
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Introduction of TOPIC
As Gowthorpe (2003: P457) argued, that “A budget is a plan, expressed in financial and/or more general quantitative terms, which extends forward for a period into the future.” Budgeting actually refers to the process that, after the strategic plan of the business has been made, companies made a short term plan (usually one year) to meet the strategic purpose. Traditional budgeting has offered a lot of contributions in so many years’ practice. But it seems it is more and more unsuitable for the modern business. In this paper, I will give a brief induction for traditional budgeting; and then discuss the strengths and weaknesses of the traditional budgeting; last I will explain and evaluate the alternative.
Every business leader wants competitive success, the best management team, continuous innovation, low costs, loyal customers, and high standards of corporate governance and control. The benefits of great business planning are obvious – better use of capital, more efficient operations and many other. According to the article on FT, the indexes of traditional budgeting include: product profitability, department costs, unit sales, and capital efficiency ratios.
Richard Barrett, VP of International Marketing at ALG Software, comments, “The annual budget is still the most widely used performance management process and the primary tool for controlling expenditure and setting performance targets.” Generally speaking, the objectives of budgeting are as following:
1. Budgeting report provides information to determine whether current-year revenues were sufficient to pay for current-year services.
2. Budgeting report demonstrates whether resources were obtained and used in accordance with the entity’s legally adopted budget.
3. It also demonstrates compliance with other finance-related legal or contractual requirements.
4. Budgeting report provides information to assist managers in assessing the service efforts, costs, and accomplishments of the organisational entity.
Over the past 30 years, governmental entities and organisations have used a variety of budget approaches and formats. Such as: (1) line-item, or “traditional,” budgeting; (2) program budgeting; (3) zero-based budgeting (ZBB); and (4) site-based budgeting. It should be noted that the formats of the prepared budgets may be quite similar; for example, the format of a site-based budget may be quite similar to the format of a line-item budget. Each of the basic approaches has relative advantages and limitations.
Line-item budgeting was a widely used approach in many organizations because of its simplicity and its control orientation. It is referred to as the “historical” approach because managers often base their expenditure requests on historical expenditure and revenue data. One important aspect of line-item budgeting is that it offers flexibility in the amount of control established over the use of resources, depending on the level of expenditure detail (e.g., fund, function, object) incorporated into the document.
The line-item budget approach has several advantages that account for its wide use. It offers simplicity and ease of preparation. It is a familiar approach to those involved in the budget development process. This method is consistent with the lines of authority and responsibility in organisational units. As a result, this approach enhances organisational control and allows the accumulation of expenditure data at each functional level. Finally, line-item budgeting allows the accumulation of expenditure data by organisational unit for use in trend or historical analysis.
However, as the FT article shows, organisations are becoming increasingly frustrated with traditional budgeting tools as they continually fail to meet today’s business demands.The traditional budget process fails to identify waste, does not identify the incoming workload, does not support continuous improvement, does not identify cost drivers, and appears to have a general lack of ownership and buy-in.(Cassel
l. M, 2003) The most severe criticism is that it presents little
Traditional budgeting methods are proving ineffective in today’s unpredictable and fast-paced business climate. Traditional budgets are based on a calendar or fiscal year, creating artificial time lines that do not match new product schedules.
Since this budget presents proposed expenditure amounts only by category, the justifications for such expenditures are not explicit and are often unintuitive. As Lester(2000) said, it may invite micro-management by administrators and governing boards as they attempt to manage operations with little or no performance information.
Other criticisms of the traditional budgeting process are that it is extremely time-consuming for the benefits achieved; it focuses on resource inputs instead of the outputs generated by those inputs.
What is more key performance indicators are not incorporated into existing budgeting processes and therefore traditional tools are too slow, one-dimensional and backward looking. However, to overcome its limitations, the line-item budget can be augmented with supplemental program and performance information.
In nowadays, most organizations have recongnised that the traditional budgeting is the greatest barriers to achieve the goal. The traditional budgeting is described as “Bane of corporate America” and “tool of repression”. So, what are the alternatives? Many accountants believe that Activity-based Budgeting (ABB) and 4P-based Budgeting(PBB) are the most widely approaches used by the modern organizations all over the world.
According to Tom Pryor(2003), the 4Ps of 4P-based Budgeting(PBB) refer to Paradigm-Based Budgeting, Process-Based Budgeting, Priority-Based Budgeting, and Performance-Based Budgeting. Next, I will explain and evaluate the 4P-based Budgeting(PBB) with comparison to traditional budgeting.
The main feature of 4P-based Budgeting(PBB) is that the budgeted expenditures are based on a standard cost of inputs multiplied by the number of units of an activity to be provided in that time period.(Stephen)
Traditional budget methods focus on the worker. The P-Based Budgeting focuses on the work.
Instead of using this year’s spending level as the foundation for next year’s budget, the new paradigm looks at activities and their projected workloads. Activity workloads are also referred to as output measures or activity drivers.
Traditional budget methods often contain inconsistent workload assumptions between departments. P-Based Budgets focus on synchronising activity workloads within the business processes that cross departmental boundaries.
One of the challenges confronting managers is synchronising the budget. Functional managers traditionally prepare their departmental budgets independent of one another. Even though they may be using the same sales forecast as a guide, the workload assumptions for activities often vary from department to department. For example, the Purchasing Manager may budget for 1,000 purchase orders next year yet the Receiving Manager is planning for only 700 receipts. The left 300 budget variances are sure to occur. Process-Based Budgets assign each activity to a business process. Before departmental budgets are submitted, managers synchronise the budgeted workload of their process activities, thereby minimising waste.
Traditional budget methods cause senior management to classify departments as required or discretionary. Every organization has limited resources. Therefore, it is not uncommon for budget requests to exceed budget limits.
When limits are exceeded, traditional budgeting reviewers are often forced to allocate resources based on the perceived importance of each department. This promotes illogical thinking, e.g. Sales is more important than Marketing or Human Resources and should get more budgets. P-Based Budgeting provides the opportunity to force rank activities, not functions. P-Based Budgeting provides managers the opportunity to prioritise activities, no matter who performs them. As a result, Issue Purchase Orders would be ranked as a higher priority than Attend Staff Meetings.
Traditional budget systems focus on expenditures. P-Based Budgeting focuses on outcomes. Managers have been actively asking themselves during the past couple of years, “What are the desired results for each department’s budget?”; “What can I expect from the balanced budget?”
The purpose of Performance-Based Budgeting is to provide a sound basis upon which to make resource allocation decisions; to communicate the measurable results expected to be achieved from a budget allocation; and to build a connection between budget and program performance results for the same operational unit over same period of measurement.
Performance-Based Budgeting has five steps:
(1) Identify desired outcome; (2) select an outcome performance measure; (3) set a goal; (4) report results; and, (5) implement consequences.
The benefits of Performance-Based Budgeting are:
1. increase the efficiency and effectiveness of government operations by focusing resources toward the most critical and important outcomes;
2. improve operations by linking budget and program performance over time;
3. make managers more accountable for program decisions that affect budget outcomes;
4. improve understanding and communication about critical issues and priorities relative to budget requests and the use of resources.
To sum up, it is time to significantly change the ways that organisations are managed. As the traditional budgeting become increasingly unsuited to modern business. Organizations need to move to a ‘Beyond Budgeting’ approach to meet the competitive enviroment. The 4P-based budgeting replaces fixed budget measures with relative targets, prevent gaming of executive compensation and respond faster to change. Anthony, Hawkins and Merchant(2003) have suggested that the best practice and methodology can dramatically alter the processes and systems that underline business performance management. As a result, the 4P-based budgeting gives us far more information and far more control than the traditional budgeting ever did.