Mourik, Greg Van --- "Better budgets - Accounting" [2006] MonashBusRw 41; (2006) 2(3) Monash Business Review 44

Better budgets
Accounting

Greg Van Mourik

Greg van Mourik looks at the traditional role of budgets, the potential for improvement and the radical alternative of disposing of them altogether.

The once entrenched process of budgeting is under review and with good reason. It’s well known that managers incorporate slack in budget targets and also may defer achievements. They also set unachievable targets when the personal benefit of being bullish outweighs the consequences of failure. Various academics and practitioners point to the counter-productive effect of compensation linked to budget targets and argue against their use in compensation formulae because of the gaming that surrounds target setting and achievement. All this adds up to budgets sometimes being more of a hindrance than a help.

But it is not all bad news for the humble budget. On the positive side, budgets remain effective tools in managing performance, communicating expectations and deploying resources. Participative budgeting helps information sharing and coordination, and reduces uncertainty. They control deviations, facilitate management/subordinate interaction and can assist in strategic transition during change.

Criticisms of budgeting

In their book Beyond Budgeting: How managers can break free from the annual performance management trap (Harvard Business School Press, 2003), Jeremy Hope and Robin Fraser criticise budgets for obstructing organisations’ adaptation to the Information Age’s intense competition, uncertainty and need for quick response to change. Hope and Fraser claim budgets support a command and control culture that disempowers a frontline that must act within management constraints rather than before the needs of customers or competitive threats.

This also deprives management of market information because the frontline has no incentive to share their experience. According to Hope and Fraser, budgets are set after the protracted process of establishing what data indicates about the future which is often dictated by the self-interested wrangling of management. Meanwhile the fixed-term performance contracts of budgets do not always generate the sort of teamwork and agility needed to respond to market changes.

Toward better budgeting

Research undertaken at the Cranfield School of Management’s Centre for Business Performance, Victoria, identified five key techniques to improve budgeting and planning: Rolling budgets and forecasts, activity-based budgeting, zero-base budgeting, value-based budgeting and profit planning.

Research found that only rolling budgets and forecasts have potential as a better regulator of the budgeting approach. This technique solves some of the problems associated with infrequent budgeting, is more responsive to changing circumstances and overcomes problems associated with budgeting to a fixed point in time. Meanwhile activity-based budgeting and zero-base budgeting improve accuracy but involve more work than do traditional budgets. Value-based budgeting, which focuses on the creation of shareholder value, and profit planning, which focuses on the future cash flows of profit centres, were more theoretical and did little to simplify the process.

The researchers went on to identify what they termed the “5 + 1” critical success factors for radical planning and budgeting process re-engineering.

1. Minimising the budget negotiation process in favour of explicit forecasting models so plans are based more on explicit assumptions and less on negotiated ‘consensus’. This also allows new forecasts to be generated quickly in changing circumstances.

2. Using information technology to create a single and widely accessible view of the company’s revenues and costs.

3. Understanding that better financial performance comes from executing good competitive strategies, not from better financial management.

4. Making comparisons with the competition, not with internal benchmarks and basing incentives on beating the competition rather than achieving internal budgets.

5. Managing future results by acting on forecasted variances rather than explaining past performance.

6. A commitment to a common purpose and the right degree of trust among managers.

Beyond budgeting

Hope and Fraser propose scrapping the humble budgets because they reinforce inappropriate issues for the modern company such as centralisation, inflexible planning, and command and control. Organisations that have abandoned the budgeting model in one form or another are predominantly Scandinavian and include Svenska Handelsbanken, Volvo Cars, IKEA, SKF, Borealis, Fokus Bank and Ericsson. But is it simply a question of eliminating the budget process, or is there a need to change many other features within the organisation?

In 1998, the Consortium for Advanced Manufacturing – International (CAM–I) established a research forum called the Beyond Budgeting Round Table (BBRT). This model now represents a set of management best practices, from organisation design and devolution of authority to planning and managing performance. These self-managed teams define success in terms of current performance relative to competitors rather than internal targets set 12 months previously. The autonomous nature of these teams allows quick response to environmental changes and greater innovation. The focus on competitor-related targets means that teams are more concerned with pleasing their customers than boss.

In a world without budgets, targets are set relative to competition or best practice benchmarks. Performance is evaluated with the benefit of hindsight and in terms of relative improvement. Planning is a continuous activity focused on creating value and deploying resources on demand and management control is focused on the achievement and improvement of KPIs.

The use of budgets is a key determinant of how organisations function, adapt and perform. The process supporting them consumes a lot of management time and generally managers are not satisfied with the process anyway. There is not a simple solution for improving the use of budgets but nor is there a simple option of throwing them away. For improvement, there needs to be radical organisational change which may in fact mean the elimination of budgets altogether to free organisations to achieve this change. Whatever the case, it is in the interests of both practising managers and academics that this relationship is better understood.

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Cite this article as

Van Mourik, Greg. 'Better budgets'. Monash Business Review. 2006.; Monash University ePress: Victoria, Australia. http://www.epress.monash.edu.au/. : 44–45. DOI:10.2104/mbr06041

About the author

Greg Van Mourik

Greg van Mourik is a Lecturer in the Department of Accounting and Finance, Faculty of Business and Economics, Monash University. Before this, he gained extensive senior managerial experience in major information technology and telecommunications corporations. He is a member of AFAANZ and Melbourne Business School alumni.