The Inherent Weaknesses of Annual Budget Model
A budget is a short-term plan of action articulated in quantitative terms for a given future period. Traditionally, most budgets cover a period of one year. Annual budgets bases facts on historical data. For example, incremental budget approach reviews the previous budget to come up with the preceding period budget by adding a given amount to the previous figures. This is according to the changing factors such as change in size, inflation and company’s objectives. It is because of this fact that traditional budgeting approach is losing popularity among most companies in this new age. It’s an era characterized by rapid changes, complexity and uncertainty. Hence, using fixed budget will hinder the company from taking advantage of the available opportunities and overcoming its threats.
Regardless of the budgeting approach used, annual budget model has many inherent weaknesses. One of the major weaknesses is inflexibility. Conventional budgets irrespective of the approach used tend to be a fixed plan. It is a plan along which an organization bases and aligns its activities. That is, the managers cannot exercise freedom from the budget in determining what to invest in, how much and when. The company’s resources are limited; hence, the available capacity tends to be exhausted in the budget. They cannot undertake an activity which to them seems profitable than the predetermined activity. Hence, they cannot have an edge over their competitors. Or rather, they do not have a competitive advantage.
Annual budgets are prepared now for the consequent use in the future. However, dynamism and complexity of the business environment poses a major problem. The future is full of uncertainty what you predict is not what transpires hence the budget seizes to be relevant. This is a time for numerous technological advancements, hence, organizations need to be in a position to take advantage of this advancement and adapt to change. Annual budgets prevent this from happening.
The rolling budget approach even though it was made to order to overcome this problem it does not work towards the overall management of change rather it focuses more on the responses to the challenges facing the organization at that particular point hence it’s not adaptive to change.
Another major weakness is that annual budgets do not promote the need for constant improvement rather it tends to advocate for compliance to the budget. That is management ensure they utilize the resources allocated to them without putting emphasize on the need for efficiency and effectiveness. Departmental manager’s focus on hitting the target to ensure they do not lose their bonuses due to over extending the budget or misusing the resources allocated. Hence, the quality of the goods or services provided may deteriorate. A department with excess capacity may result to wastage or fraud to ensure that in the forthcoming period their resources do not reduce.
Hence, they are able to get their bonuses. Therefore, annual budgets do not promote excellence and innovation on the part of the managers and employees. It is also not a force towards continuous progress (Horngren, Sundem and Schatzberg, 2010).
Annual budgets have a disadvantage of taking up a lot of executive time and resources yet it adds minute worth to the organization. The budgeting system that is both the traditional and the modern budgeting approaches take many of the company’s resources. The zero based budgeting, activity- based budgeting and rolling budgets consume a lot of money in preparing the annual budgets, which are necessary in research and development. Developing ways of improving the quality of services and goods offered, increasing the level of productivity or make new better investments resulting to increased profitability and having an edge in this competitive business arena. The budgets focuses on allocating the resources determining what’s to be done but it does not feature in and explain or outline how it is to be done.
Lastly, annual budgets have mainly an internal focus. The managers do not consider budgets for other firms in the same industry. That is firms of relatively the same capacity and in the same field would have relatively the same budget. This calls for benchmarking; Being interested in what your competitor is doing and identifying what he is doing wrong and coming up with a better budgeting system.
A budget contains the cost of raw materials and other overheads and the forecasted revenue rose from sale of goods and service. The main aim of budgeting and budgetary control system is to minimize the cost and increase the revenue and to increase its efficiency. Businesses operate in an open system whereby they interact with the environment. They acquire raw materials from the environment, sell the goods to them hence the budgeting process needs to both internally, and externally focused to encompass all aspects of the environment in order to be efficient (Horngren, Sundem and Schatzberg, 2010).
Managers have different perceptions on annual budgets some consider them as a means to an end while others view budgets as a waste of time and resources. However, budgets are important tools of planning and control hence organizations should move towards beyond budgeting to overcome the deficiencies of traditional budgeting (Horngren, Sundem and Schatzberg, 2010).
Traditional Budgeting Process and Benchmarking
Benchmarking is the process of making a comparison with the best in the industry or other industries. This process makes sure that a company remains competitive. Benchmarking aims at ensuring the firm improves its processes to become more efficient and effective. Its focus is on quality, time and expenditure. That is, it reduces the cost of production; it is faster and cheaper but still offers better quality (Carnal, 2007).
It involves the strategic management determining the company with the best practices in the industry and evaluating its performance in relation to this company with the aim of bettering its performance. Benchmarking is a continuous process it is not a onetime event. The benchmarked results are necessary to review the previously set performance targets for the company. However, companies that use the traditional budgeting process will be disadvantaged. Due to the traditional budgets inflexibility they are not adjustable to reflect the current circumstances in the dynamic business environment, which is full of uncertainty. As a result, these hinder the implementation of the company’s strategic plans and place it on leveled ground with its competitors (Seal, Garrison and Noreen, 2008).
In traditional budgeting process, the management uses the top-down approach in setting the budget targets. That is based on what they feel is desirable. These lock out the employees in the process and they do not feel like they are a part of the organization hence they are not motivated to work. The benchmarking group includes the workers, their participation in the benchmark leaves them challenged and motivated. As a result they are do not present any resistance to change but rather embrace the change. However, with the vertical approach used in budgeting this is not achievable (Campbell, 1998).
Benchmarking can either be internal within the organization among different departments or externally among different industries. The results are quite crucial to set performance evaluation standards, which are necessary for budgetary control. The standards reflect the prevailing circumstance. This is because of the constant reviews done. Unlike the standards used in traditional budgeting which were fixed at beginning of the period hence use of such standards for performance evaluation will misguide the management (Brimson, 2010).
In conventional budgeting process, the managers set the targets, which may be unrealistic according to the employees. However, the top-down command does not give them the liberty to communicate this to the managers. As a result, the operational managers will tailor their results. Benchmarking aims at reviewing targets of other companies in the same situation and finding out what they do to achieve such targets, which they try to implement in their firms. However, with the fixed targets this will not be possible (Randall, 1999).
Traditional budgeting process fosters compliancy to the budget rather than continuous improvement. Benchmarking aims at promoting progress and improvement of the performance of the businesses processes. The use of annual budgets does not encourage this therefore hindering the achievement of strategic change, which promotes continuous improvement (Seal, Garrison and Noreen, 2008).
Traditional Budgeting Process and Balance Score Card
The balance scorecard is a tool used in measuring and performance evaluation. It uses both the financial and the non-financial measures of performance. A balance scorecard is crucial in the implementation of strategies in the everyday life of the business. It has four main dimensions the finances, customers, internal businesses processes and finally learning and growth. The balance scorecard aims at developing the strategies to be used in putting the plan into action. This is achievable using the mission statement. It also aims at integrating all the aspects and activities of the organization across all the administrative levels to establish an elaborate performance measurement scheme (Weetman, 2007).
The traditional budgeting system focuses mainly on the financial aspect of the organization. The performance evaluation is based on the financial data only. However, it does not consider the other aspect of the firm. For a firm to have competitive advantage it needs to consider all the aspects of the business that is how do our customers see us, what can we do to excel, will we be able to continue adding value and how do we look to our shareholders. The narrow view of the traditional budgeting system acts as a barrier to the effective use of the balance scorecard as a tool for performance measurement and implementation of its strategies (Sullivan, et al. 2003).
One of the disadvantages of traditional budgeting is that it tends to divide and create barriers between the departments. This is against the principles of balance scorecard, which thrives to integrate the different departments to create a system of performance measures.
Traditional Budgeting Process and the Activity Based Model
Activity based model is a model that tends to co-ordinate both the operational aspect of the company and the financial aspect. It focuses mainly on determining the activities to be undertaken by the company. The activity-based model uses activity-based theories to use the capacity demanded to determine the activities to be performed. From the activities, they determine the resource requirements using the resource consumption rate. Thereafter the operational manager generates the operational budget, which is translated to the finance budget by determining the cost of the resources (Seal, Garrison and Noreen, 2008).
In instances where there is an imbalance between the resource requirement and the available resources, the budget can be adjusted accordingly by either reviewing the rates, the quantity demanded, price and capacity. However, in traditional budgeting due to limited information they can only adjust the quantity demanded and the resource availability. This fact may encourage managers to undertake gaming activities to make ends meet and retain their bonuses.
Activity based models aim at meeting the needs and the requirements of its customers in the most efficient and effective very possible. It is externally focused but the traditional budgeting process is an internal affair hence it does not stand to promote the achievement of the aims of activity-based model since it major focus is the allocation of resources within the organization.
Traditional budgeting process involves negotiation between the different departments on the allocation of the available resources. This infers that the resources are not put to their best use. This goes against the principles of activity based model where the allocation of resources is a process that involves a lot of research on the processes involved, the activity requirement and consumption rate of those activities. Activity based management also involves a follow up on the consumption pattern to ensure any deficiencies are detected on time and corrective measure taken before it is too late. This is another aspect where the traditional budgeting process fails in that it has no mechanisms for tracking resource utilization pattern (Jones, 2008).
Traditional budgeting process expresses budgets in financial terms, which the lower level managers and employees do not understand. Their duties are not visible from the plan. Activity based model prepare an operational plan which is easy to understand. The operational plan clearly identifies activities to be performed by each department hence there is no wastage of time. The convectional budgeting process fails yet again to facilitate the achievement of the aims activity based model (Kaplan and Cooper, 2009).
Reference List
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Campbell, D. (1998) Organizations and Business Environment. Oxford: Legoprint.
Carnal, C. (2007) Managing Change in Organizations. Essex: Pearson Education.
Horngren, C. T., Sundem, G. L., & Schatzberg, J. (2010) Introduction to Management Accounting. London: Person Education.
Jones, M. (2008) Management Accounting: An Introduction. Chicago: John Wiley and Sons.
Kaplan, R. S., & Cooper, R. (2009) Cost and Effect: Using Integrated Cost Systems to Drive Profitability and Performance. London: Harvard Business School Press.
Randall, S. (1999) Strategic Human Resource Management. Boston: MPG Books.
Seal, W., Garrison, R. H., & Noreen, E. (2008). Management Accounting. New York: McGraw-Hill.
Sullivan, A. et al. (2003) Economics: Principles in Action. Upper Saddle River, New Jersey: Pearson Prentice Hall.
Weetman, P. (2007) Financial and Management Accounting: An Introduction. Chicago: Prentice Hall.