Finance for Managers - Report Example

Finance for Managers Introduction Budgeting is essential for all type of businesses, whether large or small and in public as well as private sectors.Traditionally budgeting is allocation of resources for planned actions in order to achieve desired results. ‘It also involves the comparison of actual results with budgeted results to examine how well everyone in the company contributes towards achieving the company’s overall objectives.’(Elda Du Toit, page205)1 In this write up the problems and benefits of traditional or conventional approach of budgeting are discussed in depth. Thereafter alternative budgetary approaches to conventional budgeting are explained and analyzed along with problems of these alternatives. Problems of conventional approach to budgeting The problems of traditional or conventional budgeting emerge from a variety of reasons or issues. The first issue relate to accounting of traditional budgeting. Traditional budget first build internal budget or targets. Based on these internal budgeting, the external goals are established. The internal accounting at most companies is based on allocation of expenses. It is seen that because of this traditional style of accounting of expense allocation, many efficient management reporting systems are under utilized and this accounting become the real barrier in improving the budget process. Conventional budgeting is most appropriate where output is proportionately related to consumption of resources. However, under circumstances where relation between input resource and indirect costs are not clearly defined with output, the ‘conventional budgets merely serve as authorization level for certain level of spending for each budgeted item of expense. Budgets that are not based on well understood relationships between activities and costs are poor indicator of performance and performance reporting normally implies little more than checking whether the budget has been exceeded. Conventional budgets therefore provide little relevant information for meeting the cost of supporting activities,” (Colin Drury, page 371)2 Conventional budgeting is based on incremental budgeting approach. That means allowance and allocation of completed period are taken as base and that is adjusted with anticipated changes in the input (both quantitatively and prices wise) in order to arrive at next year budgeted allowances and allocations as well targeted performances. As majority of expenditure associated with base level activities remain unchanged, under this incremental approach the cost of non unit level activities becomes fixed and also past inefficiencies and wastages are inherited into the budget for coming year. Conventional budgets, known as line item budgets, are prepared under fixed norms and inflexible approach. Therefore it is seen that variances resulting on comparison of actual results with budgeted estimates are only due to changing circumstances, poor forecasting, and managerial inefficiencies. Such variances do not point towards changed methodology or unconventional techniques used in production or rendering of services. Moreover budgets are developed for the departments or existing organizational structure. That is why conventional budgets do not reflect underlying economic realities. Inherit lags and delays are conventionally tagged with line item budgets. It is ‘an iterative, negotiating process between heads of responsibility centers and senior executives. Responsibility center managers continually seek more resources while senior executive continually attempt to control increases in spending authorized for their decentralized units. The result is that budget for next year builds on that of previous year, plus or minus a few percent depending upon the outcome of the negotiations between senior executives and local management.’(Robert S Kaplan and Robin Cooper, page 302)3 Thus there is no innovative approach, but only a routine to allocate and assess the application of resources. Benefits of conventional approach to budgeting Conventional budgeting is budgeting exercise that is most suitable under normal circumstances, where conditions are stable and the objectives of organization remain unchanged. Under such conditions incremental budgeting is perhaps the budgeting device that delivers most optimum results. Basic advantage of conventional budgeting system is that it provides basic historical data of last period’s budgetary as a support for making incremental changes. This previous period data is particularly helpful in drafting interim estimates close to last accounting period when most of current situations resemble previous period results of business activities. Conventional budget helps in reducing volume variances and save a lot of time for planning budgetary controls for ensuing period. Use of conventional budget is very economical, as the budgeting process is based on the information already processed by the entity. The entity has to make only effective uses of already researched and practiced information in the earlier period. Newly generated information is only required for initial years; otherwise conventional budgeting is an exercise of manipulation of already collected financial information. This makes conventional budgeting quite economical. Conventional budget is also called an executive budget, as all most all nations’ official budgets are based on conventional budgeting process. As per Catherine Stenzel and Joe Stenzel (page90)4 conventional budgets ‘promote internal battles over resources when budgets are prime measure; support understanding of the nature and behavior of costs; promote, track and feedback on value creation and continuous improvement; and assist management in wise use of resources.’ Alternative to overcome conventional budgeting problems Activity based budgeting (ABB) is the best alternate solution. To bring activity based budgeting into practice the existing conventional system has to be scrapped. Under activate based budgeting all costs are pooled under different cost centers. Then these costs are assigned to activities of production or rendering services. In last stage these activities are charged to products or services on some suitable basis. By using this activity based budgeting approach, ‘one can see much more clearly the products on which a company makes (or does not make) money, and margins on all customers, based on the services they demand from the company.’(Steven M Bragg, page 90)5 Importantly ‘ABB demolishes the conventional thinking about fixed and variable costs.’(Robert S Kaplan and Robin Cooper, page 302)6 Another alternative to conventional budgeting is Zero based budgeting (ZBB). Zero base budgeting is the alternative that may solve a number of problems associated with conventional budgeting. Zero based budgeting examines a program or function or responsibility from scratch, as if nothing has been achieved to compare with or improve upon. The zero based budgeting involves the following actions: 1. First the objectives of the budgeting are determined very clearly. The objective may be to effect cost reduction or to select a project out of available alternatives, or any other objective for budgeting. 2. In next stage a decision is made as to which extent ZBB should be introduced, i.e., whether it has to be introduced in all areas of the organization’s activities or only in a few selected areas on trial basis. 3. The development of decision units, i.e., units regarding which cost- benefit analysis will be done to arrive at a decision whether they should be allowed to continue or should they be dropped. Each decision units must be independent of all other units so that if cost analysis shows unfavorable results then that unit can be dropped. Zero budgeting provides a systematic key to evaluate different operations and programmes undertaken by the management. It enables management to allocate resources according to priority of the programmes. It enables the management to approve departmental budgets on the basis of cost benefit analysis. No arbitrary cuts or increases in budget estimates are made. Zero budgeting helps in identifying areas of wasteful expenditure and, if desired, it can also be used for suggesting alternative courses of action. In fact zero budgeting links budgets with the corporate objectives. Nothing will simply be allowed only because it was being done in the past, if does not help in achieving the goals of the enterprises. Zero based budgeting can also be used for introduction and implementation of the system of ‘management by objective’. Thus it can not only be used for fulfillment of the objectives of traditional budgeting but it can also be used for a variety of other purposes. Problems of alternatives For activity based budgeting everything has to be started afresh as changes are significant. Accordingly cost of change will be high. Under ABB it will be difficult it will be difficult to correlate the marginal increase in cost with particular cost driver. In practice it is very difficult to achieve standardization of cost of activities related to particular product or process. ABB is still being evolved and accordingly its success cannot be ensured in every setup or industry. Zero based budgeting is also called fund budgeting as it is mostly applied for government funded projects or schemes. Zero based budgeting is more of a managerial technique that lays stress on adoption or rejection of activities or projects. Its operation is generally found to costly when compared with traditional budgeting. These are reasons that ZBB is not gaining popularity in general application. References: Read More