Alternate Budgeting System - Essay Example

Alternate Budgeting System Budgeting is a popular financial tool to plan future income, cash flow, financial position and other related decisions andactivities of a business enterprise or a government entity. Though conventional budgeting has numerous advantages of planning the future activities of a business enterprise, it has also problems that limit its applicability. With the result a voice is being raised against the use of budgeting process as a tool of future business planning. As per Catherine Stenzel and Joe Stenzel (page 90)1 conventional budgeting has three technical limitations and also these budgets create two behavioral dysfunctions described here under: “Technically conventional budgets are financial only and do not relate to non financial measures that may be actual drivers of performances; create an excessive lag time between budget construction and plan execution that risks budget irrelevancy; are usually constructed annually, remain until next budget cycle, and are static and are not amenable to adoption when conditions change. In terms of behavioral dysfunction, conventional budgets promote internal battles over resources when budgets are a prime measure; and direct focus internally at the expense of learning about competitors and allies.’ Budgeting involves planning about income and expenditures in order to find out the capital requirements for executing the project under consideration. There are generally no hassles when owned capital is employed for executing budgetary plans. But problems arise on use of debt capital. These problems of debt financing are as under: 1. Economically, debt financing, also called deficit financing, increases the cash flow of money that are responsible for increase in prices. 2. Cost of debt capital, i.e., interest affects profitability and thereby many financial aspects of business decisions. 3. Financial leverage or gearing of the capital employed affect future funding for the business. For example during periods of depressions the entities will find difficulties in raising capital through issuance of equities. On basis of study conducted by Catherine Stenzel and Joe Stenzel (page 82)2, it may be observed that irrespective of model of the budget adopted, budgets normally incorporate three mistakes that limit the scope and decision taking abilities of the entities. Those three mistakes are as under: It is seen that budgets do not align resources to strategic objectives of the firm. Budgets do not reveal the business strategies. Logically the budgets should translate the strategic goals into actionable operations in quantitative terms. But this does not happen. Budgets and strategic objective some time appear far apart in planning the use of resources. Budgets are constructed keeping in mind the resources in hand. There is no planning under budgetary process to create resources to meet strategic objectives. Entities declare mission statements and strategic objectives enthusiastically in big way. It is seen that during budgeting, very few so called flaccid budgets, that are presently in operations, care for business plans and plan activities to achieve those strategic goals. In words of Catherine Stenzel and Joe Stenzel ‘one final flaw that can reduce budgeting relevance and lead to flaccid budget centers on parochial claims to resources.’ That is to say resources under budgetary process are allocated on competitive basis and not as per preferences set out in the strategic objectivity. Conventional budgets do not describe methods for arriving at budget proposals or at allocation of funds. The methodology adopted by conventional budgets is to take up the budgetary allocation of resources of the past period and make additions or deletions thereto as per changed requirements of envisaged expenditure for the next period. That is why ‘conventional budgeting is also known as incremental budgeting. It assumes that activities of the last year must be continues and must be funded at least at last year level of budget or accrual, and that they have to forgo no alternative.’(Allied Publishers, page 384)3 Conventional budgeting is regularly used for state budgeting. But even as a tool of state budgeting conventional budgeting lack in- built motivational approach. There are two reasons for such deficient approach. ‘First, they have short term frames – one year in countries that have only annual budgets, three to five years in countries that budget within medium- term fiscal frameworks. These time horizons are too short to account for the downstream risks taken by governments when they establish pension systems and other entitlements, issue or guarantee loans, or promise to make good on shortfalls in financial performances. Second, conventional budgets record only cash flows; they do not account for buildup of liabilities, contingent obligations, or the future costs of past commitments.’ (Hana Polackova Brixi and Allen Schick, page 79)4 Problems of the budgeting have made entities to develop methodologies that operate beyond budgeting. Scorecard is such a methodology that tries to create a beyond the budget approach. ‘The Scorecard is tool for helping front- line teams manage strategy. It provides them with a means of ensuring that goals and actions are consistently aligned. It enables targets to be set and reviewed at any time and offers a framework for continuous dialogue between manager and leader. Rewards can be based on performance on each perspective, provided that relative measures are used rather than fixed numbers to be met by fixed dates. To avoid parochialism, these measures should be dependent on both the team you’re in and the team you lead.”(Jeremy Hope and Robin Fraser, page 185)5 Score cards and other measures that work beyond budgeting are not the real solutions to budgeting problems. These measures do not substitute budgetary process. These are management tools to motivate improved performances. In fact these are not even the alternatives to budgeting. It is true that conventional budgeting in whatever form is ineffective in coordinating activities with corporate strategic goals. This is because conventional budgeting is only confined to allocation of resources to activities. But the priority of allocation of resources has become competitive ignoring strategic preferences. Conventional budgeting needs refinement in order to induce motivational energy to attain strategic objectivity. The answer lies with Activity Based Budgeting (ABB). ABB is conceptually different from conventional budgeting. That is why it has many added advantages over conventional budgeting. ABB involves presenting budgets in terms of costs of an entity’s products or services rather than in cost factors like salaries, conveyance, training expenses etc. Under ABB first the required output is estimated product wise or customer wise. (This action is almost similar to conventional budgeting). That is objectives are drawn prior to proceeding with actual budgeting process. These output or objectives become the basis for estimating the demand for organizational activities. In other words cost drivers are established as per requirements of output of products or services. Organizational activities naturally seek resources to be operative. Resources are supplied to organizational activities in appropriate quantity as per needs of activities. In the language of activate based costing, cost centers and cost drivers are set up. Wherever resources are short, adjustments are made to match resources required for the demand. When it is possible to predict the level of cost drivers for budgetary period, then by using the cost of single unit of activity or cost driver, it is possible to develop budget for every single budgetary unit based on activity based costing information. In nutshell under ABB activities that incur costs in each function are established. Thereafter relationships are established between activities. On the basis of this information budgeting is processed on basis of allocation of resources to each activity. ‘ABB seeks to plug the gap between output and resources by providing a through understanding of what activities have to be performed to deliver a certain level of output and in the context of a budget, what activities and resources would be required to satisfy the projected level of customer demand. Armed with this information, managers can make informed decisions about the appropriateness of resources levels and the demand placed on them by top down targets. Matching supply and demand in this way could for example, involve budgeting for more resource, transferring resources from another area, changing staff mix or releasing spare capacity to another part of the business- all insight that would be difficult to achieve in a traditional budgeting environment. ABB makes explicit the relationship between revenue targets, volume of production and impact on workload.’(Gary Simon, 9 July 2007)6 Activate based budgeting is the real solution for companies facing problems with conventional budgeting. ABB clearly indicate the products or services on which the company is making profits. ‘With this better information, the management can target cost reduction in those areas where there is little return on money invested, while targeting expense increase if there is corresponding increase in margin.’(Steven M Bragg, page 113)7 ABB may prove costly in operation as compared to conventional budgeting, but it is based upon scientific approach of budgeting and not a built up budget making additions or deletions to pervious period budget. References: Read More