Budgetary control - the organisational aspects
| by Mike Tayles
01 Dec 1998
Planning and control are major activities of management in all organisations. Budgets are central to the process of planning and control. The involvement with budgets places the management accountant as a key player in the provision of management information. Readers will not be surprised to know that most organisations employ some form of budgeting, those of any size have quite formal mechanisms. A large survey of over 300 companies supported by ACCA, on which the author was engaged, reported recently that almost all respondents used some form of budgeting and budgetary control.
This article will discuss budgets in a wider planning and control context and discuss a number of issues surrounding the generation and use of budgets. It will not go into the detail of the mechanics of budget preparation because this would take up considerable space and is covered adequately in a number of text books. Readers should be aware that budget construction (both financial budgets such as profit and loss statements and subsidiary budgets such as sales, production and purchases) is a part of the syllabus of paper 8. Equally, however, is the ability to demonstrate an understanding of and to discuss how budgets fit within an organisational context. It is towards these latter aspects that the article is directed, these are also within the syllabus of paper 8 as it forms a foundation for paper 9.
Budgets in context
A good starting point is to set budgets within an overall organisational planning and control framework. A common sub division of the wider planning and control framework in organisations is strategic planning, management control and operational or task control.
Strategic planning is the process of deciding on the goals of the organisation and the formulation of the broad strategies to be used in attaining these goals. It is the responsibility of top management, it is creative and involves identifying a company’s strengths and opportunities to grow whilst minimising weaknesses and threats. It has a long-term orientation and looks outside the organisation at customers and competitors.
Management control is the process by which management assures that the organisation carries out its strategies. It is more short-term, is focused on middle managers and is more rhythmic and routine.
Operational or task control is the process of assuring that specific tasks are carried out effectively and efficiently. The timescale here can be very short-term, perhaps daily, and addresses targets of junior management. Often it is based on the use of non-financial measures and may be based on clearly defined input/output relationships.
Figure 1 summarises some of these features.
Outline of a management control system
Any system consists of a structure and a process. The formal planning and control structure is built around responsibility centres which emphasise performance related particularly to cost, revenue, profit and investment. Centres established on the above lines attempt to tailor the budgetary control system to the organisation structure and the consequent delegation of authority within the organisation. This is in line with the controllability principle of reporting to a manager about those things over which he/she has control or most influence over, omitting any items which are uncontrollable.
The management control process involves both informal and formal communication and interaction. Figure 2 is used to depict the phases of this process in a typical organisation.
Figure 2 Phases of Management Control.
To elaborate on the features of Figure 2 programming is the link with strategic planning. It identifies the products a company intends to develop, projects which management intend to pursue to meet the organisation’s overall goals. Budgets are derived from these and are specified in terms of a managers responsibility.
Operating and measurement is the collecting of actual costs and outcomes identified to both programmes and responsibility centres. Finally, reporting and analysis takes place as a basis for control to the budget, for the co-ordination of activities and as a basis for future decisions perhaps to change the original plan.
Budgets as they are generally understood form the cornerstone of management control and the management control system, they are a multi-purpose management tool supporting planning, control, co-ordination, communication, performance evaluation and motivation.
Feedback and feedforward
Traditional budgetary control is an example of feedback where actual outcomes are compared to budgets. The budgetary process is one of feedforward, in that expected outcomes are compared with desired outcomes, e.g., spending levels, ROI, market share etc. These are revised in successive iterations until a desired outcome is identified. In practice it may be observed that many companies do not simply adopt a feedback approach i.e., comparison of actual to budget. They operate processes which require periodic re-forecasting of likely outcomes in order to better manage their planning and control activity. They are adapting the principles of feedforward and feedback to meet their planning and control needs.
Fixed and flexible budgets
By the start of an annual budget cycle the managers of any organisation should have formalised their views and identified the most likely outcomes and targets they will work to for the coming year in terms of profit, sales, costs etc., that is, the budget will have been set and agreed. A set of feasible and desirable end results will have been established. These will be incorporated into the master budget statement, a document which all managers will hold. This is an example of a fixed budget, that is a planning budget of expected outcomes, before the event.
Flexible budgets are budgets that are designed to change in response to changes in output levels or, on occasions, changes in other relevant factors. Flexible budgets can complement the use of fixed budgets, they have a part to play and can apply in more than one context. In the planning process it is quite usual to produce a range of estimates for different planning scenarios of sales, costs, market prices, etc.
This is part of the feedforward process mentioned earlier and as such flexible budgets are a useful part of planning. An equally appropriate use of the flexible budget is for the purposes of control. When preparing performance reports it is important to take account of the variability of some costs with different levels of output. When actual output levels have varied from those planned in the fixed budget the cost targets being used for all variable and semi-variable costs should be adjusted.
It is not helpful comparing the actual costs incurred for a certain output level with the budget developed for another output level, a flexible approach to budgets takes account of this. At a simplistic level all budgeted variable and semi-variable costs should be adjusted proportionately to take account of the actual output level. Fixed costs being by definition ‘fixed’ would not be expected to change in spite of changing output. Flexing does not, incidentally, have to be restricted just to output levels but can incorporate changes for any factor which differs from what applied when the budget was prepared, for example different states of the economy. In this way, flexing is saying “If I knew then what I know now what budget would I set?”. It is a useful concept but can lead to some concern, if taken to extremes, because managers can be confused and frustrated if faced throughout the year with a possibly moving target.
Standard costing is a topic which would justify a full article on its own. It is appropriate here only to point out the close relationship between standard costing and budgets. Whereas budgets are plans for the whole organisation, or departments of it, standard costs are cost plans developed for each unit of product or service.
Budgets and standard costs have similar objectives in that they support planning and control through the isolation of variances. They may also be part of a system of performance evaluation and standard costs being derived from budget values are aids to pricing and decision-making. It can be seen that, along with budgets, they are an important aspect of the information system within organisations.
A common way to develop budgets for direct cost items is to refer to product standard costs and multiply these by the budgeted production levels. Conversely, standard costs for overhead items are usually produced by dividing the budgeted overhead cost by the budgeted volume to arrive at the standard overhead cost per unit. It follows that a system of standard costing cannot exist without some form of budget especially for overheads and volume levels. A company can operate budgets without standard costing, but some of the budget computations are often made easier when standard costing exists.
Standard costing had its origins in manufacturing companies in which it is still widely employed, but service organisations also can apply the principles. For example ,restaurants deal with standard recipes for meals and if these are dealt with in large quantities, say at conferences, then mass production systems can also apply. They may not be calculated with the same accuracy as in manufacturing environments but the principles are still relevant. It has also been pointed out that in many organisations where continuous improvement is the aim, standard costs may not be so useful. It is better to be judged by beating your immediate past performance than a standard which was set some time ago. This is a point to bear in mind, perhaps the performance measurement emphasis of standard costing may not be emphasised so much, however, there is not much evidence at this time of widespread moves in companies to change their established standard costing systems.
The accountant preparing financial information in the context of management control must be aware of the increasing role of non-financial information in strategic planning, managerial and operational control. It has long been the case that operational control has been supported by non-financial measures. For reasons of both relevance and timeliness it has been common to use performance measures to evaluate efficiency, material waste, throughput and many other operational aspects using quantitative but non-financial measures in addition to those of a financial nature. Initial impact is made with a non-financial perspective though this could subsequently be reported with financial values attached.
Whilst they will not replace the use of financial information these measures provide a useful complement and an opportunity to generate a balanced perspective of organisational performance. This development can be seen as both an opportunity and a threat to accountants. It could be claimed that as the accountant is a specialist in periodic reporting that all measures should be reported through the accounting reporting system and this would enhance the profile of the accounting function. However, the choice of the accountant for this role is not automatic, for example others, such as IT specialists, may take over this responsibility.
Budgets and management behaviour
Some would argue that any problems which arise out of the budget system are a result of how managers use the information provided by it and how such use affects the information that is entered into the budget. That is, budgets have implications for human behaviour. A few points on this are briefly mentioned below, note that the syllabus for paper 8 does require appreciation of behavioural issues at an introductory level.
Budgets as targets
From many psychological studies it is pointed out that better performance is achieved when targets exist than when this is not the case. Furthermore, demanding targets extract better performance than weak ones. This is up to a point, totally unattainable targets tend to be counter productive. The precision which is applied to a target is seen to be important because if targets are not accepted by an individual, then poorer performance may result from that person’s ‘withdrawal’ from the task than would apply if a less demanding target had been set. It is also important that managers achieve their targets frequently enough to give the positive reinforcement in their efforts. A practical consequence of this is that a budget which might get the best performance out of a manager, a demanding target, is unlikely to be achieved most of the time. It is not therefore, a useful forecast of actual outturn. Conversely a budget that is an accurate forecast of what is likely to be achieved will only motivate a modest level of performance.
Budget as forecasts
General observations and academic experiments have suggested that managers behave conservatively when required to make budgets which are to be used as forecasts for future achievement. That is, they under estimate sales and over estimate costs. They see it as in their interests to incorporate ‘slack’ into the budget. Managers also engage in games of building up slack in good years and converting it to reported profit in poor years. Conversely, there are observations from other studies that some managers, after a run of mediocre results, deliberately overstate revenues and understate cost estimates. They no doubt feel the need to make an immediate favourable impact by promising better performance in the future. It may be, of course, that this merely delays the problem for which these managers are subsequently censured when they fail to hit these optimistic targets.
Budgets in performance evaluation
A further use of budgets is as a basis for setting performance standards and rewards, for example, bonus, status or enhanced promotion prospects are often linked to budget attainment. Organisations are complex, tasks are interdependent, there are many dimensions of performance and these are not all easily quantified and certainly not in financial terms. Problems can occur here because the budgets are quite narrow specifications of what are desired organisational outcomes.
Placing emphasis on budget achievement can have repercussions on other, perhaps long-term, aspects of organisational performance. Management might not place emphasis on other important aspects of their jobs such as maintaining quality or staff morale if, as a consequence, they run the risk of not achieving the financial budget. Alternatively, stressing the need to achieve these budget results may result in the budget being met but this may be as a result of manipulation by managers of both the budget and actual results.
The use of budgets in evaluation and control is also influenced by the way they are used by the manager. Different management styles of budget use have been observed, for example:
budget constrained — placing considerable emphasis on meeting budget targets;
profit conscious — where a balanced view is taken between budget targets, long-term goals and general effectiveness;
non-accounting — where accounting data is seen as relatively unimportant in the evaluation of subordinates.
The style is suggested to influence, in some cases, the superior/subordinate relationship, the degree of stress and tension involved and the likelihood of budget attainment. Note also, the style adopted and its implications are affected by the environment in which management is taking place. For example, the degree of interdependency between areas of responsibility, the uncertainty of the environment and the extent to which individuals feel they influence results, are all factors to consider in relation to the management style adopted and its outcomes.
It is often suggested that participation in the budget process and discussion over how results are to be measured has benefits in terms of budget attitude and performance of the budgetee. Views on this point are varied however, and the personality of the individuals participating, the nature of the task (narrowly defined or flexible) and the organisation culture influence the success of participation. But a budget when carefully and appropriately established can naturally extract a better performance from the budgetee than one in which these considerations are ignored.
Coping with conflicts
As a forecast the budget seeks to be the best assessment of the likely outcome of the interaction of the organisation with its environment. The most effective planning budget is that which is most probable. The budget level set for this purpose will not necessarily get the best performance out of managers, it will not create optimum motivation. Generally it is believed for budgets to motivate, higher objectives should be set — stretching targets, that is to say possible but not probable results. Budgets set for motivation purposes run the risk of not being likely to be met most of the time. So if this sort of budget is used for planning there is a risk that it will not be attained, furthermore it will not help to identify optimal use of resources for the organisation.
Budgets are often viewed by managers as fixed standards of performance against which they will be judged. In other words once objectives are set they are fixed and failure to achieve them will be seen as unsatisfactory performance and will have repercussions.
There is certainly something to be said for setting targets and not deviating from them, it focuses the mind of the budgetee. On the other hand, in evaluating managers it is often considered appropriate to remove uncontrollable items. Indeed it may often be deemed desirable to adjust budgets for uncontrollable and unforeseeable environmental influences (see flexible budgets above). But what is the likely effect on motivation of an opportunity to change the budget during or at the end of the planning period? Motivation may be impaired by the fact that it is anticipated that performance standards may change or be changeable. Though it is not helped either by the rigid application of clearly inappropriate fixed budgets.
There can be no ideal solution to the above conflicts, management will have to develop their own ways of dealing with them in a way which best suits their organisation, the sort of business they are in and the personalities involved.
This short article has dealt with budgets and emphasised two aspects:
Accountants generally, and candidates for paper 8 in particular, should be aware of these aspects, though detailed behavioural implications apply to paper 9.
Accountants are often criticised for spending more time establishing controls than understanding the true nature of control within the enterprise. In the dynamic environment currently faced by most businesses, the budget is still an important information source. They should be aware of the cost of maintaining this planning and control system and set this against the benefits obtained, but as yet there is no evidence of wide use of any alternative approach.
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