Definition and Objectives of Budgeting
What is a Budget?
The Objectives of Budgeting
Control and Motivational Objectives of Budgeting
This section defines what is meant by budgeting and outlines the objectives of
budgeting.
What is a Budget?
There are numerous definitions of the term 'budget' but it is most simply defined as:
"a plan expressed in financial terms".
An alternative definition which is more applicable to the public sector has been
suggested by Hadley et al (‘Public Sector Accounting and Financial Control’)Note this
reference needs to be checked. Is it Henley?
"Budgeting is a process of measuring and converting plans for the use of real (i.e.
physical resources) into financial values. It is the classic problem of how to add
together quantities of apples and oranges into a meaningful economic measurement,
the only practical way for everyday use is to express their economic values in terms
of monetary costs and revenues. Through the process of budgeting the finance
function provides the essential link between management planning and management
control."
It is clear from these definitions that the terms budgeting and planning are closely
interlinked. Budgets represent the expression in financial terms of an organisation’s
policies and constitute a statement of intent against which any achievements or for
that matter failings can be compared.
Anthony (2007) categorises organisational controls at three levels: Strategic,
Management and Operational. Strategic planning involves the use of information on the
environment and information on internal service capabilities to determine the future
strategy of the organisation. Management Control systems entail the implementation of
strategy and the effective use of resources. In most organisations budgetary control is one
on the most important forms of Management Control.
In the past budgets have often been classified according to the timescale for which
they have been set. This scenario is now changing as budget users have realised that
the main objectives of budgets are common and are not time dependent. In the
public sector budgets are now seen an aid to policy makers in setting tax levels and
other charges. A more recent development in the public sector has been the
emergence of long term or strategic planning. Budgeting is of course concerned with
the implementation of an organisation's approved programme of activities within the
context of the long term plan and the capital budget.
The principles discussed here apply generally across the public and private sectors.
The ensuing discussion will identify the key objectives of budgeting and how these
integrate with service planning. Different types of budgetary models will then be
evaluated by reference to their applicability to the public sector. Finally,
consideration will be made regarding how these theoretical models can be applied to
the public sector particularly in the context of current regulatory and legislative
challenges.
The Objectives of Budgeting
The objectives of budgeting depend on two key factors:
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the type of budget being produced;
the organisation for which the budget is being produced.
Budgets have a key function in that they also serve a number of useful purposes
which are key to an organisation’s success, i.e.
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Planning;
Co-ordination;
Communication;
Motivation;
Control;
Evaluation.
Planning
Managers are required to produce detailed plans to enable the implementation of the
long term or strategic plan. The annual budgeting process encourages managers to
plan for future operations, refine existing strategic plans and consider how they can
respond to changing circumstances. This encourages managers to anticipate
problems before they arise and ensures reasoned decision making. Without this
incentive the pressures of day to day operations may tempt managers not to plan for
future operations and hasty decisions based on expediency rather than reasoned
judgement will be minimised.
Co-ordination
Budgeting facilitates consolidation and co-ordination and allows the actions of the
different parts of the organisation to be brought into a common plan. It also compels
managers to examine the relationship between the different parts of an organisation
when making decisions and in assists in identifying and resolving conflicts. Examples
of the type of conflicts which could arise in a manufacturing setting for example
would be between a purchasing manager who buys in bulk to obtain large discounts,
a production manager who wishes to avoid large stock levels and an accountant who
is concerned about the impact on the business’s cash resources. Budgeting aims to
reconcile these differences.
Communication
All managers within the organisation must have a clear understanding of the role
which they are required to play in ensuring budgetary compliance. This ensures that
the most appropriate individuals are made accountable for budget implementation.
Senior management can also use budgets to communicate corporate objectives
downwards and ensure that other employees understand them and co-ordinate their
activities to attain them. The act of preparation as well as the budget itself will also
improve communication.
Participation in budget setting relates to the extent that subordinates are able to
influence the figures incorporated in their targets. Participation is often referred to as
bottom-up budget setting whereas a non participatory approach whereby
subordinates have little influence on the target setting process is sometimes called
top-down budget setting.
Motivation
Budgets can also provide a motivation for managers to perform in line with
organisational objectives. It therefore sets a standard which under circumstances
managers may be motivated to achieve. It is important, however, that managers are
involved in the budget setting process and that budgets are used as a tool to assist
them in managing their departments. With ‘top-down’ approaches there is a risk that
dysfunctional motivational will occur.
Control
Managers can also use budgets to control the activities for which they are
responsible. Analyses of variances allow managers to identify those costs which do
not conform to the long term plan and therefore may require alteration. By
investigating the reasons for budget deviations managers may also be able to
identify inefficiencies.
The budget forms the basis of a controlling mechanism for the various resources of
an organisation which is achieved by comparing the resource measured to the end of
a given period with that which was expected. This approach can be used for all
measurable resources and activities within the organisation – not just those which
are directly financial.
Budgetary control highlights variations from the expected in order that management
can take remedial action to ensure that the policy objectives set in the budget can be
met. It is a constant monitoring process and requires continual updating and
amendment of the budget through operational feedback. This also allows for
performance against objectives or targets to be measured.
Evaluation
Budgeting can also be used as an effective management tool. It provides an
important mechanism for informing managers as to how well they are performing in
meeting targets they have previously helped to set and an employee's ability to meet
agreed targets is used is many organisations to determine promotions and bonuses.
In this circumstance budgets will therefore influence human behaviour.
Differences Between Public Sector and Private Sector Budgeting
While in broad terms the objectives of budget are the same in both public and private
sectors, the different environment conditions that public sector organisation operate under
can lead to certain distinguishing characteristics
Private Sector Characteristic
Public Sector Characteristic
Market Driven- future depends upon sales.
Consequence: Budget preparation often
begins with sales forecasts which drives
other budgets. Need for considerable
changes to budget during year as sales
levels change
Resources determined by political
decisions. Consequence: Acceptable level
of taxation determined first and then total
resources generated by taxation are
rationed between services by political
decision. Budgets largely fixed for the year
once the political decision has been made
Politicians responsible for determining
service priorities Senior Managers
accountable to politicians and other
stakeholders for delivery. Consequence:
Highly formalised process to budget
creation which includes political input.
Outputs often non financial.Control
empasis is upon keeping costs within
budget and on the use of non financial
indicators of performance
Senior Managers accountable to
shareholders for financial performance.
Consequence : Management relatively free
to determine details of budget , since it is
the bottom line i.e. profit that matters to
shareholders
Performance defined by relating value of
sales to financial inputs. Consequence:
Control emphasis on profit.
It should however be noted that the above distinctions are only a broad generalisation. In
the last 25 years the boundaries between public and private sectors have become blurred.
Some public services have developed trading activities and have become more market
orientated, hence to some extent moving towards the private sector model.
Control and Motivational Objectives of Budgeting
Of the above objectives two, control and motivation, are worthy of further
examination from a theoretical perspective.
Control theories and responsibility accounting
Hopwood (1976) has identified three forms of control of work in organisations:
1 Administrative controls- these include performance measurement systems and the
budget monitoring syatem forms part of this. While these can be useful they need to be
carefully designed in order to avoid demotivating effects
2. Social Controls. These operate through staff sharing common perspectives. Quality
circles and team working are examples of this form of control
3. Self control. This is down to individual behaviour but this can be helped by a suitable
system of rewards e.g performance related pay.
It is important to note that these forms of control are interrelated. For instance if people
deliver services in teams there is an argument that the performance of the team should be
measured and that rewards should be team based.
In a small organisation management can interact with staff on a day to day basis and
social controls may predominate. However in larger , more complex organisations senior
management need to delegate decision making and responsibility and semi autonomous
divisions/units may be created. There however remains the need ensure that these
divisions/units are operating in accordance with organisational goals and hence a group
of controls will need to be created. These controls will include the budget planning and
monitoring system
One core element of the management control system is responsibility accounting
which involves the creation of responsibility centres which enable accountability for
financial outcomes and results to be allocated to individuals throughout the
organisation. For each centre the process involves setting a performance target,
measuring performance, comparing performance against the target, analysing the
variances and taking action where significant variances exist between actual and
target performance.
Responsibility Accounting involves:
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distinguishing between those items which managers can control and for which
they should be held accountable and those which they cannot and therefore
should not be held accountable;
determining how challenging any financial targets should be;
determining how much influence managers should have in the setting of
targets.
There are four types of responsibility centre:
Cost Centre ( Manager responsible for controlling costs)
Revenue Centre ( Manager responsible for controlling sales revenue)
Profit Centre ( manager responsible for controlling profit)
Investment Centre ( manager responsible for controlling profit relative to level of
investment)
In this section we focus mainly upon cost centres since this is the predominant type of
responsibility centre in public services.
There are two types of cost:
Engineered costs. These are costs which can be estimated with a high degree of
reliability. This is normally where inputs and outputs can be measured in physical terms.
These types of costs are commonly found in manufacturing industry and can be found in
in public services e.g. the cost of putting double glazed windows into a council house.
Cost control can be exercised by setting a standard cost and measuring actual costs
against it.
Discretionary Costs. These are costs which are dependent upon management judgement.
Input can be measured in monetary terms but output is difficult to physically measure.
Examples include administrative and support units that give advice. The levels of this
type of budget are a matter of political/management judgement and control is exercised
predominantly at the planning stage by having discussions on what task should be
undertaken by the unit and what level of budget is appropriate. The financial performance
report on actual costs does not adequately measure the performance of the unit since it
does not record what has been produced by the unit. Therefore control needs to be
achieved through non financial measures.
The controllability principle suggests that it is appropriate to charge to an area of
responsibility only those costs that are significantly influenced by the manager of the
responsibility centre. This means that budgetary control reports should distinguish
between controllable and uncontrollable items or eliminate the latter.
Applying the principle in practice can be difficult in practice as many items do not fit
easily into either category. Merchant ( (1985) suggested that there were two
possible errors which may occur when dealing with the consequences of
uncontrollable factors:
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managers may not be protected from the effects when they should be;
managers may be protected when they should not be.
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Merchant has suggested that uncontrollable and controllable items can be
distinguished by applying the following rule of thumb: ‘Hold employees
accountable for the performance areas you want them to pay attention to’. In
the public sector for example, the assignment of the cost of using central
administrative functions (e.g. policy or human resources) to responsibility
centres encourages managers to question the quantity and quality of the
service which they receive. It is essential, however, that managers have
sufficient influence over these areas and also that they are able to deal with
uncontrollable factors prior to the event by insuring against uncontrollable
events. ;
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Merchant has identified three types of uncontrollable factors:
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economic and competitive factors;
acts of nature;
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interdependencies.
Revenues and costs are affected by economic and competitive factors e.g. changing
government regulations or changes in the expectations or requirements of service
users. Responding to these changes is a key part of management’s role and
managers should therefore not be shielded completely from the effects of economic
and competitive factors even though their risk should be minimised.
Acts of nature are large one off events with effects on performance that are beyond
the ability of managers to anticipate e.g. fires, accidents or machine breakdowns.
Controllability only applies here where the event could have been avoided.
Interdependence arises where a responsibility centre is not completely self contained
and the outcomes are affected by other units within the organisation. There are four
types of interdependence:
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pooled which apply where centres use common firm resources such as shared
administrative activities;
sequential where the outputs of one unit are the inputs of another;
reciprocal which exist in diversified organisations when a centre produces
outputs that are used by other units and the centre also uses inputs from
these units;
senior management influence where decisions are imposed on a budgetee or
where an imposed course of action that requires higher approval is not
ratified, e.g. enforced changes in working practices without sufficient retraining being provided.
Finally the key guidelines for applying the controllability principle which were
identified in the US in 1956 remain valid today:
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if a manager can control the quantity and price paid for a service then the
manager is responsible for all the expenditure incurred for that service;
if the manager can control the quantity of the service but not the price paid
then only that amount of difference between actual and budgeted spend that
is due to usage should be identified with the manager;
if the manager cannot control either the quantity or price paid then the
expenditure is uncontrollable and should not be identified with the manager.
Motivational theories
If managers are to be motivated to achieve higher levels of performance it is not
enough that a budget or financial target represents a specific quantitative goal. It is
also essential that these targets are accepted. It is impossible to specify exactly the
optimal degree of difficulty for targets since task uncertainty, personality factors,
cultural and organisational issues will all affect this.
Otley(1987) has developed a model which demonstrates the theoretical relationship
between budget difficulty, aspiration and performance. The aspiration level (i.e. the
level of performance which they hope to attain) relates to the personal goal of the
budgetee. As the budget difficulty increases, Otley argues that aspiration levels and
performance improves until a point is reached when it is perceived as impossible to
achieve beyond which aspirational and performance levels decline. This can mean
that the budget that is expected to be achieved will motivate a lower level of
performance than the one which offers the greatest degree of motivation.
Hofstede adopted a similar approach to illustrate a hypothesised relationship
between the level of difficulty of an expense budget, the aspiration level and
performance. His key conclusions concerning budget difficulties were:
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budgets have no motivational effect unless they are accepted by the
managers involved as their own personal targets;
up to the point where the budget is no longer accepted the more demanding
the budget target the better the results achieved;
demanding budgets are seen as more relevant than less difficult targets but
negative attitudes result if they are seen to be too difficult;
acceptance of budgets is facilitated with good upward communication skills
and regular meetings;
managers reactions to budget targets were affected by their own personality
and more general cultural and organisational norms.
This means that if budgets are to be set at a level which motivates individuals to
achieve maximum performance adverse budget variances are to be expected. In this
situation it is therefore essential that adverse budget variances are not used by
management as a punitive device since this is likely to encourage budgetees to
attempt to obtain looser budgets by either underperforming or deliberately
negotiating easily attainable budgets.
Otley has suggested that the optimum point at which a budget would cease to
motivate may be where individuals perceive that there is significantly less than a
50% chance of it being achieved. Inevitably there is a trade-off between adopting
tight budgets to maximise performance even though this may ultimately not be
achieved and using achievable budgets which provide managers with a sense of
achievement and self esteem but do not maximise performance and achievement.
Highly achievable budgets are therefore to be preferred from the motivational
perspective but are likely to result in aspirational levels and performance not being
maximised. It is essential in planning any performance related bonus scheme that
managers have an incentive not only to achieve any budget target but also to exceed
it.
References/Bibliography
Anthony, RN and Govindarajan, V (2007) Management Control Systems. 12th Edition .
New York: Mc Graw Hill
Hopwood ,A.G. (1976) Accounting and Human Behaviour Eaglewood Cliffs, New
Jersey: Prentice Hall
Merchant. K.A (1985) Control in Business Organisations. Boston: Pitman
Otley, D.T. (1987) Accounting Control and Organisational Behaviour, London :
Heinemann