Management Control Systems (2nd Edition)

Budget as an Instrument of Control : Overview

The budgeting process usually uses a combination of both the top-down approach, where the top management decides the budget and passes it on to the lower levels of management, and bottom-up approach, wherein the lower levels of management set the budget and present it to the top management who review it and suggest the required changes before implementation. Participative budgeting helps in increasing the communication between the top management and the employees.

Traditional budgets are generally set at the beginning of every financial year and are followed till the end of the year, even if the information used becomes outdated. On the other hand, 'rolling budgets' or 'rolling forecasts' are developed at regular intervals, say after every three months, and forecast performance for a specified time period, say the next twelve to eighteen months. Rolling budgets help organizations to control inaccuracies regarding projections and in turn minimize the discrepancies between the standards and the actuals.

Budgets influence employee behavior. For example, the attainability of budget goals has a significant impact on the behavior of the employees who are required to achieve these goals. Easily attainable budget goals will not trigger enough effort from the employees and managers toward performance. On the other hand, if the budget goals are too demanding, there are chances that the employees and managers may resort to unscrupulous means to achieve these goals. Budgets should therefore be challenging but attainable.

Budgetary slack refers to the amount that is budgeted in excess of the actual requirement. Slack is sometimes beneficial as it may help improve creativity, help solve goal conflicts, and also help the management in retaining people. On the other hand, it also has negative effects as it represents managerial inefficiency and self-interest.

National cultures also influence the way in which budgets are prepared. The four dimensions of national culture are power distance, uncertainty avoidance, individualism/collectivism, and masculinity/femininity. Participative budgeting is not usually employed in a culture that rates high on power distance, uncertainty avoidance, or masculinity. Budgeting is an internal process and hence lack of cultural similarities will pose a problem in the budget being communicated across subsidiaries of the organization.

When the compensation is linked to the budgets, there is a general tendency for functional units to set lower than expected budgetary goals and targets for themselves and also to use means that may not be in the interests of the organization to achieve these budgetary goals and targets.

The different types of budgets used by organizations are appropriation budget, flexible budgets, capital budgets, and the master budget. Master budgets form the basis of the control systems of the organizations. The master budget has two components: the operating budget and the financial budget. The operating budget includes budgets for sales, production, direct materials, direct labor, factory overhead, ending inventory, cost of goods sold, selling & administrative costs, and income statement. The financial budget includes the capital budget, the cash budget, and the budgeted balance sheet.

In Zero-Based Budgeting (ZBB), the budget is devised as for a new venture. In ZBB, the responsibility centers are called decision units and the process and activities involved in each decision unit are called decision packages. The ZBB process involves the following steps: decision unit identification; decision package development; evaluation and grading of decision packages; and resource allocation. The assumption in ZBB that the next year's budget is zero helps managers in carrying out the cost benefit analysis of individual activities of their respective decision units. ZBB is designed to evaluate the whole spectrum of functional activity so that areas that are inefficient and of little value are identified.

Some of the limitations of ZBB are that it provides for creation of budgetary slack; it involves a lot of documentation and hence is a slow process; and it is expensive to implement.

Chapter 4 : Overview