Budgetary Control

University Degree Business and Administrative studies

11/03/2010

Budgetary control is part of overall organisation control and is concerned primarily with the control of performance. The use of budgetary control in performance management has of late taken on greater importance especially as a more integrative control mechanism for the organisation. Discuss.

1 - Introduction

Budgetary control is a determining factor of organizational control. It has become increasingly important especially as a more integrative control mechanism. Nevertheless, its use has brought many problems to light with respect to the capital market. This essay will therefore focus on the growing integration of corporation with the capital market and will attempt to provide a viable solution.

2 - Framework - Organisational and Budgetary Control

Organisational control can be defined as a combination of control mechanisms so that employees will behave in ways consistent with the organisation’s goal (Malmi & Brown, 2008). Figure 2.1 illustrates such control mechanism by comparing it to a thermostat that controls a central heating system.

Control within an organisation works in a similar way. It is often said that control is a word with a multitude of meanings and connotations (Otley, 2001). Nonetheless, a definition given by Webster’s Dictionary is good from a business perspective (Emmanuel, Otley, & Merchant, 1990). It states that control is the application of policies and procedures for directing, regulating and coordinating production, administration and other business activities to achieve the corporation’s goal (Emmanuel, Otley, & Merchant, 1990). Budgetary control is one of those management accounting system. “Planning and control are two sides of the same coin” (Emmanuel, Otley, & Merchant, 1990) and budgetary control effectively considers them together for a company to grow.

A budget is an important aspect of any organisation. They are used to plan, coordinate, communicate, motivate, control and evaluate the various actions of the firm (Drury, 1997). Budgets allow managers to determine how much money should be spent for generating certain levels of sales and income (Vitez, 2009). A master budget is most important to set out the plans and targets of the company. It is often very detailed and will therefore be produced on a yearly basis. On the other hand, the flexible budget tracks the cost variances from the production process and is therefore part of daily operations (Vitez, 2009). Variances can be either favourable (positive) or unfavourable (negative). Accountants will be comparing actual expenditure on materials, labour and overheads to the budgeted expenses allowing managers to change or correct their operations for cost overrun problems (Vitez, 2009).

Management accounting systems are vital because they are one of the few integrative mechanisms capable of summarising, in quantitive terms, the effect of an organisation’s action (Emmanuel, Otley, & Merchant, 1990). Budgetary control is described as the planning, controlling, co-ordination and motivation through money values and department within an organisation (Ryan, 2007). Figure 2.2, much related to figure 2.1, applies the elements of a mechanical control system to a budgetary control system (Drury, 1997).

Implementing this type of mechanism enables effective control. Moreover, due to its accounting roots, the use of budgets is very effective for the control of the financial performance by comparing actual results to targeted results. This is important for motivational purposes because, as budgets are used as standards for performance evaluation, rewards are connected directly with budget achievement (Emmanuel, Otley, & Merchant, 1990). Managers are therefore motivated to perform well and meet budgeted targets.

The use of budgetary control has recently become increasingly important especially as a more integrative control mechanism for an organisation. It has become more ...

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The use of budgetary control has recently become increasingly important especially as a more integrative control mechanism for an organisation. It has become more integrated in terms of:

the business context
various departments within a firm
the capital market

The transition from a static budget to a flexible budget recognises that the business context in which firms operate is dynamic. External factors have a prominent effect on a firm’s strategy and plan. Having a static budget, and forever expectation of that static budget, is not realistic. For example, if there is a problem with supply, the manufacturing department might have to change its target within the flexible budget. Therefore, the use of flexible budgets for effective control integrates the firm with the business environment and recognises the reality of the market place.

Traditionally, budgets were also much more specific to different department. Individual functional budgets (marketing, sales, manufacture etc) were not integrated. However, a connection is now established between the departments to fulfill the market demand. One budget would determine another and effective control for the whole organisation is possible.

Finally, the budget has become very important as a communication tool between the organisation and the financial community. The budget is used to signal plans to the financial community. The use of budget as a control mechanism therefore allows the company to be integrated with the capital market. This aspect of budgetary control has many implications, which will now be investigated.

3 - Implication of Budgetary Control’s Strong Connection with the Capital Market

3.1 - The growing importance of the Capital market

In the last thirty years, the interaction with the capital market has gained significant importance. In the past, organisations were more concerned with the product market. Nevertheless, due to the growing importance of the capital market, it is now required for companies to interact with both the product and capital market (Ryan, 2007). Figure 3.1 illustrates this interaction.

The problem with this interaction is that instead of having a multitude of individual shareholders, corporations suffer the pressure of having few financial institutions. The system of budgetary control has gained a lot of importance since it is both a method of control as well as a communicative means of linking corporations to the capital market (Ryan, 2007). For example, Deutsche Post’s 2010 conservative budget was signaling the financial community that the firm was adopting a conservative financial strategy (Lindores, 2010).

Two problems can now be identified due to this strong connection between the budgetary control and the capital market. First of all, organisation’s budgetary control is too narrowly focused in increasing financial performance to satisfy its shareholders thus focusing on short-term objectives rather than their long-term goals.

3.2 - The Focus on Financial Performance

Recently, companies have become obsessed with the creation of shareholder value due to this growing interaction with the capital market. It can be argued that this is one of the main reasons why corporations have extensively used the budgetary control system. The capital market is interested in the financial performance of corporations only, which is reflected in the budget. Therefore, corporations are also focusing too much on their financial performance to satisfy its shareholders. The extensive use of budgetary control has meant that performance is only described in financial terms, forgetting about important non-financial aspect. Nevertheless, this is a too narrow view (Otley, 2001). The company should have other goals to consider such as product range, quality, market segmentation, customer service and others (Ashton, Hopper, & Scapens, 1995). Non-financial performance measure would offer some distinct benefit (Bhimani, Horngren, Datar, & Foster, 2008). Itnner and Larcker suggest the followings (Bhimani, Horngren, Datar, & Foster, 2008):

Provides indirect quantitive information on a company’s intangible asset
Can be good indicators of future financial performance
Can improve managers’ performance by providing more transparent evaluation of their action
Provides a closer link to long-term organisational strategies

It could therefore be argued that other means of control should be adopted. The Balance Scorecard is one method involving both financial and non-financial measures and will later be discussed in this essay.

3.3 - Short-Term v. Long-Term Performance

As we have just discussed, the use of budgetary control as a mean of communication between the capital market and corporation pushes organisations to focus on the financial performance only. Additionally, managers focus primarily on the short-term profit. They have a duty to fulfill the shareholder’s need who no longer show a long-term loyalty to the companies in which they invest (Ryan, 2007). They are expecting to see their returns within the short-term (Ryan, 2007). For example, looking at Deutsche Post again, investors were disappointed when the firm announced lower target than expected. Shareholders did not see it as possible recovery strategy and punished the firm by selling its share (share drop 1.6% in price) (Lindores, 2010). As we can see, corporation use the budget to share their plans with the analyst community who will exercise major influence over corporate strategy by their buy, sell, or hold recommendations to fund managers (Ryan, 2007). This constant pressure has led organisations to change the use and intensity of the budgetary control system (Ryan, 2007). The consequences of this intensity have led to a budgetary control style described to be rigid. A rigid budgetary control style means that managers are evaluated primarily on whether or not they meet the budget’s target (Stede, 2000). The fact that the budgetary control system is so extensively used, it puts too much pressure on managers to meet the budget (Stede, 2000). If managers miss the target, they could face the loss of bonuses, organisational resources, and potentially their job (Stede, 2000). This type of pressure would encourage a short-term orientation (Ryan, 2007). Although Wim A. Van der Stede hasn’t found enough evidence in his study to suggest that there is a direct positive relationship between rigid budgetary control and managerial short-term orientation, the data supports an indirect relationship between the two through budget slack (Stede, 2000) as figure 3.2 illustrates.

Budget slack is when managers intentionally set their budget target lower than their best guess forecast or negotiate easy budget target so that the budget becomes easier to achieve (Stede, 2000). Budgeting therefore becomes a time-consuming game for everyone with senior managers trying to get the most out of their staff, while junior manager fight back to negotiate an easily achievable target. Although this may sound like a negative aspect, Wim A. Van der Stede argues that it allows a higher degree of flexibility in our dynamic environment (Stede, 2000) and managers would be more entitled to take risk for innovation purposes and long-term profitability. Nevertheless, even if managers were to negotiate for lower target, it would only be to lower the pressure in meeting short-term performance. That is because many budgeting system are conducted on an annual performance and most manager change their jobs (internally or externally) every few years (Prendergast, 2000). Most managers would therefore yield to short-term thinking (Prendergast, 2000).

4 - A Possible Alternative to Budgetary Control - the Balanced Scorecard

The budgetary control system is a very powerful tool. Nevertheless, there seems to be some major drawbacks as we have seen throughout this essay. A possible alternative could be the use of the Balanced Scorecard. It uses both managerial and business measurement to evaluate performance. By using strategic non-financial performance measures and traditional financial metrics, both financial and non-financial objective are investigated the meet the ultimate financial goal. This will allow the company to measure financial performance but also customer satisfaction, innovation and others (Prendergast, 2000). Within the Balanced Scorecard, the adoption of a rolling forecast would allow organisation to predict financial performance and to monitor short-term cash requirement (Fanning, 1999). Shareholders would therefore be satisfied. David Otley argues that the Balanced Scorecard is one of the most clearly stakeholder-oriented technique currently on offer (although its proponent Kaplan & Norton believe it is designed to generate shareholder value) (Otley, 2001). Two stakeholders are explicitly identified (Otley, 2001) giving David Otley an advantage in his argument. A stakeholder approach would be very interesting because the stakeholder theory says that a manager’s duty is to balance the shareholders financial interest against the interest of other stakeholder even if it reduces shareholder returns (Smith, 2003). This model is therefore impressive because it allows the satisfaction of most stakeholders. It doesn’t only satisfy the shareholder whose interest is very often addressed through profit (Smith, 2003). An extended discussion within the area of shareholder and stakeholder would however need consideration.

The possible problem with the Balanced Scorecard approach is that it does not completely replace all other control techniques (Otley, 2001). Moreover, the Balanced Scorecard is a long and difficult implementation. It could also be argued that non-financial targets are a lot easier to corrupt than financial target. Human nature therefore seems to be the biggest obstacle in using the Balanced Scorecard effectively.

5 - Conclusion

As much as the Balanced Scorecard seems to be a possible solution to the problems examined within this essay, the real solution would be to persuade the capital market to look at the long-term profitability of a corporation. This will loosen the independence of firms on the capital market and make budgetary control more effective. The shareholders versus stakeholders debate is something that would need extensive studying to understand what is truly best for the future of organisations. Additionally, the current economic crisis should be the trigger to see a change in the dialogue between the capital market and organisation.

Bibliography

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Bhimani, A., Horngren, C. T., Datar, S. M., & Foster, G. (2008). Management and Cost Accounting . Essex: Pearson Education Limited.

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Emmanuel, C. R., Otley, D., & Merchant, K. (1990). Accounting Management for Control. London: Chapman and Hall.

Fanning, J. (1999). Budgeting in the 21st Century. Management Accounting , 24-25.

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Smith, H. J. (2003). The Shareholder vs. Stakeholder Debate. MIT Sloan Management Review , 85-90.

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Vitez, O. (2009, June 19). Budget Types in Management Accounting . Retrieved March 6, 2010, from eHow: http://www.ehow.com/list_5992737_budget-types-management-accounting.html