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© McGraw-Hill Education (UK) Limited 2013 Beyond Traditional Budgeting Chapter 10 1.

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Presentation on theme: "© McGraw-Hill Education (UK) Limited 2013 Beyond Traditional Budgeting Chapter 10 1."— Presentation transcript:

1 © McGraw-Hill Education (UK) Limited 2013 Beyond Traditional Budgeting Chapter 10 1

2 © McGraw-Hill Education (UK) Limited 2013 Yearly forecasts using line budgeting, which in many cases focus on volume. In many line budgets the yearly forecasts are incredibly detailed and use an incremental approach every year to update the figures within the budget. In other words they simply look at last year and add on an agreed percentage to cover inflation or an expected growth in production. Traditional budgeting 2

3 © McGraw-Hill Education (UK) Limited 2013 To be able to respond to changes in the business environment an organization needs to provide their employees an opportunity to be creative which encourages innovation, and this means the budget or management philosophy needs to be flexible enough to deal with this. The issue of traditional budgets focusing on costs rather than adding value to the shareholders of the organization has long been a criticism of traditional budgeting. Users of budgeting have complained that traditional budgets can be too time-consuming and therefore costly to produce 3 Traditional budgeting

4 © McGraw-Hill Education (UK) Limited 2013 CIMA (2009) survey shows that yearly forecasts and incremental budgeting are still commonly used, they are renowned for the problems they can create. One of the biggest problems with traditional budgeting systems is that there is a presumption that at the time the forecasts are set, the environment will remain the same for the time period in which they are used. If a budget is set one year or three years in advance and any of these items change, such as the number of competitors in the market, your forecasts may become irrelevant because they do not meet the needs of the organization anymore. 4 Traditional budgeting

5 © McGraw-Hill Education (UK) Limited 2013 Reeves and Deimler (2011) argue most traditional systems such as budgets assume that the world is predictable and relatively stable. Frow et al. (2010) found, organizations are now facing economic uncertainty, new technologies, new business models and shorter product life cycles, all of which undermine the traditional budgeting systems. Reeves and Deimler (2011) suggest that companies, in order to remain competitive, can no longer rely on being known as excelling at something; instead they need to be really good at learning new things. 5 Traditional budgeting

6 © McGraw-Hill Education (UK) Limited 2013 Alternative budgets offer organizations different ways of planning and managing their budgets, many of which overcome some of the criticisms of traditional budgeting. CIMA (2011) reported that one of the most important roles of the management accountant is to provide up-to-date advice for planning and budgeting. This advice should fit with the strategic direction of the organization. Rolling forecasts/budgets With traditional budgeting being criticized for having fixed targets, often on a 12-month basis, rolling forecasts overcome this by offering continual assessment of the environment within which the budget is set. Alternative budgeting systems 6

7 © McGraw-Hill Education (UK) Limited 2013 Rolling budgets are popular within organizations because they are less detailed than traditional budgets. This results in managers having a clearer picture of what is important, rather than been confused by a level of detail that traditional budgets are often criticised for. In addition, rolling budgets do not have a set end date; managers are encouraged to continually think about the future. Using budgets which cover shorter periods, such as quarterly forecasts, while having predicted forecasts for the next six to eight quarters provides an opportunity for changes to be made, as and when they are required. 7 Alternative budgeting systems

8 © McGraw-Hill Education (UK) Limited 2013 Rather than focusing on detailed fixed plans, rolling budgets analyse the drivers of the resources and focus on these issues within the budget. 8 Alternative budgeting systems

9 © McGraw-Hill Education (UK) Limited 2013 Zero-based budgeting Zero-based budgeting (ZBB) is very distinctive; the past is not taken into consideration when setting new budgets. It is a technique that evolved in the 1960s. Every year a new budget is created which reflects the current environment to which they are working in. Zero-based budgeting is more popular with larger organizations than medium-sized ones. The basic idea is that every year you start with a blank piece of paper and focus on what drives the resources. This type of budgeting is not as popular as rolling budgets because it is more relevant to organizations that do not have processes and businesses which are repeated on an annual basis. It is often associated with the public sector. This type of budgeting is easier to achieve with services or discretionary costs. 9 Alternative budgeting systems

10 © McGraw-Hill Education (UK) Limited 2013 Process of using ZBB comprises three steps: 1) All activities within the organization need to be identified. For each activity a report needs to be generated to analyse the costs, justify the reason for the activity to go ahead and to present all alternatives. At this stage appropriate targets should be identified as a performance tool. These activity reports are commonly referred to as ‘decision packages’. 2) Every activity report will then be given due consideration and they will be ranked in order of what is required for the forthcoming budget period. 3) The final stage is the allocation of resources which is determined by the ranking performed in stage 2. 10 Alternative budgeting systems

11 © McGraw-Hill Education (UK) Limited 2013 Kaizen budgeting Kaizen budgeting is part of the continuous improvement philosophy. This type of budgeting works within organizations that use quality systems working towards continuous improvement. Rather than maintaining one set of predetermined costs at the beginning of the budgeting period, the budget embeds a reduction in operational costs as they occur. The process of Kaizen budgeting requires a manager to continually identify areas of improvement within the process of manufacturing. This is achieved by seeking small changes to every process within the production line. Although the ultimate outcome is based on cost reductions, this is more within an accounting technique; Kaizen techniques are part of a cultural mindset. Everyone working with the environment should recognize that every process can achieve small improvements on a continuous basis. 11 Alternative budgeting systems

12 © McGraw-Hill Education (UK) Limited 2013 Activity-based budgeting Activity-based budgeting is based around activities; it centres on the information generated through the ABC system, focusing on the operations of the business within the value chain. CIMA (2009) survey showing that just under 50 per cent of the respondents from this category using this method. Approximately 30 per cent of large and medium-sized organizations used ABB. However, within smaller organizations the use dropped to around 20 per cent 12 Alternative budgeting systems

13 © McGraw-Hill Education (UK) Limited 2013 The process of creating ABB is as follows: 1. Analyse products and customers to be able to predict the production and sales demand. 2. Use the information from the ABC system to estimate the resources required to perform organizational activities. 3. With demand predicted, estimate the quantity of each resource that will be needed to meet the demand. 4. Allocate resources based on these predictions for each activity. 13 Alternative budgeting systems

14 © McGraw-Hill Education (UK) Limited 2013 The process of creating ABB is as follows: 1. Analyse products and customers to be able to predict the production and sales demand. 2. Use the information from the ABC system to estimate the resources required to perform organizational activities. 3. With demand predicted, estimate the quantity of each resource that will be needed to meet the demand. 4. Allocate resources based on these predictions for each activity. 14 Alternative budgeting systems

15 © McGraw-Hill Education (UK) Limited 2013 Many of the issues with traditional budgeting, such as setting targets based on fixed budgets rather than focusing on what was strategically important to the company, was the impetus for the beyond budgeting philosophy evolving. Hope and Fraser (2003) are often recited in this area; one of the articles brought the issue of ‘who needs budgets?’ to a wider audience. Beyond budgeting 15

16 © McGraw-Hill Education (UK) Limited 2013 Hope and Fraser (2003, p. 108) began their argument with a very strong message: ‘Budgeting, as most corporations practice it, should be abolished.’ This was a very bold statement and resulted in budgeting in general being revisited, with academics questioning if companies need budgeting to be successful 16 Beyond budgeting

17 © McGraw-Hill Education (UK) Limited 2013 Hope and Fraser (2003) stated that traditional budgeting distracted employees from what they should be doing by channelling attention to targets, based on irrelevant information. 17 Beyond budgeting

18 © McGraw-Hill Education (UK) Limited 2013 The argument behind the beyond budgeting philosophy is based on five issues, all identified as problems arising from using traditional budgeting: 1) Using fixed budgets to set targets will only ever achieve small improvements. 2) Setting incentives based on fixed targets can create fear, rather than encouraging innovation. 3) Fixed targets create a sense of compliance rather than adding value. 4) Allocating resources through traditional budgeting encourages managers to hoard resources rather than use them where they are needed. 5) Centralization ignores market reactions (Hope and Fraser), 2003. 18 Beyond budgeting

19 © McGraw-Hill Education (UK) Limited 2013 Principles of beyond budgeting Governance and transparency 1. Values Bind people to a common cause; not a central plan 2. Governance Govern through shared values and sound judgement; not detailed rules and regulations 3. Transparency Make information open and transparent; don’t restrict and control Accountable teams 4. Teams Organize around a seamless network of accountable teams; not centralized functions 5. Trust teams to regulate their performance; do not micro- manage them 19 Beyond budgeting

20 © McGraw-Hill Education (UK) Limited 2013 6. Accountability Base accountability on holistic criteria and peer reviews; not on hierarchical relationships Goals and rewards 7. Goals Encourage teams to set ambitious goals, don’t turn goals into fixed contracts 8. Rewards Base rewards on relative performance; not on fixed targets Planning and controls 9. Planning Make planning a continuous and inclusive process; not a top-down annual event 10. Co-ordination Co-ordinate interactions dynamically; not through annual budgets 11. Resources Make resources available just in time, not just in case 12. Controls Base controls on fast, frequent feedback; not budget variances 20 Beyond budgeting

21 © McGraw-Hill Education (UK) Limited 2013 The central argument here is that organizations should move away from centralized hierarchical management and instead move towards a devolved network of teams who will be responsible for adding value and making the decisions necessary to achieve this. By providing authority to move resources where required, the system moves from a command and control system to a more adaptive management process. The concept of trust is central for this philosophy to work. 21 Beyond budgeting

22 © McGraw-Hill Education (UK) Limited 2013 Frow et al. (2010) argue that some of the principles of beyond budgeting need more explanation. For example in relation to resource allocation, how would an organization deal with competing resources allocation requests? When the value of the requests is more than the supply of resources, who will arbitrate these requests? 22 Beyond budgeting

23 © McGraw-Hill Education (UK) Limited 2013 Otley (2007) questions the use of relative targets within the beyond budgeting philosophy. He argues that while relative targets for senior managers can be useful to benchmark against competitors, when you are creating PMSs for lower-level managers the benchmarks can be very difficult to generate. Most companies keep this detailed information to themselves and therefore benchmarking can be very difficult in many industries. 23 Beyond budgeting

24 © McGraw-Hill Education (UK) Limited 2013 Both CIMA (2009) and Dugdale and Lyne (2010) suggest that rather than abandoning traditional budgeting systems, organizations are focusing on improving the budgeting systems that they already have. 24 Beyond budgeting

25 © McGraw-Hill Education (UK) Limited 2013 Libby and Lindsey (2010) examined companies in America and Canada to analyse the views of budgets as the currently stand and improvements that the users wanted to see in the future, this can be seen in Management Accounting Insight 10.2. Many of the findings in the Libby and Lindsey (2010) article show that organizations are in many cases wanting to achieve some of the ideas behind the beyond budgeting approach. However, the beyond budgeting philosophy is taking a ‘leap of faith’; it is not simply replacing one system or adapting existing systems within an organization, but is an entire change to the way management think. Although there are concerns about whether some of the principles work in practice, the philosophy offers organizations an opportunity to create new business models, which for many organizations, have proven to be very successful. 25 Beyond budgeting

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