Budgeting is very important process for proper functioning of an organisation. Budgets involve financial planning regarding resource allocation in various activities of business which allows systematic flow of those activities in order to achieve the organisational goal (Clowes & Scriven 2015). The traditional or incremental budgeting has been widely used in almost all types of business. But due to significant changes in business environment in modern scenario and rise in competition the traditional budgeting process do not seems to be of much use. A need arises to develop alternatives approaches to traditional budgeting like activity- based budgeting, zero- based budgeting, rolling forecasts to overcome the drawbacks of traditional budgeting.
Benefits of Budget:
The aim of any business organisation cannot be achieved without proper planning, and for a proper planning firm have to go through with budgeting process. Budgeting plays an important role in growth and development of business. Budgets act as guide to various managerial staff at each level (Needles, Powers & Crosson 2013). Budgets are significant for every kind of firm and if a manufacturing firm like ABC Ltd. is concerned, its importance increases further. A manufacturing industry has much more complex process than any trading or service industry. A suitable planning for available resources becomes necessary for such firm to avoid any wastage and maximise its profits. Budget can prove beneficial to a firm in many ways:
- Budgets are the basic tool for planning the activities of business. Plans without budgets are difficult to execute. It promotes growth as it is always designed to ensure better performance of current year than previous years. Further with help of budget a firm can plan for future growth of organisation by ensuring that it has sufficient capital and resources in hand whenever required to make decisions regarding expansion of business (Vitez 2017).
- Budgets also help in coordinating the actions of various departments. It discloses in advance the target for each department, i.e., target sales units to sales department, estimated production units to production department to meet the sales and desirable finished goods requirement. Likewise estimated units to be purchased are assigned to purchase department accordingly to fulfil the requirement of production department. This coordination is very necessary for proper functioning and resources allocation in an organisation. For example, it may result in over or under purchasing of materials by purchase department then what was required which will result in wastage of materials or risk of shortage in materials, which will ultimately affect the production process and will further affect the sales target. It facilitates proper communication at each level or organisation and among each department regarding their authority and responsibility. This ensures that organisation is working systematically and decorously. This makes management to let the flow of work go according to budgets and focus their attention more on planning for future growth and development of business (Dima 2013).
- Controlling ensures that activities are performing as per plan which are designed for development of organisation. The standards determined in budgets are compared with actual performance and the reasons for any adverse deviations are identified to take corrective actions. It helps in evaluating the performance of each department and responsibility centre and company as a whole in terms of efficiency and effectiveness. In case of major deviations either reasonable steps are taken to make the performance according to plan, or the budgets are revised to make it more realistic (Peavler 2016).
- If incentive or bonus plans are linked to budgets, it acts as a motivating factor for each employees and managers at all level as it encourages everyone to perform better than the targets mentioned in budgets. This proves beneficial for not only employees but to the whole organisation.
- Budgets are mainly designed so that a systematic planning of available resources can be done, that is, how much amount will be required for each activity. This is very necessary in order to check any wastage or pilferage during any process. This helps in efficient and effective utilisation of resources and the saved resources can be used for expansion and development opportunities (Bamber & Parry 2014).
- The rising competition in market do not allows a firm to raise sales price above a certain limit to earn more profits. Thus profit can be maximised only by minimising the costs which is possible only by preparing and adhering to various costs budgets, designed to ensure earning desired profit. Without budgets it becomes difficult to control costs (BIFA n.d.).
Traditional Budgeting Approach in ABC Ltd:
ABC Ltd. conducts a business of wooden flooring system and it prepares its budget on incremental basis. It starts with revenue forecasts; estimation of desired sales is key element for traditional budgeting on which all other element will be based. The estimated sales is forecasted keeping in mind two factors, first is the level of sales achieved during past year and second is companies’ desired goals and expectations for future years. The expenses are designed according to desired sales and amount of expenditure incurred last year. The expenditure to be incurred for procurement of materials used for wood flooring like wood logs, lamination paper, décor- paper, fibre sheets, glue, paint, other tools are estimated, possible negotiation with suppliers is performed regarding material rates. Estimation of number of labour required and their wages are included in labour budget. Any increase in pay scale is considered. It is important to examine whether existing machinery and equipment are sufficient to achieve desired sales. Budget need to address whether a further investment for advertising, publicity and sales promotion activities, efforts for procurement of new contracts is required (Hansen, Mowen & Guan 2007).
The budget should consider projected net cash flow position needed on monthly basis for smooth functioning of business activities. A proper cash budget is essential for a business to save itself form any cash shortage and enables a quick decision on important matters. It is essential to determine the number of budgets required according to nature and size of business, small business can operate with single budget but for a large manufacturing company a detailed planned for desired sales, estimated material requirements, projected labour requirements, estimation of direct and indirect variable overheads is greatly required and thus required a separate budgets for same. Budget should address estimation of each element of both variable and fixed costs and how such cost will increase in current year. Fixed expenses need to examine in detail as in case further investment is required the budget will take a different form for procurement of required funds (CIMA 2008).
Advantages and Disadvantages of Traditional Budgeting:
Traditional budgeting is method of preparing budgets on incremental basis, where previous year is taken as base and adjustments in revenue and expenses are made considering the market situation, inflation rate, business trends and customers demand. Traditional budget is advantageous on the fact that it is easy to prepare and implement. It saves time as it is prepared on the basis of last year budgets only after making few adjustments. It encourages growth in business activities by ensuring that standards are set at higher level than previous year. It makes sure that funds are available to each department on continuous basis without much analysis requirements (Bandy 2014). But this method of budgeting has several limitations and it fails to provide efficient outcome in modern era.
It assumes that business working and activities will be carried out in same way as in past year thus it fails to encourage creative approach to working methods and development of new ideas or innovation. These budgets are less flexible and rigid in nature. There are so many internal and external factors which may change during a year like economic and market condition, laws and regulations, emergence of new entrants with new technology, ideas, concepts, change in competition level and changes in business conditions internally. A traditional budget fails to take into account such factors and becomes useless for efficient business operations (Pidgeon 2010).
Traditional budgeting involves just adding the percentage to previous budgets which always assumes that all costs will increase in order to increase output. The problem with this approach is that first of all, it may happen that there were some inefficiencies and wastage in past activities that resulted in higher costs, adding percentages to same amount means that no steps are taken to reduce wastage and same inefficiencies are reflected in new budget. Another issue is that not every cost has direct relationship with level of output. Some indirect costs or support activities do not change with the change in output level and if changes they do not represent any clearly defined relationship with units produced. Estimates of resource consumption for such cost on the basis of input- output relationship will only give freedom and authorisation to authority concern to spend more till budget allows (Drury 2008).
If incentives and compensations are linked to performance compared against budgets it leads to deliberate efforts by managers to suggest inflated budgets to top level of management for resource allocation. This results in internal negotiation among mangers and unethical issues which ultimately cause budgets to lose its spirit and relevancy (Wolf 2017).
Alternatives to Traditional Budgeting:
Zero- based budgeting:
Zero- based budgeting tries to overcome the limitations of incremental budgeting. In this method, figures of past years are not considered, rather estimation of each expenses are made taking base as zero. It involves detailed examination and evaluation of activities and programmes to be performed for each decision unit (CMI 2013). For each decision unit, decision package are identified which describes the cost to be incurred for each activity, purpose of performing such activity and consequences of not performing a particular activity. It also establishes the alternative means to achieve the purpose. A cost – benefit analysis is performed for each decision package to rank them in order of priority. The available limited resources are allocated to various decision packages according to their priority level (Kavanagh 2011).
Justification of each expense becomes necessary while formulating this budget; this facilitates efficient allocation of resources to each department. Since budgets are not based on past expenses, any inefficiencies or wastage related to past year can be eliminated. It enhances the understanding and knowledge of actual trends and behaviour of costs prevailing in market and ensures accuracy in budgeted amounts which presents more realistic figures. Despite several advantages this budgeting method is criticised on the fact that it consumes lot of time and efforts as it require detail examination of each expense and revenue items. It also requires a high level of expertise which may not be present in the managers of all level. Further, there may be some expenses which are although lubish in nature, but not be able to justified, for example some expenses related to research and development. This may cause rejection of authorisation of such important expenses which may negatively affect the performance of organisation. The ranking of such activities which have benefits in qualitative nature becomes difficult which further ads to the complexity of this budgeting method (Serna & Weiler 2016).
Activity- based budgeting:
This budget aims at authorising only those activities which are necessary to perform for the achievement of desired goal. It does not follow incremental approach. The process involves estimating the desired level of sales and production, than determining the organisational activities required to meet that level. It helps in eliminating the wasteful activities and concentrate only of useful activities (Davis & Davis 2011). Next level involves identifying the resources required for each activities and the estimating the amount of expenses to be incurred for those resources. The last stage of this budgeting process is to compare the existing available resources to the estimated resources required for current objectives. In case required estimation exceeds the available capacity, measures are taken in budget to authorise for acquisition of additional resources and in case of opposite situation, suitable actions are taken to redeploy the existing resources which are not required any more (Shim, Siegel, & Shim 2011).
Overhead costs can occur as a large part for total operating costs; this method of budgeting strives toward taking measures to reduce such costs by encouraging better management and understanding of drivers of costs. By reducing the costs related to unnecessary activities, this budgeting provides a competitive advantage to a firm (CGMA 2013). This budgeting system treats business as a single unit and not as combination of various departments and is prepared considering the requirements of organisation as whole. But this budgeting is quite complex and requires deep research and understanding of various factors and functional areas affecting the business. This makes this approach costly and time taking, requires lot of expertise and involvement of top level managers.
One of the effective alternatives to traditional budgeting is rolling forecast which involves estimation partly on the basis of past performance and rest on the basis of changing market conditions and internal/ external factors affecting business (Lynn & Madison 2004). This method provides flexibility to budgets as a projection is made for a certain time horizon, which keeps on rolling (Hope & Fraser 2003). As a part for that particular period expires, say a month or quarter and next projections are made on continuous basis according to the financial and operational performance of organization and market situation. Rolling budgets are considered as more realistic and accurate than any other budget as it updated on regular basis as changes occurs in business environment. It saves time and resources as it requires only minor changes to previous budgets. But this method has limitation on ground that continuous change in budget may distract the managers and employees who were working toward the achievement of fixed target and can create confusion in organisation which might adversely affect their performance (Kapalan Financial Knowledge Bank 2012). It is advisable to only those businesses which are exposed to constantly changing environment with extremely varying factors otherwise it will only waste time and resources.
Application of Budgeting Methods to ABC Ltd.:
The whole budget process of a company like ABC Ltd. depends on the marketing and sales forecast made in advance after signing contracts with various builders and constructors. Different project have different requirements, for instance, a project may require natural wooden- flooring which requires natural wood logs which are quite expensive and further involves cutting and finishing process and different kind of machinery. Another project may require laminate wooden flooring which is relatively cheaper and requires different material like high- density fibre board, décor paper, etc. and has different procedure. The incremental budgeting will not be suitable in such business as every year changes takes place in contracts and their nature. The company was also facing some problems with this budgeting process which depicted favourable operational variance but lower profits than estimated. This may be because of over-allocation of resources to be expanded than actually required because of just incrimination of previous expenditure.
ZBB may seems to be applicable in this case but the problem is ranking of different activities and processes for different projects may become difficult and bias, as different projects may have different quality factors. For example a project may have comparative low profit margin and involves high cost but has various environmental benefits to society or might have specific benefits to company in terms of future opportunities for further contracts and on the other hand another project might be very profitable but doesn’t involve such qualitative benefits. Such situation makes ranking difficult and unable to apply ZBB.
ABB can be successfully applied given the type of business. In addition it is required that it keeps on rolling within certain period for necessary updates Problem with application of each budgeting method is that lack of expertise and necessary skill in the company may not justify the required budget. Application of modern budgeting system can be costly and might require installing software.
Application of ABB to ABC Ltd.:
ABB based budgeting seems to be most appropriate for a business of wooden flooring system with a mixture of rolling forecast. While implementing ABB, the company need to first asses in advance the on-going projects and up-coming projects and estimate the tentative quantity (generally in sq. feet) required in coming next year. On the basis of that quantity and type of projects to be completed the necessary organisational activities to be performed are determined. Than company has to calculate resources required for each activity like designing process, for research- development or innovation for manufacturing the items, material procurement, production process, assembling, overhead cost like salary, rent, lighting, and for other administration and sales promotion activities. It has to determine the quantum of previous available resources which can be utilized again and need for procurement of additional resources. It has to be decided whether the material required should be outsourced or manufactured through cost- benefit analysis. Budgets should explain and justify each activity and resource requirement. Further it should be flexible in nature given the type of work the company performs and should have quality of rolling budget. It may happen that any project can be cancelled in between due to some circumstances like change in regulations, government notice, climatic condition, or other unforeseen situation, in that situation company may have to revise its whole budgeting process.
The kind of work performed by ABC Lt. involves some variations each year according to the nature of projects and contracts. The existing system of incremental budgeting is not appropriate for such business. Zero- based budgeting can prove to be quite costlier thus most appropriate one should be the Activity based budgeting along with feature of rolling forecast which enables it to revise the budgeting process according to change in circumstances. As company is also planning to re- structure its operation, the ABB approach will provide fresh estimation of activities actually required in operation in more realistic way.
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