Continuous budgeting and better management accounting systems
One of the major concerns with periodic budgeting (i.e. building budgets for one calendar year) is that managers’ time horizon shortens as the year unfolds: in January, they see 12 months ahead; in July they see six months ahead; in December they see only one month ahead. This may accentuate myopia and short-term decision making, especially at the end of the year. Continuous budgets always keep managers’ attention over a full year ahead, so that they do not become too narrowly focused on short-term results.
A continuous budget (sometimes also called rolling forecast or running budget) is a budget continuously updated by adding one period when one period is over. The time horizon is therefore always one year in the future.
The implementation of such continuous budgets would be extremely costly if not for better management accounting systems. The proponents of Activity-Based Budgeting (ABB) argue that it improves budgets’ accuracy and makes the budgeting process faster by relying on the knowledge of resource consumption built in Activity-Based Costing. More generally, any good management accounting system producing reliable estimates can fully leverage cost estimation techniques to facilitate the production of budgets.
Another major issue was the mechanical renewal of past discretionary expenditures, without adequate scrutiny. Zero-based budgeting prevents this by forcing managers to start their budget from scratch every year. What is required for the upcoming period has thus to be thought through, irrespective of whether each element of cost was higher or lower than in the past. This forces managers to review their activities in greater detail, question the relevance of their expenses, and justify their choices. In that sense, zero-based budgeting directly addresses criticism against incremental budgeting.
Zero-based budgeting is a budgeting approach in which all expenses are to be justified rather than assumed to be modelled on the previous period.
Zero-based budgeting is usually unnecessary for engineered costs, i.e. short-term costs which have an identifiable relationship with some activity level. In this context, reliance on a good management accounting systems saves a lot of time. The only exception is when processes are re-engineered.
Re-engineering is a fundamental rethinking and redesign of business processes to achieve improvements in critical measures of performance such as costs, quality, services, speed and customer satisfaction.
Budgeting can be implemented in three generic ways: authoritative, consultative, or participative. The selected approach can have dramatic consequences on the reliability of the numbers which are produced.
Authoritative budgeting is an approach to budgeting which occurs when a superior informs subordinates what their budget would be, without requesting input.
Consultative budgeting is an approach to budgeting which occurs when managers ask subordinates to discuss their ideas about the budget, but no joint decision-making occurs.
Participative budgeting is an approach to budgeting which uses a joint decision-making process in which all relevant parties agree about setting the better targets.
Authoritative budgeting is a top-down approach in which top management sets the budget and imposes it on lower levels of the organization. It goes fast but suffers from major drawbacks. First, unilaterally imposing expectations on people and then penalizing those who do not meet those expectations generates resentment rather than cooperation and commitment. Second, front-line managers often have a more intimate knowledge of operations and can therefore provide more reliable estimates. This is why many managers believe that self-imposed budgets are the most effective. However, at the other extreme, participative budgeting also gives managers the opportunity to build slack into the budget by setting for themselves objectives that are easy to achieve.
If targets are too high and employees know they are unrealistic, motivation will suffer. If the targets are too easy, waste will occur. This is why many iterations and negotiations are often unavoidable and desirable in the budgeting process. On the one hand, lower-level managers are more familiar with day-to-day operations. On the other hand, top managers are more familiar with the strategy and the relationships with other stakeholders. Each managerial level should therefore contribute its unique knowledge and perspective to develop an integrated budget.
Benchmarking or relative performance evaluation
One way to reduce gaming behavior is to use different budgets for planning (where some slack is desirable) and performance evaluation (where slack is undesirable). Decentralizing planning and centralizing target setting by relying on benchmarking or relative performance evaluation is one way to achieve this goal.
Relative performance evaluation consists in evaluating managers’ performance against similar managers’ or competitors’ performance rather than against preset objectives.
These practices make budgetary games pointless, limit the waste of time, and focus managers’ attention on customers and competitors. Moreover, such targets are usually deemed more relevant, dynamic, and ambitious. They can also be compared early on to distinct forecasts to anticipate discrepancies (feed-forward) and correct them in a proactive rather than reactive way (variance analysis gives a late feedback). They however raise other issues, namely that managers do not know the performance they should achieve until the period is over. This creates intense pressures fostering other kinds of dysfunctional behaviors.
A last criticism against budgets we I did not mention previously was an excessive focus on financial metrics, especially on costs. Such a focus may be detrimental to other performance dimensions like quality, on-time delivery, and more generally any revenue driver. Balanced Scorecards complement financial metrics with non-financial metrics informing about long-term performance drivers to prevent managers from an excessive focus on short-term financial performance.
Beyond budgeting - or better budgeting?
Some organizations claim they have abandoned budgeting following the recommendations of the “Beyond Budgeting” movement. While they certainly have abandoned the term “budget” because of its bad connotation, I would argue that they mostly altered the way budgets are implemented and used.
In essence, “Beyond Budgeting” techniques simplify the process (based on a sound management accounting system), maintain a constant 12-month window with rolling forecasts (so implement continuous budgeting), use external benchmarks rather than negotiated targets (so rely on relative performance evaluation), and disconnect capital budgeting from operational budgeting.
Therefore, instead of using only budgets to serve all functions and purposes it can serve, “Beyond Budgeting” relies on a diversified set of tools and specializes these tools to serve specific purposes:
The only function of budgets not covered by specific tools in the “Beyond Budgeting” recommendations is coordination. The function might be ensured by greater transparency (also increasing peer pressure), more frequent lateral interactions between managers, and a greater involvement of management accountants. Or it might explain why, in most organizations, budgets are still prevalent.