Implementation Challenges Of Formal Budgeting Systems In Innovative Companies
Introduction
The budgeting process was invented almost a hundred years ago in order to improve performance of large organizations such as DuPont, General Motors, and Siemens. For almost half a century, it worked quite well, but since then this traditional tool has been the center of dispute as to whether it meets the organizations' needs, and is worth being utilized. Uyar (2009) visualizes the argument on a continuum. On the one end, the process is considered well-functioning. On the opposite end, it is considered outdated. Somewhere in between, it is claimed that the process requires improvements in order to acknowledge changing business environments and technological developments. The dynamic and volatile nature of the business environment renders budgeting more of a barrier than a support for improvements in organizational performance. In an attempt to regain control, organizations tend to pull harder on existing management levers. They end up doing more of what they already do, e.g. lengthier budgeting processes, tougher targets or stricter follow-ups. What they fail to realize is that in this new business climate, people need more and not less room to move. The more urgent the need to break free of the past and go for radical management innovation, the stronger the fear of letting go and leaving the well-tested management practices.
The Need for Budgeting
Traditionally, budgeting is a forward-looking financial plan that provides a basis for directing and evaluating individual and organizational performance, and for coordinating responsibilities within organizations. Traditional budgeting and resource allocation processes act as management tools to aid financial decisions in organizations.
The process begins with the submission of detailed project proposals to the senior management, which then reviews the portfolio and allocates resources carefully. While projects deemed critical to the organization get financed, others tend to receive few or no resources. As existing customers are the major revenue source, organization’s financial priorities incline them to fund projects directed towards them. Thus, resources are typically allocated to incremental product-enhancements rather than ground-breaking innovative strategies.
Limitations of Traditional Budgeting
Traditional budgeting process is costly, time-consuming and outdated. Therefore, valuable resources are wasted on a process meant to provide insights into operational requirements. Instead of customer demand and long-term financial success, decision-making becomes submissive to the budget. Budgets constrict organizational responsiveness and flexibility, and are often a barrier to change. They add little value as they tend to be bureaucratic and discourage creative thinking. They are based on unsupported assumptions. They encourage gaming, corporate politics and dysfunctional behavior, while strengthening vertical command and control. They fail to adapt with changing organizational structures, while reinforcing departmental barriers. Moreover, traditional budgeting theory is limited in its ability to understand the role of budgeting in terms of power and organizational politics. Inertly, it accepts its own assumptions of the rational purposes served by accounting information. Therefore, it is important to avoid passively accepting the assumption that budgeting is complicit in organizational power and politics. Furthermore, they fail to measure the key performance indicators that make organizations successful in a global economy, such as customer loyalty, development of intellectual properties, speed to meet customer expectations, employee development and product quality.
Interplay of Budgeting and Innovation
According to Simons (2005), the modern era pressurizes organizations to balance between the need to achieve predefined objectives and the need to innovate i.e. between efficiency and flexibility. The tensions created by a rapidly innovating business environment in relation to the role of budgets are vastly recognized in literature. Innovation is a process of commercial exploitation and application of ideas and inventions. Given rapid globalization and increasing competition, the ability to innovate is essential for achieving competitive advantage and enhancing financial performance. Innovation can be described as unpredictable, risky and highly uncertain in regard to its development process and market response. Davila (2005) explains that innovation can either be incremental or radical. Incremental innovation modifies the strategy but keeps the organization on its current strategic path. In contrast, radical innovation redefines the organization’s future strategy. Organizations can easily identify the effects of incremental innovation, as it builds upon existing competencies. Thus, involving lower risks and lower expected returns. Budget as a formal control system plays an important role in this innovation strategy. It supports the translation of the organization’s strategy into actionable plans, monitors their execution and helps identify variances for corrective measures. However, with the intended strategic actions, senior management does not formulate a deliberate strategy. In fact, strategies are formed as a consequence of the organization’s daily activities. In other words, senior management only focuses on defining guidelines that shape the strategy, allowing budgets to provide a framework for innovation and capture organizational learning. In contrast to incremental innovation, radical innovation involves higher risks and higher expected returns. It tends to dramatically change the organization’s industry structure. In this scenario, budgets play a minimal role and informal controls prevail, to encourage experimentation and discovery. Budgets are often assumed to serve a traditional role of performance evaluation, through its diagnostic nature. However, formal budgeting systems can have a more interactive use as well. While the diagnostic use is performed to check and reward achievement of pre-defined goals, the interactive use focuses on expanding opportunity-seeking and learning, thereby fostering successful innovation. The interactive use focuses on the intensive use of control system, which facilitates communication, along with the strategic validity control, which monitors whether the organization has the right strategy in place or not. Thus, interactive budgets serve as a dialogue and learning mechanism.
The interactive use of budgets depends on the continual exchange of information between and within various levels of an organization. Effective communication is key for setting achievable standards, analyzing reasons for variances and deciding on the need for corrective action. Such a budgeting system becomes a means of debating how to react to changes in operating conditions and learning more about the alternative responses. Interactive dialogue between organizational members is positively associated with members’ effectiveness and motivation, which is important in an innovation environment. Research indicates that interactive usage contributes to reducing the risk of excessive and inadequate innovation in high-innovating firms, and the risk of too little innovation in low-innovating firms. Thus, it has a moderating effect on the impact of innovation on performance. However, Simons (1999) believed in the diagnostic usage of management control systems for the purposes of limiting innovative excess, and the interactive usage for creativity stimulation in areas of strategic uncertainty.
In an attempt to identify differences in the design and usage of budgeting processes, Jallow and Anastasova (2015) researched three innovative, pharmaceutical companies, namely Active Biotech, Probi and CellaVision. Findings revealed that these organizations prioritized time in their innovation strategies and project management. The time concern reduced the budget’s control function and necessitated greater cost flexibility. Active Biotech used rolling forecasts and placed a strong emphasis on its planning and forecasting functions. It relied more on informal controls, but did not use budgetary system interactively. It developed radical long-term innovations with unpredictable discovery processes, driven by scientist’s intrinsic motivation. Thus, the applicability of the budget’s control function was diminished, and the use of rolling forecasts for planning purposes was accentuated.
In contrast, Probi and CellaVision practiced more traditional budgeting. They balanced between planning and control roles of budgets, by using them interactively and considering them a framework for communication between senior and lower management. Balancing between budgetary control and creative innovation requires a combination of formal budgeting procedures with informal social interactions. The ability to reallocate resources through communication within and across organizational functions, keeping in view the changing business environment, is fundamental. Maintaining the balance is crucial to manage the lack of individual controllability generated during the pursuit of innovation. Thus, traditional budgetary control may not always hinder innovation within an organization, given that management uses traditional budgetary controls flexibly and responsively.
In the light of an increasing emphasis on innovation within the organization, Consortium for Advanced Manufacturing – International (CAM-I) has researched budgeting systems modifications introduced by organizations. However, the research focuses on the identification of a best practice, rather than providing insight into the rationale behind such modifications, or their associated problems. Hope and Fraser (2003) justify the failure of traditional budgeting systems on the basis that they operate as a barrier to change required to compete in the contemporary, knowledge-based business environment. New management techniques, developed in response to environmental volatility, fail at successful implementation due to the invisible power of the inflexible nature of budgets. Thus, innovative organizations demand changes in the design of management control systems, in order to avoid inertia and rigidity.
Recent Developments in Budgeting Systems
Better Budgeting Due to volatile business environments, certain organizations find traditional budgeting insufficient as a management control and decision-making tool. Thus, a new budgeting innovation, called better budgeting, is being introduced in several organizations to overcome the traditional budgeting limitations. Better budgeting techniques include activity-based budgeting, zero-based budgeting, value-based management, rolling forecasts etc.
While activity-based budgeting and zero-base budgeting help in improving the focus and accuracy of budget outputs, they tend to be even more cumbersome. Therefore, it is difficult to use them on a regular basis. Value-based management tends to be more theoretical rather than a widely-adopted approach. Therefore, it is difficult to assess its efficacy. Rolling forecasts, on the other hand, seems to have the most potential as a better regular budgeting approach, being successfully adopted by several large organizations. In order to increase accuracy and effectiveness of traditional budgeting systems, rolling forecasts allow organizations to conduct reforecasts at regular intervals, e.g. monthly or quarterly, to reflect the environmental changes and other variances. Traditionally, different departments maintain different spreadsheets to provide their part of the budget information, providing room for manual manipulation. However, modern software packages can make the budgeting process less cumbersome. Sophisticated models to enable organizations to prepare forecasts quickly and automatically consolidate reports, and to assess and compare alternative business scenarios rapidly, are available. E-budgeting is another viable option, which reduces administrative costs and frees the finance department to focus on strategy.
In zero-base budgeting, the budgeting process starts from scratch in every period, rather than using the historical budget as the starting point when budgeting for the next period. This approach allows managers to reassess their operations from the ground up and justify every dollar spent in terms of current corporate goals. Zero-base budgeting avoids building on the inefficiencies and inaccuracies of history. However, its viability depends on stability of the operating environment.
Activity-based budgeting focuses on generating a budget from an activity-based model of the organization. Its fundamental thrust is to expand activity-based and capacity management concepts into budgeting. It contends that budgeting serves primarily a planning role and that budgeting suffers because the financial-oriented, higher-level budgeting process is not adequately connected to the underlying operational model of the organization. It creates an operationally feasible budget before generating a financial budget. It converts the estimated demand for products into activity requirements using activity consumption rates, and then translates activity requirements into resource requirements using resource consumption rates. Subsequently, it works to achieve an operational balance between the resources required to fulfill demand and the capacity. Next, the approach develops a financial plan based on the operational plan. Financial balance is achieved when the financial plan meets a predetermined financial target. Once the organization knows the demands, activities, and resources, it determines the cost of resources, traces them to activities, and then to products. If there is an imbalance, the organization can adjust the variables involved in forming the budget. As traditional budgeting processes do not collect information on activity and resource consumption rates, they offer fewer possibilities to adjust the budget.
The activity-based approach avoids unnecessary calculations of the financial effect of operationally infeasible plans, by first balancing operational requirements. As it generates a budget explicitly from activities and resources, it is able to highlight the sources of imbalances, inefficiencies and bottlenecks. The explicit analysis of resource capacity and resource consumption allows organizations to identify capacity issues and make adjustments earlier in the budgeting process, as compared to traditional budgeting processes.
The resulting transparency of the activity-based budget potentially promotes the allocation of resources to their best uses in line with organizational priorities, decreases the scope for political gaming, enhances decision making and performance evaluation, and improves operational flexibility. However, one potential limitation of this approach is information availability about activities, processes, and resources, and the cost of creating and maintaining the information.
Value based management is a formal and systematic approach for managing the creation of shareholder value overtime. All expenditure plans are evaluated as project appraisals and assessed in terms of the resulting shareholder value. It helps to link strategy and shareholder value to planning and budgeting processes.
Beyond Budgeting
Apart from better budgeting techniques, an innovation called Beyond Budgeting, which intends to move away from the budgeting practice altogether, is being introduced in response to recent criticism that budgeting is a non-value-adding and obsolete for modern enterprises. Beyond Budgeting is not a management control tool, but a new management philosophy based on real-world applications, to create a flexible organization using already-existing tools such as balanced-scorecard, rolling forecast and customer relationship management. Beyond Budgeting is a mindset that helps companies achieve their full potential by finding the right management model with the optimal balance between autonomy and control. Beyond Budgeting is about rethinking how organizations are managed in a post-industrial world and which innovative management models represent the only sustainable competitive advantage. It is also about releasing people from the burdens of stifling bureaucracy and suffocating control systems, trusting them with information and giving them time to think, reflect, share, learn and improve. Moreover, it is about learning how to change from many leaders who have built and managed "beyond budgeting" organizations.
Beyond Budgeting Model is based on twelve principles, concerning the creation of a flexible organizational structure in which authority is delegated, and the designing of an adaptive management process. It is a decentralized model rather than top-down, and evaluates performance on relative targets rather than fixed, thus allowing organizations to break free from the annual fixed performance trap. Furthermore, it makes planning a continuous process, gives autonomy and responsibility to the teams and units, and does not allocate resources based on annual static budget, but based on the needs of subunits. As a result, the approach saves time and money by avoiding the budgeting process. It eradicates much of the political gaming opportunity. It enables organizations to respond to the changing environment through the use of more adaptive processes. Successful transition to adaptive processes and radical decentralization allows permanent reductions in the cost structure, higher degree of innovation, customer retention and release of the full potential of management systems and tools.
Conclusion
Traditional budgeting and resource allocation processes act as management tools to aid financial decisions in organizations. As organizations have financial priorities, most of the resources are directed towards revenue-generating initiatives. As a result, projects deemed critical to the organization are typically incremental product enhancements within established businesses rather than ground-breaking strategies.
In the contemporary world of globalization and increasing competition, the ability of firms to innovate is frequently considered to facilitate firms gaining competitive advantage and enhancing financial performance. Traditional budgeting systems have been criticized for failing to adapt and respond to environmental changes, emerging in the contemporary, global, innovative business environment. The interplay between budgeting and innovation is related to an organization’s need to balance between control and flexibility. The budgeting process requires improvements in order to acknowledge the changing business environments and technological developments.
Traditional budgeting process is costly, time-consuming and outdated. It constrains organizational responsiveness and flexibility, and acts as a barrier to change. It fails to add significant value as it discourages creative thinking. It encourages gaming, corporate politics and dysfunctional behavior, while strengthening vertical command and control. It is limited in its ability to understand the role of budgeting in the context of power and politics of organizations. It tends to be unresponsive in the face of competition and turbulence in the business environment. It fails to measure key performance indicators of the global economy. Despite several limitations of formal management controls, they can be made flexible to meet the needs of innovations by means of interactive usage and emphasized planning against control function. The role of budgets as a management control system is to provide a framework for innovation and capture the learning that happens in the organization. Traditional budgeting systems can have diagnostic and interactive uses. While the diagnostic use is performed on an exception basis to monitor and reward achievement of pre-established goals, the interactive use aims on expanding opportunity-seeking and learning, thereby fostering successful innovation. They key to interactive usage is information-sharing and informal, social interactions throughout the organization. Developments in the budgeting alternatives include better budgeting and beyond budgeting approaches. While the former believes in improving formal budgeting systems to increase flexibility, agility and adaptability, the latter considers abandoning budgeting altogether to be the best approach. However, both alternatives are not independent solutions. While better budgeting techniques have their own drawbacks, beyond budgeting requires further research to make this new philosophy a viable option.
