Budgeting: Approaches and Shortcomings

von: Roman Hinka

8th semester

Introduction  3

Chapter I. The Nature of Budgeting And Its Functions  4

1.1. Definition of Budgeting  4
1.2. Requirements to Budgeting 6

1.2.1. Integrity of Budget Allowances  6
1.2.2. Strategic Adherence of Budget Allowances  7
1.2.3. Prevention From Opportunistic Behavior  7
1.2.4. Flexibility  7
1.2.5. Economic Efficiency 7

Chapter II. Classical Budgeting 8

2.1. Brief Description of Classical Budgeting  8
2.2. Performance Profile of Classical Budgeting 9

2.2.1. The Reach of Budgeting Process 9
2.2.2. Alignment With Strategy  10
2.2.3. The Threat of Misuse 11
2.2.4. Flexibility  11
2.2.5. Economic Efficiency of Classical Budgeting 12

2.3. Appropriateness 12

Chapter III. Zero-Base Budgeting  14

3.1. The Concept of Zero-Base Budgeting 14
3.2. Performance Profile of Zero-Base Budgeting 15

3.2.1. Integrity of budget allowances  15
3.2.2. Strategic Adherence of ZBB  15
3.2.3. Prevention From Opportunistic Behavior  16
3.2.4. Flexibility  16
3.2.5. Efficiency of ZBB  17

3.3. Appropriateness 17

Conclusions  19

List of literature  20

Introduction

The present paper purposes to highlight two most well known approaches to budgeting, specifically classical and zero-base budgeting. In last years there is much criticism blaming shortcomings of the both. However, such treatment seems to be biased without deep penetration in the nature of budgeting systems. The paper does not intend to summarise information about approaches to budgeting, but rather to explore system specific features that bring the shortcomings about. The paper is composed in the way not to contrast the approaches, that is to show the superiority of one of them, but to draw a profile of the approach with respect to selected criteria. The criteria, introduced in the first chapter, reflect major requirements to the budgeting systems from managerial point of view. They encompass integrity of budget allowances, adherence to strategy, impact on employees behaviour, flexibility and efficiency. Owing to scarce capacity the paper omits aspects specific to management and organization but still affecting the performance of the budgeting approaches. These are, for example, organization of planning process (bottom-up, top-down, etc), corporate culture, incentive structure, degree of activity formalization, management style, etc. The second and third chapter discuss instantaneously performance of classical and zero-base budgeting respectively. Analysis begins with brief description of most important features of the approaches and concentrates extensively on how respective approach meets the requirements. Finally, there will be discussed the most suitable type of production which makes up in part for disclosed shortcomings.

Chapter I. The Nature of Budgeting And Its Functions

1.1. Definition of Budgeting

Budgeting belongs undoubtedly to the most wide spread financial coordination tools of management. Despite this fact there is no unanimity among theorists about definition and functions of budgeting1. The clear contrast one can observe between American and German concepts of budgeting resulting from different approaches to controlling. Anglo-Saxon point of view regards budgeting mostly as a tool for financial planning, thus as a subject to financial department activities: �A budget may be considered to be a set of financial statements resulting from a particular scenario- generally the most likely or hoped for scenario. A budget therefore reflects management opinions regarding future financial circumstances�2. This synonymic treatment of budget and financial plan was adopted from governance practice of public corporate bodies where budgeting embraces comparison of income and outlay entries.

The German doctrine considers budgeting more likely as planning conducted on all management levels and for different time perspectives: �Ein Budget ist für uns ein formalzielorientierter, in wertmäßigen Größen formulierter Plan, der einer Entscheidungseinheit für eine bestimmte Zeitperiode mit einem bestimmten Verbindlichkeitsgrad vorgegeben wird?Unter Budgetierung wollen wir den gesamten Budgetierungsprozess verstehen, d.h. insbesondere Aufstellung, Verabschiedung, Kontrolle sowie Abweichungsanalyse 3. For the purpose of this paper we will depart from the following budget features:

1. Budgeting is a process of compilation, adoption, and supervision of budgets.
2. Budgets are compulsory by nature, i.e. person in charge has to meet the allotments.
3. Budgeting assigns rather target values than particular actions to departments and delegates certain discretion to responsible managers.
4. Budgeting bases on planning, that is one chooses the most probable scenario under assumption about future sales volumes commodity, and factor prices4. The role or the aim of budgeting is to govern decision units and departments in the organization towards its goals5. Generally, one distinguishes following functions of budgeting:

- Motivation. By means of performance measurement, evaluation, and remuneration budgeting should direct managers toward companys goals. This function aims to solve or at least to mitigate the problem of information asymmetry. Personal benefits conditioned to objectives, often expressed in financial form, and participation of subordinates in planning process supplies enough incentives for a man on site not to shirk, but to act on behalf of the firm.
- Coordination. Owing to the overall planning character of budgeting, it facilitates management to overcome difficulties of recourse, profit, and risk interdependencies. Using vertical and horizontal reconcilement enables you to reveal possible bottlenecks and problems as well as counteract erroneous tendencies.
- Communication. For the purpose of effective management subordinates should have sufficient information about organizational goals in order to adjust their actions appropriately. On the other hand, superiors need to be up to date about strategy progress. Budgeting, because of planning procedures suffices this function at least formal.

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1 Cp.: Horváth (2004), pp. 68.

2 Altman (1986), pp. 17.

3 Horvath (2001), p. 233.

4 See: Pfaff (2002), pp. 232.

5 Cp. Ibidem, p. 233.