Langdale Ltd is a supplier and distributor of personal computers in the UK. It currently employs incremental budgeting in order to manage its levels of operational efficiency. The inherent nature of incremental budgeting has reduced it to a mere form filling exercise amongst its managers and its efficacy as a management tool is in doubt. The aim of this report is to analyze alternate budgeting tools to manage operational efficiency while also trying to side step the current problems faced by the company with its existing budgeting process.
Problems with Incremental Budgeting
Incremental budgeting is a simple process to effectively allocate funds to various departments within an organization. The process entails adding additional numbers to the previous period's budget numbers taking into consideration factors such as market conditions, labour efficiency, new legislations enforced and the effect of new accounting policies implemented. Even though incremental budgeting in spirit is meant to extrapolate numbers for the current period using the previous year's numbers as the base, what normally happens is that managers and other budgeting personnel view it as a mere form filling exercise and put out fresh numbers for the current year using a flat percentage. Most managers do not take into account changes in the real world while applying the percentage. As a result the budget numbers are not grounded in facts and actual circumstances and become difficult to achieve.
One of the fundamental assumptions of incremental budgeting is also its biggest flaw. Incremental budgeting assumes that things will remain the same for a foreseeable future. This is hardly true in today's rapidly evolving economies. The growth that happens is not just linear. Businesses can grow through acquisitions and expansions into new markets, many of which may be spontaneous decisions and difficult to plan for. Assuming that business circumstances will remain stable and numbers will grow in an uncomplicated and linear manner is taking an entirely simplistic view of the situation.
Incremental budgeting allocates fixed amounts of money to budgets. This means that it does not incentivise managers to cut costs and improve on operational efficiency. On the contrary, managers can be tempted to overspend in order to completely utilize their allocated budgets and ensure a similar allocation in the next budgeting period. This will bring down operational efficiency in the long run and affect productivity. Like their budgets, managers will also fall into an operational rut and be content with doing their routine tasks just so long as the budget numbers are achieved. Incremental budgeting does not recognize the need to innovate fresh ideas and bring new perspective into performing old tasks.
This system of budgeting assumes that the previous year's budgets are robust and water tight enough while preparing the current year's budgets. The incremental budgeting process does not take into consideration the efficacy of the previous year's numbers nor does it use the power of hindsight to understand whether mistakes were committed in the previous budgeting period. As a result the errors can get carried forward to the current period as well.
Incremental budgeting utilizes the previous year's numbers to arrive at current year's budgeted numbers. However, there are a number of problems with this assumption. Firstly, the prevailing circumstances might mean that the business viability of one department has gone down and hence merits lesser budget allocation than last year. But with incremental budgeting this information might not be processed and an increased amount of funds might be allocated to this department. For example, if the Finance team has been recently downsized then lesser allocation needs to be made towards their overall costs. Also if a paint company plans to concentrate more on developing newer products in the current year, it needs to make an increased allocation towards this department. In short, incremental budgeting is flawed because it does not take into consideration the strategic objectives of the company.
Incremental budgeting is an ineffective tool when it comes to managing the operational efficiency of the business. It also does not drive employees to come up with fresh ideas and better ways of accomplishing their tasks. This budgeting process at best reduces employees to mere drones who strive to achieve numbers that may bear no relation to prevalent business realities. As such it kills motivation and affects productivity in general.
Alternate Methods of Budgeting
Langdale Ltd can look at the following alternate methods of budgeting in order to effectively plan for expenditure and manage their operational efficiency.
Zero Based Budgeting
Activity Based Budgeting
Zero Based Budgeting
The biggest advantage with the zero based budgeting approach is that it asks for managers to justify the numbers extrapolated and completely ignores previous year's figures. Each year is independently analyzed and the budget figures are arrived at from 'zero'.
The first step in zero based budgeting requires each function/department to critically examine and identify its significant channels of revenue generation and operational activities. Managers have to also justify the relevance of the department's operations vis-à-vis the organization's goals and objectives and whether the function is strategically aligned with the rest of the organization. Each operational activity is budgeted using a 'decision case' approach and evaluated independently. Management may decide to evaluate each 'decision' on different funding levels. The manager is required to not only justify the funding by providing ostensible measurements for outcome but must also suggest alternatives for the activity and the ramifications if the funding is not approved. This places a lot of emphasis on operational efficiency.
Zero based budgeting might involve higher administration costs but it is a highly utilitarian tool in times of tight budgets. Management can attempt to offset some of the administrative costs by building a core budgeting team who can perform this exercise for all departments in conjunction with the concerned managers. With an intelligent and communicative approach to the process, it is also possible to build in some flexibility to a degree in the budgets laid out. Managers will also be less tempted to consider their departments as independent 'islands' and to align their department's operations more in consonance with the overall goals of the organization. This will instil in them a feeling of team spirit and build motivation that will percolate through to lower levels as well.
Activity Based Budgeting
Activity Based Budgeting is perhaps the most efficient budgeting method available today. The fundamental purpose of the process is to analyze the relationship between costs, activity and related output. Each department analyzes and categorizes its activities into significant categories. Activity Based Budgeting is advantageous because it seeks to allocate more resources for activities that have a higher demand-pull for the output than others. It incorporates common sense and logic into the budgeting process by allocating resources for expected output levels than the other way around. Thus, it takes into account the prevalent economic and business realities during the budgeting process.
Activity Based Budgeting is effectively an extension of the Activity Based Costing Models followed by many manufacturing companies. It effectively correlates between resources allocated and the output it generates and thus, is an effective means of measuring operational efficiency. It seeks to first determine the level of feasible output that a department is expected to produce. In case of Langdale Ltd, for example, the Sales Department would be studied on the basis of the number of catalogues and instruction manuals they are expected to sell and the printing department will get resources based on the expected demand for the catalogues and the amount of stock that is desired to be maintained. By using the Activity Based Budgeting model, managers can adequately plan for the resources that are required to achieve the desired output and maintain operational efficiency. This will bring about improvement in every aspect of the business. Managers will also be motivated to stay within the resources allocated and to strive for greater involvement in the budgeting process as such.
Resources allocated using the Activity Based Budgeting model may be supplemented by a central resource pool. For example, management may choose to fund the utility bills and tax payments on revenue from a central budget that is distinct from the activity budget. Langdale Ltd can easily transition to Activity Based Budgeting because it is only an improvement on the incremental budgeting approach. Previous year's numbers are not entirely ignored and the incremental approach is supplemented with an activity based approach to evolve a logical and realistic budget number.
Langdale Ltd can adopt either of the two methods listed above or even a combination of the two to evolve its own unique budgetary process. It can use zero based budgeting along with activity based budgeting to evolve budget numbers that bear direct correlation to the output when liquidity is in short supply and finances are under strain. When in growth mode, the company can choose to go only with the Activity Based Budgeting model and achieve the most optimum resource allocation. This can also ensure maximum flexibility in the budgeting process and encourage resourcefulness and initiative among the workforce.