Purpose of Budgeting
Conflict between Planning and Control
A budgeting system serves two principal purposes: planning and control. In making planning decisions, budgets communicate specialized knowledge from one part of the organization to another. For control, budgets serve as benchmarks for performance-measurement systems. Budgets serve several purposes; therefore, trade-offs must be made when designing or changing a budgeting system. The budget becomes the benchmark against which to judge actual performance. If too much emphasis is placed on the budget as a performance benchmark, then managers with the specialized knowledge will stop disclosing accurate forecasts of future events for planning decisions. Managers will tend to report budget figures that makes benchmarks easier to achieve.
The conflict between planning decisions and control is particularly severe in marketing. Salespeople usually have specialized knowledge of future sales. This information is important in setting production plans, such as how many units to manufacture. If budgeted sales are used to evaluate salespeople at the end of the year, salespeople have an incentive to under-forecast future sales, thus improving their performance evaluation. However, production plans will be too low, and the firm will incur costs due to its inability to plan the most efficient production schedules.
To manage the conflict between planning decisions and control, many organizations put the chief executive officer in charge of the budgeting process. While the actual collection of data and preparation of the budget is the formal responsibility of the chief financial officer or controller, the president or CEO has the final responsibility. The CEO has immediate control for numerous reasons. First, it signals the importance of the budgeting process. Second, resolving disagreements among departments requires making trade-offs and the chief executive, who has the overall view of the entire firm, is best able to make these trade-offs .
In addition to placing the chief executive in charge of the budgeting process, many firms also use a budget committee. Such a committee consists of the major functional executives (vice presidents of sales, manufacturing, finance, and human resources) with the CEO as chairperson. The budget committee facilitates the exchange of specialized knowledge and the achievement of consensus in establishing a budget. The budget is an informal set of contracts between the various units of the organization. By accepting the budget, the organization’s managers agree to perform the responsibilities assigned and to abide by the limitations that it specifies.
Most budgets are established through a negotiation process involving lower- and higher-level managers. Lower-level managers have incentives to set easier targets to guarantee that they will meet the budget and be favorably rewarded, whereas higher-level managers have incentives to set more difficult targets to motivate the lower-level managers to exert additional effort. The conflict between making planning decisions and control is often viewed as a trade-off between “bottom-up” budgeting versus “top-down” budgeting.
Bottom-up budgets are submitted by lower levels of the organization to higher levels and usually imply better information for planning decisions.
An example of a bottom-up budget is the submission by the regional sales offices of their sales forecasts for the next year to the marketing department.
A top-down budget would be the central marketing department’s use of aggregate data on sales trends to forecast sales for the entire firm, and then disaggregating this firm-wide budget into regional targets.
This top-down budget provides greater control; but by not soliciting input from the field offices, it forgoes assembling knowledge from its sales staff.
A bottom-up budget process, in which the person ultimately held responsible for meeting the target makes the initial budget forecast, is called “participative budgeting”. Participation enhances the motivation of the lower-level participants by motivating them to accept the targets.
The extent to which a budget is bottom-up or top-down ultimately depends on where the knowledge is located. If the knowledge is with the regional salespeople, the responsibility to set the budget should be linked with the knowledge and placed in the field. If the central marketing organization has better knowledge, a top-down budget is likely to be best. Which budgeting scheme provides better motivation depends, in the final analysis, on how the performance measurement and reward systems are designed.
In a survey of Australian manufacturing firms, managers indicated that they used participative budgeting more frequently when lower-level managers had specialized knowledge. A Finnish study of 83 managers concluded that participative budgeting had a positive effect on performance when managers had a high level of cost-management knowledge. Moreover, participative budgeting is more frequently used when managers’ rewards are based on their performance against the budget.
This evidence is consistent with efforts to design budgets and performance reward system to link them to responsibilities and specialized knowledge.
Budgeting systems are an administrative device that contributes to the achievement of organizational goals. In particular, these systems link knowledge with the responsibility to make planning decisions. Budgets are also used to distribute responsibilities and to measure and reward performance for control. This series further analyses various budgeting devices, such as short-term versus long-term budgets, line-item budgets, budget lapsing, and flexible budgets. These are important budgeting devices used in most organizations.