The disadvantages of the traditional approach to budgeting
Budgeting in an organisation, also known as the annual planning process, is designed to provide managers with a blueprint for operating the company. The budget shows what the company intends to spend in order to generate revenues, what the projected revenues are and the profit the company will earn if it achieves its revenue goals. Even within companies where the budgeting system has been in place for a number of years, the process is not completely efficient.
Traditional approach summarised
The traditional approach to budgeting is a blend of top-down and bottom-up budgeting methods. Top-down means top management sets goals for the year and communicates them down the chain of command. In bottom-up budgeting, department managers prepare budgets for the business segment they are responsible for and send the budget up to top management for consolidation into a company-wide budget or plan.
Goals set by senior executives include specific revenue growth targets as well as guidelines regarding expenditures. A company might set a goal of increasing revenues by 10 per cent, or cutting costs by 5 per cent. Unless the people at the top solicit input from the departmental managers who have responsibility for achieving the results, the objectives are likely to be seen by lower level managers as arbitrary, unfair and not achievable.
The bottom-up approach can mean that only management personnel contribute to producing the departmental budgets -- employees below the managerial level are not included in the process. These employees often have key pieces of information that could result in a more realistic, achievable plan. Sales personnel, for example, may know that certain products are beginning to decline in popularity with customers, so marketing resources should be deployed to the products with greater growth potential.
The budget always goes up
To prepare their budgets, department managers often take last year's budget and add an incremental amount, such as 8 per cent, to cover assumed cost increases. They don't take the time to scrutinise all line item expenditures to see if there were any areas where funds were wasted. What they should do is look for expenditures that did not contribute to improved efficiency or revenue growth and cut these from next year's budget, not add 8 per cent to them.
Padding, then cutting
Seasoned department managers are adept at playing the "budget game." They know top management will take the budget they submit and chop a certain amount from it, so they ask for more money than they really need. When the revised budget is approved, it turns out they got everything they wanted in the first place. This penalises other managers who were sincere in their efforts to submit a realistic expense forecast and then had to deal with their budget being reduced.
Companies may use the budget as a punitive device rather than a guideline. Managers who don't precisely achieve forecast results are subjected to severe criticism from senior management and may even receive poor performance reviews. The truth is that a business very seldom achieves its forecast numbers. Too many variables affect the company's performance, including competitors becoming stronger or the economy becoming weaker. Top management must take these factors into account when judging a department manager's performance, and not look at the variances from budget alone.