Budgeting Budgeting Theory Definition and Objectives What is a Budget?

Objectives of Budgeting Differences between Public and Private Sector Budgeting Control and Motivational Objectives of Budgeting Sources of Further Information May 2007

Definition and Objectives of Budgeting

This section defines what is meant by budgeting and outlines the objectives of budgeting.

What is a Budget?
There are numerous definitions of the term 'budget' but it is most simply defined as: "a plan expressed in financial terms". An alternative definition was which is more applicable to the public sector has been suggested by Henley et al in 1992, and is still valid today.(1992): "Budgeting is a process of measuring and converting plans for the use of real (i.e. physical resources) into financial values. It is the classic problem of how to add together quantities of apples and oranges into a meaningful economic measurement, the only practical way for everyday use is to express their economic values in terms of monetary costs and revenues. Through the process of budgeting the finance function provides the essential link between management planning and management control." It is clear from these definitions that the terms budgeting and planning are closely interlinked. Budgets represent the expression in financial terms of an organisations policies and constitute a statement of intent against which any achievements or for that matter failings can be compared. Historically Budgeting has been synonymous with financial planning and authorisation for the next fiscal year. However more recently budgeting has always been seen as a tool in the implementation of strategic plans. Anthony (2007) categorises organisational controls at three levels: strategic, management and operational. Strategic planning involves the use of information on the environment and information on internal service capabilities to determine the future strategy of the organisation. Management control systems entail the implementation of strategy and the effective use of resources. In most organisations budgetary control is one on the most important forms of management control. In the past budgets have often been classified according to the timescale for which they have been set. This scenario is now changing as budget users have realised that the main objectives of budgets are common and are not time dependent. In the public sector budgets are now seen an aid to policy makers in setting tax levels and other charges. A more recent development in the public sector has been the emergence of long term or strategic planning. Budgeting is of course concerned with the implementation of an organisation's approved programme of activities within the context of the long term plan and the capital budget. The principles discussed here apply generally across the public and private sectors. The ensuing discussion will identify the key objectives of budgeting and how these integrate with service planning. Different types of budgetary models will then be evaluated by reference to their applicability to the public sector. Finally, consideration will be made regarding how these theoretical models can be applied to the public sector particularly in the context of current regulatory and legislative challenges.

Objectives of Budgeting
The objectives of budgeting depend on two key factors:

the type of budget being produced;

the organisation for which the budget is being produced.

Budgets have a key function in that they also serve a number of useful purposes which are key to an organisations success, i.e.

Planning; Co-ordination; Communication; Motivation; Control; Evaluation. Authorisation

Planning Managers are required to produce detailed plans to enable the implementation of the long term or strategic plan. The annual budgeting process encourages managers to plan for future operations, refine existing strategic plans and consider how they can respond to changing circumstances. This encourages managers to anticipate problems before they arise and ensures reasoned decision making. Without this incentive the pressures of day to day operations may tempt managers not to plan for future operations and hasty decisions based on expediency rather than reasoned judgement will be minimised. Co-ordination Budgeting facilitates consolidation and co-ordination and allows the actions of the different parts of the organisation to be brought into a common plan. It also compels managers to examine the relationship between the different parts of an organisation when making decisions and in assists in identifying and resolving conflicts. An eExamples of the type of conflicts which could arise in a manufacturing local authority setting for example would be between a purchasing manager who wants to buy buys in road salt in bulk to obtain large discounts, a stores production manager who wishes to avoid large stock levels of salt and an accountant who is concerned about a possible overspend on the Highways budget and the Highways manager who wants to avoid running out of salt in bad weather and therefore carry high levels of stock.,the impact on the businesss cash resources. Budgeting aims to reconcile these differences. Communication All managers within the organisation must have a clear understanding of the role which they are required to play in ensuring budgetary compliance. This ensures that the most appropriate individuals are made accountable for budget implementation. Senior management can also use budgets to communicate corporate objectives downwards and ensure that other employees understand them and co-ordinate their activities to attain them. The act of preparation as well as the budget itself will also improve communication. All managers within the organisation must have a clear understanding of the role which they are required to play in ensuring budgetary compliance. This ensures that the most appropriate individuals are made accountable for budget implementation. Participation in budget setting relates to the extent that subordinates are able to influence the figures incorporated in their targets. Participation is often referred to as bottom-up budget setting whereas a non participatory approach whereby subordinates have little influence on the target setting process is sometimes called top-down budget setting. Motivation Budgets can also provide a motivateion for managers to perform in line with organisational objectives. It therefore sets a standard which under certain circumstances managers may be motivated to achieve. It is important, however, that managers are involved in the budget setting process and that budgets are used as a tool to assist them in managing their departments. With top-down approaches there is a risk that dysfunctional motivational will occur. Control

Managers can also use budgets to control the activities for which they are responsible. Analyses of variances allow managers to identify those costs which do not conform to the long term plan and therefore may require alteration. By investigating the reasons for budget deviations managers may also be able to identify inefficiencies. The budget forms the basis of a controlling mechanism for the various resources of an organisation which is achieved by comparing the resource measured to the end of a given period with that which was expected. This approach can be used for all measurable resources and activities within the organisation not just those which are directly financial. Budgetary control highlights variations from the expected in order that management can take remedial action to ensure that the policy objectives set in the budget can be met. It is a constant monitoring process and requires continual updating and amendment of the budget through operational feedback. This also allows for performance against objectives or targets to be measured. Evaluation Budgeting can also be used as an effective management tool. It provides an important mechanism for informing managers as to how well they are performing in meeting targets they have previously helped to set and an employee's ability to meet agreed targets is used is many organisations to determine promotions and bonuses. In this circumstance budgets will therefore influence human behaviour. Authorisation A budget is normally prepared by the management of a public body, but in a democracy is normally approved by a legislative body representing the interests of the general public. Thus the objective of the budget in the public services can be to achieve democratic authorisation to raise taxes and spend money.

Differences between Public and Private Sector Budgeting

While in broad terms the objectives of a budget are the same in both public and private sectors, the different environmental conditions under which public sector organisation operate can lead to certain distinguishing characteristics. Differences between Public and Private Sector Budgeting Private Sector Characteristic Market driven - future depends upon sales. Consequence: Budget preparation often begins with sales forecasts which drives other budgets. Need for considerable changes to budget during year as sales levels change Public Sector Characteristic Resources determined by political decisions. Consequence: Acceptable level of taxation determined first and then total resources generated by taxation are rationed between services by political decision. Budgets largely fixed for the year once the political decision has been made Senior managers accountable to shareholders for financial performance. Consequence: Management relatively free to determine details of budget , since it is the bottom line i.e. profit that matters to shareholders Performance defined by relating value of sales to financial inputs. Consequence: Control emphasis is upon keeping costs within Consequence: Control emphasis on profit. budget and on the use of non financial indicators of performance Consequence: Highly formalised process to budget creation which includes political input. Outputs often non financial. Politicians responsible for determining service priorities. Senior managers accountable to politicians and other stakeholders for delivery.

It should however be noted that the above distinctions are a broad generalisation. In the last 25 years the boundaries between public and private sectors have become blurred. Some public services have developed trading activities and have become more market orientated, hence to some extent moving towards the private sector model.

Control and Motivational Objectives of Budgeting

Of the above objectives two, control and motivation, are worthy of further examination from a theoretical perspective. Control theories and responsibility accounting Hopwood (1976) has identified three forms of control of work in organisations: 1. Administrative controls These include performance measurement systems and the budget monitoring system forms part of this. While these can be useful they need to be carefully designed in order to avoid demotivating effects. 2. Social controls These operate through staff sharing common perspectives. Quality circles and team working are examples of this form of control. 3. Self control This is down to individual behaviour but this can be helped by a suitable system of rewards, e.g. performance related pay. It is important to note that these forms of control are interrelated. For instance if people deliver services in teams, there is an argument that the performance of the team should be measured and that rewards should be team based. In a small organisation, management can interact with staff on a day to day basis and social controls may predominate. However, in larger more complex organisations senior management need to delegate decision making and responsibility and semi autonomous divisions/units may be created. There however remains the need ensure that these divisions/units are operating in accordance with organisational goals and hence a group range of controls will need to be created. These controls will include the budget planning and monitoring system. One core element of the management control system is responsibility accounting which involves the creation of responsibility centres which enable accountability for financial outcomes and results to be allocated to individuals throughout the organisation. For each centre the process involves setting a performance target, measuring performance, comparing performance against the target, analysing the variances and taking action where significant variances exist between actual and target performance. Responsibility Accounting involves:

distinguishing between those items which managers can control and for which they should be held accountable and those which they cannot and therefore should not be held accountable; determining how challenging any financial targets should be; determining how much influence managers should have in the setting of targets.

There are four types of responsibility centre:

1. 2. 3.

Ccost centre (manager responsible for controlling costs e.g. a hospital ward ); Rrevenue centre (manager responsible for controlling sales revenue rare in public service organisations ); Pprofit centre (manager responsible for controlling controlling sales revenue and costsprofit e.g. a catering unit );

4.

Iinvestment centre (manager responsible for controlling profit relative to level of investment e.g. a publicly owned airport).

This section focuses mainly upon cost centres since this is the predominant type of responsibility centre in public services. There are two types of cost:

Engineered costs These are costs which can be estimated with a high degree of reliability. This is normally where inputs and outputs can be measured in physical terms. These types of costs are commonly found in manufacturing industry and can be found in in public services e.g. the cost of putting double glazed windows into a council house. Cost control can be exercised by setting a standard cost and measuring actual costs against it.

Discretionary costs These are costs which are dependent upon management judgement. Input can be measured in monetary terms but output is difficult to physically measure. Examples include administrative and support units that give advice. The levels of this type of budget are a matter of political/management judgement and control is exercised predominantly at the planning stage by having discussions on what task should be undertaken by the unit and what level of budget is appropriate. The financial performance report on actual costs does not adequately measure the performance of the unit since it does not record what has been produced by the unit. Therefore control needs to be achieved through non financial measures.

The controllability principle suggests that it is appropriate to charge to an area of responsibility only those costs that are significantly influenced by the manager of the responsibility centre. This means that budgetary control reports should distinguish between controllable and uncontrollable items or eliminate the latter. Applying the principle in practice can be difficult in practice as many items do not fit easily into either category. Merchant (1985) suggests that there were two possible errors which may occur when dealing with the consequences of uncontrollable factors:

managers may not be protected from the effects when they should be; managers may be protected when they should not be.

Merchant has suggested that uncontrollable and controllable items can be distinguished by applying the following rule of thumb: Hold employees accountable for the performance areas you want them to pay attention to. In the public sector for example, the assignment of the cost of using central administrative functions (e.g. policy or human resources) to responsibility centres encourages managers to question the quantity and quality of the service which they receive. For instance the head teacher of a school may review the cost and quality of support provided by the central authorities human resources division. If not satisfied with the quality the head teacher may request either an increase in quality or a reduction in price. It is essential, however, that managers have sufficient influence over these areas and also that they are able to deal with uncontrollable factors prior to the event by insuring against uncontrollable events. Merchant has identified three types of uncontrollable factors:

economic and competitive factors; acts of nature; interdependencies.

Revenues and costs are affected by economic and competitive factors e.g. changing government regulations or changes in the expectations or requirements of service users. Responding to these changes is a key part of managements role and

managers should therefore not be shielded completely from the effects of economic and competitive factors even though their risk should be minimised. Acts of nature are large one off events with effects on performance that are beyond the ability of managers to anticipate e.g. fires, accidents or machine breakdowns. Controllability only applies here where the event could have been avoided. Interdependence arises where a responsibility centre is not completely self contained and the outcomes are affected by other units within the organisation. There are four types of interdependence:

pooled which apply where centres use common firm resources such as shared administrative activities; sequential where the outputs of one unit are the inputs of another; reciprocal which exist in diversified organisations when a centre produces outputs that are used by other units and the centre also uses inputs from these units; senior management influence where decisions are imposed on budget managers or where an imposed course of action that requires higher approval is not ratified, e.g. enforced changes in working practices without sufficient retraining being provided.

Finally the key guidelines for applying the controllability principle which were identified in the US in 1956 remain valid today:

if a manager can control the quantity and price paid for a service then the manager is responsible for all the expenditure incurred for that service; if the manager can control the quantity of the service but not the price paid then only that amount of difference between actual and budgeted spend that is due to usage should be identified with the manager; if the manager cannot control either the quantity or price paid then the expenditure is uncontrollable and should not be identified with the manager.

Motivational theories If managers are to be motivated to achieve higher levels of performance it is not enough that a budget or financial target represents a specific quantitative goal. It is also essential that these targets are accepted. It is impossible to specify exactly the optimal degree of difficulty for targets since task uncertainty, personality factors, cultural and organisational issues will all affect this. Otley (1987) has developed a model which demonstrates the theoretical relationship between budget difficulty, aspiration and performance. The aspiration level (i.e. the level of performance which they hope to attain) relates to the personal goal of the budgetee. As the budget difficulty increases, Otley argues that aspiration levels and performance improves until a point is reached when it is perceived as impossible to achieve beyond which aspirational and performance levels decline. This can mean that the budget that is expected to be achieved will motivate a lower level of performance than the one which offers the greatest degree of motivation. Hofstede (1967) adopted a similar approach to illustrate a hypothesised relationship between the level of difficulty of an expense budget, the aspiration level and performance. His key conclusions concerning budget difficulties were:

budgets have no motivational effect unless they are accepted by the managers involved as their own personal targets; up to the point where the budget is no longer accepted the more demanding the budget target the better the results achieved; demanding budgets are seen as more relevant than less difficult targets but negative attitudes result if they are seen to be too difficult; acceptance of budgets is facilitated with good upward communication skills and regular meetings; managers reactions to budget targets were affected by their own personality and more general cultural and organisational norms.

This means that if budgets are to be set at a level which motivates individuals to achieve maximum performance adverse budget variances are to be expected. In this situation it is therefore essential that adverse budget variances are not used by

management as a punitive device since this is likely to encourage budgetees to attempt to obtain looser budgets by either underperforming or deliberately negotiating easily attainable budgets. Otley has suggested that the optimum point at which a budget would cease to motivate may be where individuals perceive that there is significantly less than a 50% chance of it being achieved. Inevitably there is a trade-off between adopting tight budgets to maximise performance even though this may ultimately not be achieved and using achievable budgets which provide managers with a sense of achievement and self esteem but do not maximise performance and achievement. Highly achievable budgets are therefore to be preferred from the motivational perspective but are likely to result in aspirational levels and performance not being maximised. It is essential in planning any performance related bonus scheme that managers have an incentive not only to achieve any budget target but also to exceed it.

Sources of Further Information

Anthony, R.N. and Govindarajan, V. (2007) Management Control Systems (12th Edition). New York: McGraw Hill. Bergman ,Andreas (2009) Public Sector Financial Management ( 1st Edition) Harlo w . FT Prentice Hall.l Henley, D.A., Perrin, J., Evans, M., Lapsley, I. and Whiteoak, J. (1992) Public Sector Accounting and Financial Control (4th Edition). London: Chapman and Hall. Hofstede, Geert H. (1967) The Game of Budget Control. How to Live With Budgetary Standards and Yet Be Motivated By Them. Assen: Van Gorcum and Comp. Hopwood, A.G. (1976) Accounting and Human Behaviour. Eaglewood Cliffs, New Jersey: Prentice Hall Merchant, K.A. (1985) Control in Business Organisations. Boston: Pitman Otley, D.T. (1987) Accounting Control and Organisational Behaviour. London: Heinemann