Friday, June 10, 2011

Budgets are often criticized for controlling the wrong things, or for creating pervasive incentives when they are used in performance reviews. The criticism often overlooks the various benefits of budgets and the budgeting process, but that doesn't mean that the criticisms are totally unfounded.
Budgets facilitate decision control and can be used as benchmarks to gauge performance. Specialized information is gathered from lower levels of management up to the top levels and can be used as a gauge against actual performance. Top-level management can use the assumptions made during the budgeting process as performance measures for the owners of the budget. The budgeting process in large companies is the orchestration of specialized knowledge of numerous departments.

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The executive team sets goals for the upcoming year based on previous performance, and current or expected economic trends. The marketing team assembles their budget based on the marketing campaigns that will be used to meet the goals. The operations departments build their budgets based on the expected volumes resulting from the marketing campaigns. This transfers the specialized knowledge of the marketing department to the operation departments through the budget process and both departments use their specialized knowledge to build their own budgets. The executives then review the bottom up budget against the previous year's performance.

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Sometimes, the executive may request a 5-10% reduction in the budget dollar amounts offset by a corresponding increase in productivity or other cost reduction in a reverse ratchet effect. In effect ratcheting down the budget instead of ratcheting up the budget based on consistent level of productivity. The executive leaves the decision of how to achieve the productivity increase to lower levels of management that are closer to the process. These decisions are made with the knowledge of the current business environment, and should be made after careful deliberation so they don't set unreasonable or unattainable goals that could discourage lower levels of management.
Budgets provide decision control in terms of expenses, but often companies take another step in using accounting for control by requiring actual expenditures to be sign off by higher levels of management than those that actual incur the budgeted expense. A more efficient process allows for the routine processing of budgeted expenses, while the total amount of the expense is controlled at the yearly or monthly level. If an operational manager is responsible for a process that incurs a regular expense, then they have the authority to spend the budgeted dollars used in that process. If a manager has the responsibility of processing credit card applications then their input is used to produce a budget for that expense. If the CEO has approved the budget that contains a regularly incurred expense of $120,000 per year or $10,000 per month, but if the company has a policy that requires all expenses over $7,500 to have prior CEO approval, does the CEO have to approve the monthly budgeted expense every month? It would be more efficient to approve the expense once in the budget and have the volume of the budget cost driver monitored.
Criticisms of budgets are usually are about how the budget process is used rather than a direct criticism of the budgeting process itself. The budget process does not require the budget to be used in performance evaluation. If the budget controls the wrong things, then this could indicate a problem in how the budget was created not necessarily in the budget process itself. It's usually a criticism of inadequate cost allocation.

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