What Is Budgeting?

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3.3. Innovation restrictive

One of the major critics of budgeting is that incentivizes employees to follow strictly the budget, leaving their innovation capabilities restricted. There are two levels in this analysis: first of all, extremely detailed budgeting leads to the managers’ perception that they need to strictly follow all the “budget steps”, and makes them unable to see possible little innovations in their currents processes. At a second level, due to the uncertainty of most of innovative projects, most companies’ budgets tend to consider lower percentages for “Innovation” (many times low budgets are assigned for R&D).

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4. OUR PERSPECTIVE ON BUDGETING

As Nova SBE Masters in Finance students, we were taught that we should only and always take positive Net Present Value (NPV) projects, independently on the project’s financing structure.

“John, I have a very important issue to talk to you. I know that we have only 2 million in budget for new projects, but my team found an incredible project that requires an investment of 3 million but will deliver 10 million yearly cash-flows in the next 5 to 10 years. This is not a certain investment, but the probability of this happening is quite high!” said one of Company’s X manager to John, the Company’s X COO.

“I’m sorry Jake, but we don’t have room in the budget for that project. I know it creates a lot of value for our company, but my hands are tied” replied the COO.

This sort of behavior can be counterproductive for companies. “Budget reasons” should not be an obstacle for taking any positive NPV project. The management needs to be flexible and understand that the budget is a tool, not a constraint.

5. BUDGETING APPROACHES

The budgeting process can be done by two major ways, among others, depending on how to use past information to build the budget.

In first place, there is an approach known as incremental budgeting. It consists in taking a look at what happen in the previous period and, based on that information and adding some adjustments in several factors which are expected to change, construct the budget for the following period. It is used mostly in areas where the relationship between the inputs and outputs is hard and not clear to establish. Therefore, this kind of budgeting is commonly used in areas such as research and development and training, and also in local and central governments. It is very easy to spend a lot of resources without driving a clear benefit, but is a very simple a time saving (and resources) method.

In second place, several firms use a method called zero-base budgeting. This method lays in the assumption that an investment is only done if it represents “value for money” and not only because it was done in the past. The budget in a zero base and only increases if a good outcome can be provided by the firm’s scarce resources. This procedure allows the managers to take more experienced decisions once they have to follow a process which puts in doubt every possible future expense. However, this process should not be used very frequently because the analysis could become very me mechanical and so, the approaches will lose its benefits.

Both approaches present advantages and disadvantages, and they can be the best and proper choice depending on the frequency and the goal of the project.

5.1. Traditional and beyond budgeting

The traditional budgeting process lays on a hierarchical management structure where the higher levels are the ones who make the decisions and meeting the budget is the preferential method to evaluate the managerial performance. These structure promotes a high lower hierarchy dependency.

The beyond budgeting process is more decentralized, where the decision making process is done by the managers of each department, promoting a network structure rather than a hierarchical one. These leads to higher motivations of the employees as they are part of the decision making process and also improve the performance of each sector due to the know-how of the decision makers.

In order to better understand the differences between these two processes, it will now be presented a more detailed comparison between the two of them in several areas.

5.1.1. Management

Traditional budgeting: as said before this approach centralizes the control and decision making in the executive team. This can be justified by two main assumptions. One is that it assumes that the executive team has better skills to translate the strategic plans into operational goals. The other is that the employees and sub-managers could not have the skills, the motivation and even the honesty to make decisions which best suit the company’s strategy.

Beyond budgeting: it thinks that empowering and coaching employees and supervisors is the best way to establish operational goals. This approach lays on the assumption that these people have better know-how about each operational area and therefore are able to establish better and more efficient objectives.

5.1.2. Organizational structure

Traditional budgeting: it has a centralized authority in the top management team. All the decisions made by the executive team is brought to the employees by passing through multiple hierarchy levels. The lower level teams are managed to obey to the plans made by the top of the hierarchy. This kind of structure consumes a lot of money and time due to the complex information flow.

Beyond budgeting: more decentralized structure focused in autonomous and empowered business units as they are closer to the costumer and, therefore, are more aware about the market trends. The information flows from the different units to the top managers.

5.1.3. Performance measure

Traditional budgeting: with this approach the performance of each unit depends on how well did each one of them have met the fixed targets established by the top management team (e.g. meet the budget).

Beyond budgeting: the performance is measure regarding relative targets. It uses peer performance, best practices and other benchmarks in order to follow a continuously improvement path, as targets vary over time.

6. ALTERNATIVES TO BUDGETING

More and more firms consider that