10 What are budgets (good for)?

Budgets are a quantitative expression of a business plan for a specific period of time (p.184 in Horngren 2012). In my view, they are the quintessential accounting tool and they should be the first one that every textbook discusses. Although not necessarily all firms use budgets (Hope and Fraser 2003), the majority of firms still use them (Libby and Lindsay 2010); both large multinationals and start-up firms, both firms with high profit margins and razor thin margins have budgets. The ubiquity of budgets is an indication that budgets can serve different functions in different environments. Just from the definition above, you can already guess that budgets will help with the integration of different parts of the organisations. Having an overall plan for the organisation in the form of a budget is one step in making sure that the divisions in the organisation are coordinated by headquarters. Budgets are also explicitly a quantitative version of the overall plan. When organisations budget for the next year, they are not just estimating whether their products will sell more but they estimate how much more, at which price, and what the cost is of producing the products. This means that the organisation is translating some of the specific knowledge of its sales people, production planners, and engineers into financial terms which makes it easier to integrate all that information in one plan. Finally during the year, the organisation can use the budgeted sales and costs as a target for its managers and reward them for reaching those targets.

Traditionally, these same functions of the budget are described as planning and communicating investments, implementing strategies, gathering feedback on the success of investments, and motivating and evaluating employees (Hansen and Van der Stede 2014). The ubiquity of budgets can easily be explained when you see strategies as a combination of investments that give the organisation a competitive advantage. When long-term budgets are informed by the strategy, they are quantified versions of more ambiguous strategic plans. The yearly operational budget translates the plan for the year in concrete targets and budget allocations which are easier to communicate through a large organisation compared to fuzzy qualitative plans.

In my view, an often underappreciated feature of budgets is that they force an organisation to make choices between different investments. While an university might have the aspiration to offer the best education, perform world class research, work with industry, and influence the public discourse, budget constraints, both in time and money, will make it very hard to accomplish all these objectives. The university’s budgeting process will inform the strategy, i.e. which combination of investments in teaching, applied, and basic research are feasible. Once these decisions are taken, the agreed upon budget allocation to different projects makes it clear for the whole university which projects have priority for top management.

The budget targets also serve as a way to evaluate the performance of employees and divisions. The explicit and implicit incentives based on the budget allow the firm to align the interest of the organisation with the interest of the employees. When divisions exceed their assigned budget, the performance of their manager will be negatively evaluated which affects their bonuses and promotion changes. Alternatively, budgets can set the boundaries within which employees have to do their job. This approach to budgeting is appropriate when employees have more autonomy because of their specific skills such as in the fashion industry (Davila 2013) or at Google^[1]. When the employees are expected to be creative in their task, the firm wants to set boundaries to the creativity to ensure that the employees work together, or perform the more routine tasks as well. For instance, I am, as a lecturer, happy to look through the latest news for examples I can use in my lectures. However, I need some external motivation to finish marking on time because that is a more dreary task. That is why the university has a budget on how much time I can spent on marking and why they are giving me a deadline.

The problems that are associated with budgets often stem from the difficulty to combine the different and sometimes conflicting functions. A lot of these problems are related to the problem that middle managers and rank-and-file employees have specific knowledge which top management wants to incorporate in the financial plan. However, the employees also know that the budget will be used to evaluate their subsequent performance and that the information they give top management will determine the budget they get allocated. As a result, employees have an incentive to game the budgeting process. When asked for their input, they try to steer the budget in a way to get more budget allocated to their own projects. The next section will describe how this problem affects the process of setting a budget and how organisations solve that problem.

References