Budgeting and Alternative Budgeting Techniques

1. BUDGETING

1.1Introduction

It is critical that business develop plans for the future. It is unlikely that a business will achieve whatever they set out to do unless its managers are clear on what the future direction of the business in going to be. According to Atrill & McLaney (2012), the development of plans involves, establishing the missions and objectives, undertaking a position analysis, identifying and assessing the strategic options, selecting strategic options and formulating long term strategic plans. The strategic plans are then broken down into short term plans for each business unit. These plans are known as budgets. Weetman (2010, p.317) defines budgets ‘as a detailed plan which sets out, in money terms, the plans for income and expenditure in respect of a future period of time. It is prepared in advance of that time period and is based on the agreed objectives for that period of time, together with the strategy planned to achieve those objectives.’ Drury (2013), reckons that the multiple functions of budgets include; planning annual operations, coordinating the various functions of the organizations, communicating plans to the various responsibility centres, motivating mangers to achieve organizational goals, controlling activities and evaluating the performance of managers.

1.2Traditional Budgeting

This form of budgeting is also known as incremental budgeting. As discussed by Atrill & McLaney (2012), budget setting is undertaken on the basis of what happened in the previous year with adjustments for factors expected to affect the subsequent period budget such as inflation. For instance If the salaries of doctors in a hospital was GBP 2M, when the budget for next years budget is being prepared and the hospital administrator thinks that we will need three new doctors who will be paid GBP 60,000 each and he will have to give all doctors a payrise of 5%, on the assumption that even the new doctors will get a payrise then budget for doctors salaries in the coming year will be GBP 2.18M = [2 + {60,000*3}]*1.05. This form of budgeting is deemed to have the following advantages; it is easy to prepare and can therefore be allocated to junior members of staff, it is easily understandable, owing to shorter preparation times, It has lower preparation costs, it reduces conflict amongst functions since the same approach is used organization wide, and finally impacts of any changes can easily be traced to its origin, in our example the increase in doctors salary costs can quickly be attributed to the annual increase. There has however emerged criticism to this method of budgeting. As noted by Drury (2013), the major disadvantage of this method is that the majority of expenditure associates with the current level of activity remains unchanged, which makes the costs of support activities to become fixed, and past inefficiencies and waste inherent with the status quo is perpetuated. It also gives insufficient focus on improving efficiency and effectiveness; resource allocation tends to be based on existing strategies with no thought of future strategies; it has excessive focus on short-term financial targets which often leads to arbitrary resource allocations. In considering our scenario of a company (Say Company A), operating in a stable market place with little changes in products or demand, and a company (Say company B), operating in a very dynamic rapidly changing environment, it may be partially appropriate though not optimal for company A to adopt traditional budgeting than would be for company B. Budgets based on historical figures suit better companies whose operations are relatively stable on the premise that customer relationships do not necessarily disappear year on year, and that budgets are not made without consideration of external factors such as the current economic situation and anticipated future development. According to Stevens (2007), incremental budgeting will provide accurate budget figures for variable costs since these have a clear link to production or sales, however such an approach will unlikely produce accurate figures for support departments whose costs are largely fixed. Markets have become volatile, and extremely competitive. This has created a shift of emphasis from internal effectiveness, in which traditional budgeting is a useful tool, to external effectiveness or competitive edge (Ekholm & Wallin, 2000). It is therefore advisable for both companies to consider alternative budgeting techniques.

2. ALTERNATIVE BUDGETING TECHNIQUES

2.1Zero based budgeting (ZBB)

This method is also known as the priority based budgeting, and emerged as an attempt to address the inherent limitations of traditional approach to budgeting. According to Atrill & McLaney (2012), it rests on the philosophy that all spending needs to be justified. Budgets start on a zero base and will only be increased above zero if a good cause can be articulated on why the scare resources of the organization should be allocated to an activity. Drury (2013), further states that ZBB involves three stages which are; a description of each organizational activity in a decision package; the evaluation and ranking of decision packages in order of priority; and allocation of resources based on order of priority up to the spending cut-off level. This approach is best suited to discretionary costs such are research and development and training costs, where there is no optimal relationship between input and outputs. Proponents of this method argue that it has the following benefits; it avoids the deficiencies of budgeting and represents a move towards the allocation of resources by need or benefit. Thus, unlike traditional budgeting the level of previous funding is not taken for granted. ZBB creates a inqusitive attitude rather than a complacent one that assumes that current practice represents value for money hence inefficiencies and wastage are reduced. ZBB rationalizes outputs in relation to value for money; it encourages managers to look at alternative operations plans. However critics of this approach have argued that the processes are too costly and time consuming. The process of identifying decision packages and determining their purpose, cost and benefits is extremely time-consuming (Drury 2013). There are often too many decision packages to evaluate and there is frequently insufficient information to enable them to be ranked. Further managers whose areas of responsibility are subjected to ZBB may feel threatened by it (Atrill & McLaney 2012). However benefits of this approach can be gained by using it on a selective basis, or as advanced by Drury (2013,) by applying it selectively to areas that management is most concerned and used as a one off cost reduction programme. Benefits of ZBB can be captured by using priority-based incremental budgets. Priority incremental budgets require manager to demonstrate the incremental change in their activities if their budgets were to be increased or decreased by a specific percentage. Budget allocations are made by comparing the change in costs with the change in benefits (Drury 2013).

2.2Activity based budgeting (ABB)

This approach is an extension of activity based costing. According to Atrill & McLaney (2012) under a system of ABB, the budgeted sales of products or services are determined and the activities necessary to achieve the budgeted sales are then identified. Budgets for each of the various activities are prepared by multiplying the budgeted usage of the cost driver for a particular activity (as determined by the sales budget) by the budgeted rate for the relevant cost driver. Budgets under this approach are focused on cost driving activities rather than functions. ). The idea is to create a new budgeting model, which gives the company more flexibility to react to unexpected events, thus emphasizing the importance of operational planning (Hansen, 2011). ABB involves the following steps; estimate the production and sales volume by individual products and customers; estimate the demand for organizational activities; determine the resources that are required to perform organizational activities; estimate for each resource the quantity that must be supplied to meet the demand; and finally take action to adjust the capacity of resources to match the projected supply. The aim of ABB is to approve the use of only those resources necessary to undertake activities required to meet the budgeted production and sales volume (Drury, 2013). A definite advantage of this approach is that it overcomes the incremental approach since revenues and costs are linked to activities. It also highlights the external focus such as deriving target costs from customer and market requirements and basing target setting on internal and external benchmarks (Bunce, Fraser & Woodcock, 1995). ABB reduces bureaucracy and time associated with budget preparation, meaning the value added by the process increases. Since the ABB budgeting model is usually computer based, it can easily be updated to new circumstances (Hansen, 2011). ABB highlights any imbalances and inefficiencies, by providing information that can be used to improve operations since the company can see where the resources are needed; and finally communication of objectives improves since the lower-level managers understand operational terms better than financial. However a major shortcoming of this approach is that if defining cost drivers is not done well, then the result may be vague descriptions of activities which makes it hard to properly analyze the activities and place any kind of values on them (Marcino, 2000).

3. CONCLUSION

There has been emergent critics of budgeting with some advocating for the total abolishing of the process and replacing it with Beyond Budgeting. Beyond budgeting central goal is to abolish annual budgeting, replace it with benchmarked metrics and eventually completely decentralize power (Hope & Fraser, 2000). It advocates decentralizing the whole organization and giving greater independence to lower level managers, which enables managers to make fast decisions, since they no longer need to base their decisions on budgets alone. Further Drury (2013), suggests rolling forecasts produced on a monthly or quarterly basis as an alternative to annual budgeting. Rolling forecasts should embrace key performance indicators necessary to achieve the firm’s objectives based on balanced scorecards. However from a survey conducted by Dugdale & Lynn (2006), on financial and nonfinancial managers in 40 companies concluded that budgeting was alive and well. These managers thought budgets were important for planning, control, performance measurement, coordination and communication. Rather than abandoning the budget, it would be better to diagnosis its problems and fix it (Greenberg & Greenberg, 2006.) The budget is an inexpensive and ascertained method for guiding action and reducing risk, and therefore likely to remain a ubiquitous feature of management for the foreseeable future.

4. TRANSFER PRICING

Procter (2012, p.322) defines transfer pricing as ‘the monetary value for which goods and services are exchanged between different responsibility centres of the same organization and if the responsibility centres are in different countries then the exchange value in known as the international transfer price.’ The purpose of transfer pricing includes; provision of information that motivates divisional managers to undertake good economic decisions; avail information crucial to evaluating economic and managerial performance of divisions; ensuring that divisional autonomy is maintained; allocation of divisional resources and intentionally moving profits across divisions hence minimizing tax obligations. There are various approaches to setting transfer prices for goods and services across divisions. Some of these methods are discussed below;

4.1Market based transfer prices

Market prices are those that exist in an open market (Atrill & McLaney, 2012). It would be therefore optimum for both decision making and performance evaluation to set transfer prices at this competitive market price. This condition exist in a perfectly competitive market where products and services sold are the same and no individual buyer or seller can influence the prices (Drury 2013). Divisional profits will most likely be the similar to profits that would be calculated assuming that the divisions are separate organizations. This enables divisional profitability to be compared directly with profitability of similar companies in the same business. Where selling costs for internal transfers are identical to those of selling externally, it would then not matter if the supplying division decides to transfer its product internally or sell externally. This is illustrated by Fig. 1.1 & 1.2 below; Fig. 1.1 Fig 1.2 Figure 1.1 & 1.2 illustrate an example where the supplying division either sells to a receiving division or to the external markets. If the supplying division supplies 1000 units at 9,000 and the receiving divisions incurs a further 5,000 in incremental costs and can sell the final product at 20,000, then it is evident that in both scenarios the division and overall company contribution remains unchanged. Transferring products at market prices may result in the selling division making savings relating to selling and distribution costs which may be passed on to the buying division in form of lower prices. When transfer prices are undertaken at market prices, divisional performance is most likely to represent the real economic contribution of a division to the overall company profits (Drury 2013). The use of this approach is objective and has real economic credibility, since the market price represents the opportunity cost of the products. A major challenge with this approach is that an external market price may simply not exist, which is common with goods and services tailored to the needs of the buying division which is the only market. Further if the division has spare capacity basing transfer price on the market price may lead to lost sales, hence in the short run a price higher than the variable costs should be accepted.

4.2Full cost transfer pricing

If cost is the basis of transfer pricing, then the selling department will earn no profit and the buying department will have a cost that is lower than it would pay for in an external market (Weetman 2010). This approach can hinder the evaluation of divisional performance. There will be difficulties in making resource allocation decisions concerning the level of output, product mix and investment levels within a division since profit cannot be used as a gauge of efficiency. We will consider an illustration; Simba and Chui are divisions of the Big 5 Group. Simba produces an intermediate product that is used by Chui in manufacture of the final product. Chui has developed a matrix of expected sales of the final product as follows; The costs for each division are tabulated below; A computation of the profits for the Big 5 Group as a unit is represented in Fig 2.0 below; Fig. 2.0 The profits for the Simba division are computed and tabulated in Fig 2.1 Fig. 2.1 The profits for the Chui division are computed and tabulated in Fig 2.2 Fig. 2.2 From the illustration; the optimum output level for the Group is 5,000 units. Drury (2013, p.350) defines net marginal revenue as ‘the marginal incremental revenue from the sale of an extra unit or a specified number of incremental units of the final product less the marginal conversion costs excluding the transfer prices.’ Thus the net marginal revenue associated with the receiving division is computed on Fig 2.3; Fig. 2.3 Under Full cost transfer pricing, assuming an optimum company output level of 5,000 units per Fig 2.0 the fixed cost per unit of Simba’s intermediate product will be $10 ($50,000/5000 units) thus a full cost of $19 ($10 fixed cost/unit + $9 variable cost/unit). If the transfer price is $19 ($19,000 per 1000 units) the receiving unit will purchase only as long as the net marginal revenue exceeds the transfer price. The optimal level for the receiving division will be at 4,000 units at which level the net marginal revenue will be $35,000 (Fig 2.3), hence they will not want to operate at 5,000 units which is the optimal level for the whole Group. Further at the selected level of output the Simba division total costs will exceed its transfer revenue. Its transfer revenue will be $ 76,000 ($19*4,000) whilst its costs will be ($36,000+$50,000). (Fig. 2.1). This price therefore does not ensure that optimal output decisions are made and also not suitable for performance evaluation. Under this pricing approach managers often have no incentive to control costs since these will be passed on to the buying division. However if the division has spare capacity and cannot sell externally then this approach could be justified (Weetman 2010).

4.3Cost plus a mark- up transfer prices

It is possible to add a mark up to the full cost of the intermediate product to ensure that the supplying division makes a profit. The profit should justified or it will be a matter of contention between the two divisions (Atrill & McLaney, 2012). The purpose of transfer pricing is to motivate both the supplying and receiving divisions to operate at an optimum level for the Group. In this case this level is 5,000 units. Assuming that our transfer price (based on cost plus mark-up) is $40, obtained from the summation of the fixed cost per unit, variable cost per unit and a mark-up, the profit computations for each division will be as tabulated in figure 2.1 & 2.2 above. Whilst the supplying division will maximize profits at 6,000 units (Fig 2.1) the receiving division will maximize at 3,000 units (Fig 2,2), none will be willing to operate at 5,000 units (Fig 2.0) which is the optimum level for the Group. The receiving division will not increase output beyond 3,000 units because the transfer price charged beyond this level $ 40,000 ($40*1000) exceeds the net marginal revenue of $ 35,000 (Fig 2.3). This approach does not offer managers any incentive to control costs since these will passed on the buying division. Operational inefficiencies of the supplying division are passed on to the receiving unit.

4.4Negotiated transfer prices

Transfer prices can be set through negotiations between the managers of the selling and acquiring divisions. According to Proctor (2008), this approach works best where there is an active external market for the products as the external market price will signifcantly influence the transfer price by acting as a reference point. Also in this case divisional managers are free to accept or reject offers made by other divisions. This method may however lead to severe disputes in cases where divisional manager fail to agree on a price which may require the intervention of senior management. It can be time consuming and may distract top management from their strategic role. Senior management intervention may also be interpreted by the divisional managers as undermining the autonomy of divisions (Atrill & McLaney, 2012). In other circumstances the negotiated prices may be artificial and misleading; especially in divisions whose managers have poor bargaining skills. For negotiations to work effectively it is important that managers have equal bargaining power.

5. CONCLUSION

In the absence of a perfect market for the intermediate product none of the transfer pricing methods can perfectly meet both the decision making and performance evaluation requirements and not undermine divisional autonomy. A solution may be based on marginal cost with a fee added that provides some reward to the selling division without discouraging the buying division. What matters is that both divisions employ decisions that benefit the overall organization.

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