Traditional planning and budgeting
The following BPM tool guide is one of a series produced for ICAEW by Professor Mike Bourne of Cranfield University.
I am not planning to describe in detail traditional approaches to planning and budgeting here. Most faculty members are accountants and so well versed in traditional approaches. The intention of this section is to briefly define what a traditional approach is and some of the criticisms made of this approach, so that it can be contrasted with alternative approaches in other sections (driver based budgeting and beyond budgeting).
Traditional Planning and Budgeting
Traditional planning and budgeting builds a budget from the bottom up. It starts with the projected sales, the direct costs associated with these sales and then the overheads. In smaller companies this works well as those involved are close to what is happening in reality. In larger companies, especially when there are multiple business units, there is often a process whereby the budget is done bottom up and presented to senior management, who then come back looking for improvements. As both sides know this process, the initial budget usually has some slack in it and the inevitable demand for better performance has some stretch in it.
Once set at the business unit level, the budgets are broken down into departments and functions, so the management of these activities have a guide as to how much they can spend during the budget period (usually a year). Department heads are often in the position where they ask for more resource than they need as this makes their task of delivering easier and senior management try to constrain costs. So there are behavioural issues that need to be considered in the budgeting process.
One final point, budget holders will often spend the whole of their budget. They do this as if they don’t spend it all; the budget was probably set too high. So the consequence of not spending the budget is a lower budget and therefore less resource for the following year.
- Traditional planning and budgeting creates a financial plan to guide the organisation
- It tells you when things are going off plan and corrective action is required
- It acts as a control as people are required to work within their expenditure budgets
- In stable environments they can be very accurate
- If used well, they can be motivating
Pitfalls to be avoided
- Sand bagging – this is when people over state the costs and understate the revenues to make the budget easier to achieve.
- Linking bonuses to achievement of the budget, beware as this encourages people to sand bag. It also stifles communication as information becomes power in the negotiation to set the appropriate level of budget.
- Be careful how you cut the budget. Often this is done by taking a few percent off each expense line. In the short term this probably doesn’t make much difference and it delivers the performance required, but when this is repeated year after year, it hides the fact that real people, processes and resources are being degraded by the cost cutting.
- Plans and budgets can be rendered useless after major events. For example, Boeing nearly ran out of money after 9/11 when customers just stopped taking delivery of new aircraft. Similarly, if your competitor cuts their prices are your revenue targets still achievable?
- In a traditional planning and budgeting setting, how do you quickly reallocate resources from things that are not performing to things that are going well?
- Decide what purpose plans and budgets play in your organisation. Budgets are often used to do too many conflicting things: -
- High but achievable for motivation (or even bonus payments)
- Realistic for coordination between departments and resource planning
- Conservative for cash flow forecasting
Some of this may be more of interest than directly pertinent to doing your job today, but it should be noted that planning and budgeting has developed to keep abreast of the changing control needs of larger organisations. Some of the developments below illustrate that and may give you insights into changes to come.
In the late thirteenth century, double entry book keeping became necessary as a means of managing complex trading arrangements. For example, Johnson, (1981, page 512) cites the Medici accounts as an excellent example of how a pre-industrial organisation could maintain a good account of external transactions and stock without recourse to higher level techniques, such as cost accounting .
This situation persisted until the birth of the modern factory in the early nineteenth century. Prior to the industrial revolution, merchant entrepreneurs used a domestic system for manufacturing goods such as textiles. This involved the merchant buying raw materials in the open market and coordinating their conversion into 'manufactured' items through consigning the goods to independent households (Johnson 1981). At this time, all the transactions were market based with artisans working to market determined piece rates for the job. So in reality, nothing had changed in accounting terms since the time of the Medicis. Double entry book keeping was perfectly adequate.
Johnson (1981) argues that development in accounting practice came in the United States with two major structural changes in the management of production. Firstly, piece work payment systems were replaced by wages and, secondly, factories developed from single to multiple operations.
The transition from piece work payments to a wage payment meant that managers in the early textile mills could no longer know what the product cost without records of output and wages paid. There was also an additional problem. Without a piecework rate, "they (the workers) had no automatic incentive to pursue the same goal when being paid wages" (Johnson, 1981, page 514) so employees' performance had to be measured and monitored for control purposes.
Moving from single to multi-operation production also makes an understanding of costs much more important. The development of integrated mills in the USA necessitated management cost accounting systems. In the UK, Johnson (1981) argues, single process mills relied on efficient market institutions to coordinate different production processes which eliminated the economic advantage of administrative control and cost accounting systems.
Thus, we see the emergence of early cost accounting systems for internal control around 1850 in an integrated New England textile mill (Johnson, 1972). These were used to facilitate control of productivity, measure the impact of internal changes and manage raw materials.
The next major development in management accounting coincides with companies trying to progress from managing a single (although multi-operation) production plant to the management of multiple plants as occurred at E. I. du Pont de Nemours Powder Company (Johnson, 1975). In this new multi-site manufacturing environment we see the need to coordinate activities, which were originally mediated through the market. Top management also needed to relinquish day to day control of the business to allow them time to plan for the future. Johnson (1975) argues that "the cost of integrating and coordinating internal activities is the main factor limiting the size of a unitary form organisation" (page 204).
The solution developed at du Pont between 1903 and 1912 was very similar in character to a modern standard management accounting solution. The only real difference was in the allocation of overhead (the allocation only being made to finished goods and not to work in progress). Standards were set for production and cost reporting which allowed comparisons of performance between different sites. Systems were also in place to motivate the sales force to pursue profitable sales, monitor changes in demand, coordinate sales, production and purchasing, and forecast cash flow. A further innovative approach was the introduction of Return on Capital Employed as a key ratio for measuring the success of past investments and as a basis for guiding future investment decisions.
Although Hofstede (1968) claimed that the first industrial use of budgetary control was in the United States during the 1920s and that this use was clearly derived from budgetary techniques in government (McKinsey, 1922), the du Pont example clearly predates this. Chandler (1962) argues that when companies such as du Pont, Sears Roebuck and General Motors diversified after the first world war, they discovered that sophisticated management accounting systems were fundamental to the co-ordination of multi-divisional organisations. Johnson (1978) argues that Durant's attempt to consolidate autonomous car and automotive part manufacturers into one giant firm, General Motors, failed because:
"In short, he did not have the administrative system that could direct the activities of each operating unit towards common goals" (page 492).
Whereas the system implemented by his immediate successor, Pierre du Pont, and Donaldson Brown (another former du Pont executive) did allow top management to coordinate performance. Financial policy, sales reporting and flexible budgeting indicated promptly when deviation from plan required divisional mangers to take action and allowed top management to allocate resources and executive compensation.
Whatever the original source, the use of budgets spread. A study showed that by 1941, 50% of well established US companies were using budgetary control in one form or another (Holden et al, 1941) and by 1958, budgets appeared to be used for over-all control of company performance by 404 out of 424 (just over 95%) participating in the study (Sord & Welsch, 1962).
In fact in the six intervening decades between 1925 and the publication in 1987 of "Relevance Lost: the rise and fall of management accounting", Johnson & Kaplan (1987) argue that no progress was made in the development of management accounting:
"By 1925, American industrial firms had developed virtually every management accounting procedure known today." (page 125)
This brief review of accounting history suggests that there are connections between the needs of entrepreneurs and their needs for cost and management accounting systems. In fact, Johnson (1981, page 139) himself argues that
"Accounting historians, however, seldom explore the organizational conditions underlying the emergence and role of accounting."
Johnson (1981) dismisses the concept developed by many accounting historians (Littletin, 1933; Garner, 1954: Chatfield, 1971) that modern production costing arose because it fulfilled an inherent need to integrate cost accounting into double entry financial accounting. Instead he argues that entrepreneurs responding to market forces were forced to search for alternative forms of trading and organisation. These organisations had to be managed and controlled and consequently the development of modern firms and accounting techniques are inextricably entwined. These new organisational forms could not be managed without the new techniques developed and the techniques had no relevance outside the new structures.
The main thrust of Johnson's (1981) argument is that the development of new organisational forms and management accounting control systems were governed by the laws of economics. The early entrepreneurs who created the multi-process mills, integrated firms and multi-divisional organisations could only succeed if the marginal costs of integrating and co-ordination compared favourably with the marginal costs of mediating the same transactions through the market place (Johnson, 1975, page 204). The logical conclusion of this argument is that the development of management accounting and performance measurement systems is driven by changes in the environment and it is argued here that more recent developments in accounting (e.g. Beyond Budgeting) and performance measurement (e.g. Balanced Scorecard, Performance Prism) can also be traced to changes in the business environment.
Chandler, A. D., (1962), Strategy and structure: chapters in the history of the industrial enterprise, Cambridge, Mass.
Chatfield, M., (1971), "The origins of cost accounting", Management Accounting (USA), June, 11 – 14
Garner, S. P., (1954), Evolution of cost accounting to 1925, University of Alabama Press, Alabama, USA
Hofstede, G., (1968), The game of budgetary control, Tavistock, London
Johnson, H. T., (1972), "Early cost Accounting for internal management control: Lyman Mills in the 1850's", Business History Review, Vol. XLVI, No. 4, Winter, 466 - 474.
Johnson, H. T., (1975), "Management Accounting in an early integrated industrial: E. I. du Pont de Nemours Powder Company, 1903 - 1912", Business History Review, Vol. XLIV, No. 2, Summer, 184 - 204.
Johnson, H. T., (1978), "Management Accounting in an early multidivisional organization: General Motors in the 1920s", Business History Review, Vol. LII, No. 4, July, 490 - 517.
Johnson, H. T., (1981), "Towards an understanding of nineteenth century cost accounting", The Accounting Review, Vol. LVI, No. 3, Winter, 510 - 518.
Johnson, H. T. & Kaplan, R. S., (1987), Relevance lost: the rise and fall of Management Accounting, Harvard Business School Press, Boston, MA.
Littletin, A. C., (1933), Accounting evolution to 1900, American Institute Publishing Co.
McKinsey, J. O., (1922), "Budgetary Control", quoted in Becker, S. W. & Green, J. R., (1962) "Budgeting and employee behaviour", Journal of Business, Vol. 4, 392 - 402, and in Reinoud, H., (1965), "Bedrijfsbegroting en Planning op Lange Termijn", Tijdschrift voor Efficiëntie en Documentatie, Den Haag, Vol. 1, 31 - 32,
Sord, B. H. & Welsch, G. A., (1962), "A survey of management planning and control practices”, Controllership Foundation, New York, USA