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Role and Effects of Budgeting in Managerial Practice

Seminar Paper 2010 16 Pages

Business economics - Investment and Finance

Excerpt

Table of Content

1. Introduction

2. The Role of Budgeting in Organizations

3. The Effects of Different Types of Budgets and Budget Levels on Managerial Behavior and Performance
3.1 Participatory Budgeting
3.1.1 Individual Level
3.1.2 Group Level
3.2 Activity-Based Budgeting and Beyond Budgeting Approaches
3.2.1 Activity-based budgeting
3.2.2 Beyond Budgeting

4. Implications for Further Research and Managerial Practice
4.1 Type of Budget
4.2 Design of Internal Reporting System
4.3 Managerial Control System and Organizational Design

5. Conclusion

References

1. Introduction

Budgeting is a major area of management accounting and receives a lot of interest from researchers who mainly concentrate their studies on the design of budget schemes and the process of setting budgets. Concerning the use in practice, a survey of senior managers in 219 publicly traded firms indicated that “75 percent thought of the budgetary process as a managerial rather than an accounting function” (Zimmerman, 2009, p. 250). However, the effects of budgets and budget processes on managerial performance and effort are still not clear.

This paper aims at providing an overview of a collection of recent research papers to investigate how different types of budgets influence managerial behavior and performance and what implications these findings have for managerial practice. Therefore, in the first section the general role of budgeting in organizations will be described. Next, different types of budgets and budget levels are introduced and their effects on managerial behavior and performance will be examined. Finally, several implications of those effects for managerial practice will be given, before a conclusion wraps up the main points of this report.

2. The Role of Budgeting in Organizations

Budgeting is used in organizations for multiple purposes of which the most superior ones are planning (decision making) and control. For planning purposes, budgets can serve as a tool to forecast profitability, allocate resources or communicate specialized knowledge about one part of an organization to other parts. Information sharing between organizational members is “one of the most important benefits of the budgeting process” according to Parker et al., 2006 (p. 27). Despite potential synergy effects among subordinates, a conventional theory assumes that, if full and costless commitment to information included in the budgeting process is available to superiors, budgets will yield the best results in terms of budget attainment frequencies and profits (Rankin et al., 2003). However, in practice, full commitment does not come without substantive costs, i.e. the time a superior has to spend on getting involved into the cost structure of an investment. This implies that superiors typically leave the construction of the budget to their subordinates. This process is called participative or bottom-up budgeting. Underlying rationale of this process is that the subordinate has better knowledge about his operational area than his superior(s). Participative budgeting “may enable subordinates to communicate their private information to their superiors resulting in better budgets and decision making” (Parker et al., 2006, p. 27). Hannan et al. (2006) agree on this by stating that superiors can reduce information asymmetry and principal-agency problems. In an optimal setting, this leads to accurate and detailed information on which management can rely and on which forecasts, operational planning and resource allocations can be based.

Nevertheless, participatory budgeting can never fully eliminate information asymmetry and agency costs as it also has some drawbacks. By leaving the main part of constructing the budget to subordinates, superiors run into the risk of receiving dishonest or biased forecasts due to the limited information they have themselves. When budgeting is used for allocating scarce resources, for example, subordinates have an incentive to “overstate their productivity to acquire a greater share of fixed resources” (Fisher et al., 2002). Another main force that counteracts managers’ incentive to report accurate and unbiased information is the use of budgets for decision control. For this purpose, budgets are designed as performance measurement systems. Subordinates are rewarded according to budget levels that serve as minimum targets to be achieved. There are several different methods to use budgets as performance measurement systems (see next section). In most cases, there is no distinction between using budgets for planning and decision control. Organizations typically use one and the same budget for both purposes which leads to an important trade-off. On the one hand, managers want to be informed as accurately as possible to improve forecasts and allocate resources efficiently. On the other hand, the parallel use of budgets for performance measurement creates incentives for subordinates to report more conservative and maybe even biased figures. Particularly, they have a motivation to understate their productivity because it will increase their chances on a higher reward, but at the same time decrease the reliability of budgets for planning purposes (Fisher et al., 2002). These opposing effects will be examined in more detail in the next section.

3. The Effects of Different Types of Budgets and Budget Levels on Managerial Behavior and Performance

3.1 Participatory Budgeting

3.1.1 Individual Level

The most prevalent effects of budgets on managerial behavior and performance relate to the control role of budgeting. It is common criticism that traditional budget-based compensation plans encourage managers to understate their productivity and build slack into their budgets to increase their pay-off, as described above. This, in turn, decreases the company’s profits due to “costly planning errors and greater compensation or perquisite consumption for subordinate managers” (Fisher et al., 2002, p. 848). However, the authors argue that firms are still widely using budget- based compensation plans. This contradiction can be explained by the interdependent effect of decision making and control. Specifically, the article proves that using budgets to allocate scarce resources (planning) can mitigate the negative effects of budget-based compensation (control) which leads to significant increases in subordinates’ initial budget proposals and performance as well as lower budget slacks. Specifically, the authors find that subordinates’ task performance increases by 25% due to higher motivation in receiving scarce resources and exceeding budget targets. Hence, “the tension between these two roles [planning and control] can be beneficial” (Fisher et al., 2002, p. 862-863).

Furthermore, the authors find that, if the budget is not used for resource allocation, the degree of horizontal information asymmetry affects the budget outcomes. Specifically, the more subordinates know the proposals, counteroffers and performances of their colleagues, the higher is the initial budget proposal and the less slack is included. This can be traced to increased competition among subordinates who want to achieve the best results and have the most accurate budget proposal. However, no significant relationship between the level of information asymmetry and task performance was found. Whereas Fisher et al. (2002) focus on horizontal information asymmetry, a similar approach with regard to vertical information asymmetry can be found in the study of Parker et al. (2006). They reveal that participatory budgeting increases the amount of information sharing upward because of high involvement of subordinates in the decision process including frequent discussions with upper management. During these discussions, superiors naturally receive a lot of specific information regarding operations. As already pointed out earlier, full and costless commitment of superiors to the budgeting process will yield the best performance results (Rankin et al., 2003). Hence, the more information the superior obtains, the more reliable will be the forecast by the subordinates and the less slack will be in the budgets. Similarly, Parker et al. (2006) examine, that this will lead to better job performance of the subordinate. However, both Parker et al. (2006) and Fisher et al. (2002) do not investigate whether these effects can also increase organizational performance. It could be interesting to link these variables in order to find out if disclosure of private information yields benefits in other areas such as cooperation among subunits or addressing strategic challenges. Another open question in this context relates to the potential cost of information sharing. As Rankin et al. (2003) state, the more a superior is committed to the budgeting process, which he will be when there is extensive information sharing, the more costly this will be for the owner, i.e. the company. This means that it might be inefficient to increase vertical information sharing as it can decrease the overall performance of the company because its costs outweigh the gains. Similar criticism is given in the report by Hansen et al. (2003) where practitioners complain about the time-consuming and vertical command-and-control budgeting process that is perceived to be little value-adding (see section 3.2).

Another important finding in the study of Parker et al. (2006) that relates to the effects of participatory budgeting on managerial behavior and performance is that budget participation not only leads to increased upward information sharing, but also to better downward information sharing. While upward information flow leads to better forecasts, downward information can clarify organizational expectations to subordinates. This decreases role ambiguity of subordinates which in turn increases job performance. Furthermore, this finding reveals that, if participative budgeting is used ineffectively and downward information sharing is low, role ambiguity increases. According to Parker et al. (2006) this leads to less organizational commitment of subordinates, because the expectations are unclear and motivation drops. Then, the level of upward information sharing is negatively affected which, in turn, decreases job performance. This makes clear that participative budgeting should not only be effective in upward information sharing, but should also serve to increase the level of information to subordinates to keep their organizational commitment high. Another factor that might be related to budget participation is organizational justice (fairness). This factor was not investigated by Parker et al. (2006) who propose to analyze this relation in further research.

Rankin et al. (2003) partly address this issue in their study which includes the finding that a superior (i.e. the owner) does not decide fully rational and for wealth maximization only. The authors incorporate irrational behavior due to perceived dishonesty or lacking fairness in the budget proposal of subordinates. In general, the owner receives less welfare from nonbinding announcements than from binding announcements, i.e. those announcements that state a flexible level of acceptable forecast versus a fixed level with no exceeding values being possible. Consequently, the authors conclude that full and costless commitment to the budget process is best, as mentioned earlier. However, full commitment might not be attainable or might be costly, which makes nonbinding commitments potentially more efficient. In addition, the benefit of full commitment to the owner is found to be much smaller than predicted by standard game-theoretic analysis. Hence, the costs may outweigh its benefits. However, the report is lacking concrete numbers or calculations that would prove this statement. The authors just assume that full commitment “is likely to be accompanied by significant costs” (Rankin et al., 2003, p. 89).

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Details

Pages
16
Year
2010
ISBN (eBook)
9783640979387
ISBN (Book)
9783640979752
File size
620 KB
Language
English
Catalog Number
v176624
Institution / College
Maastricht University
Grade
1,0
Tags
role effects budgeting managerial practice

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Title: Role and Effects of Budgeting in Managerial Practice