An ideal budgetary system is one that achieves complete goal congruence and simultaneously creates a drive in managers to achieve the organization’s goals in an ethical manner. While an ideal budgetary system probably does not exist, research and practice have identified some key features that promote a reasonable degree of positive behavior. These features include frequent feedback on performance, monetary and nonmonetary incentives, participation, realistic standards, controllability of costs, and multiple measures of performance.
Frequent Feedback on Performance
Managers need to know how they are doing as the year unfolds. Providing them with frequent, timely performance reports allows them to know how successful their efforts have been and gives them time to take corrective actions and change plans as necessary. Frequent performance reports can reinforce positive behavior and give managers the time and opportunity to adapt to changing conditions. The use of flexible budgets allows management to see if actual costs and revenues are in accord with budgeted amounts. Selective investigation of significant variances allows managers to focus only on areas that need attention. This process is called management by exception.
Monetary and Nonmonetary Incentives
A sound budgetary system encourages goal-congruent behavior. Incentives are the means that are used to encourage managers to work toward achieving the organization’s goals. Incentives can be either negative or positive. Negative incentives use fear of punishment to motivate; positive incentives use rewards. What incentives should be tied to an organization’s budgetary system?
The most successful companies view people as their most important asset. Their budgets reflect their underlying philosophy by including significant expenditures on recruiting and career development. Intel, for example, spends 6 percent of its total payroll on an in-house university. In addition, it rewards performance with monetary incentives. At Federal Express and Intel, all employees qualify for variable pay, which may include stock ownership, options, and bonuses. Of course, negative incentives can be used as well. The most serious negative incentive is the threat of dismissal. Jack Welch, former CEO of GE, notes that “making your numbers but not demonstrating our values is grounds for dismissal.”6 Interestingly, the Welch quotation points out that budgets are important for control (making your numbers), but that budget numbers are not the most important factor in a successful company.
Participative Budgeting
Rather than imposing budgets on subordinate managers, participative budgeting allows subordinate managers considerable say in how the budgets are established. Typically, overall objectives are communicated to the manager, who helps develop a budget that will accomplish these objectives. In participative budgeting, the emphasis is on the accomplishment of the broad objectives, not on individual budget items. The budget process described earlier for ABT uses participative budgeting. The company provides the sales forecast to its profit centers and requests a budget that shows planned expenditures and expected profits given that specific level of sales. The managers of the profit centers are fully responsible for preparing the budgets by which they will later be evaluated. Although the budgets must be approved by the president, disapproval is uncommon; the budgets are usually in line with the sales forecast and last year’s operating results adjusted for expected changes in revenues and costs.
Participative budgeting communicates a sense of responsibility to subordinate managers and fosters creativity. Since the subordinate manager creates the budget, it is more likely that the budget’s goals will become the manager’s personal goals, resulting in greater goal congruence. Advocates of participative budgeting claim that the increased responsibility and challenge inherent in the process provide nonmonetary incentives that lead to a higher level of performance. They argue that individuals involved in setting their own standards will work harder to achieve them. In addition to the behavioral benefits, participative budgeting has the advantage of involving individuals whose knowledgeof local conditions may enhance the entire planning process.
Participative budgeting has three potential problems that should be mentioned:
1. Setting standards that are either too high or too low
2. Building slack into the budget (often referred to as padding the budget)
3. Pseudoparticipation
Frequent Feedback on Performance
Managers need to know how they are doing as the year unfolds. Providing them with frequent, timely performance reports allows them to know how successful their efforts have been and gives them time to take corrective actions and change plans as necessary. Frequent performance reports can reinforce positive behavior and give managers the time and opportunity to adapt to changing conditions. The use of flexible budgets allows management to see if actual costs and revenues are in accord with budgeted amounts. Selective investigation of significant variances allows managers to focus only on areas that need attention. This process is called management by exception.
Monetary and Nonmonetary Incentives
A sound budgetary system encourages goal-congruent behavior. Incentives are the means that are used to encourage managers to work toward achieving the organization’s goals. Incentives can be either negative or positive. Negative incentives use fear of punishment to motivate; positive incentives use rewards. What incentives should be tied to an organization’s budgetary system?
The most successful companies view people as their most important asset. Their budgets reflect their underlying philosophy by including significant expenditures on recruiting and career development. Intel, for example, spends 6 percent of its total payroll on an in-house university. In addition, it rewards performance with monetary incentives. At Federal Express and Intel, all employees qualify for variable pay, which may include stock ownership, options, and bonuses. Of course, negative incentives can be used as well. The most serious negative incentive is the threat of dismissal. Jack Welch, former CEO of GE, notes that “making your numbers but not demonstrating our values is grounds for dismissal.”6 Interestingly, the Welch quotation points out that budgets are important for control (making your numbers), but that budget numbers are not the most important factor in a successful company.
Participative Budgeting
Rather than imposing budgets on subordinate managers, participative budgeting allows subordinate managers considerable say in how the budgets are established. Typically, overall objectives are communicated to the manager, who helps develop a budget that will accomplish these objectives. In participative budgeting, the emphasis is on the accomplishment of the broad objectives, not on individual budget items. The budget process described earlier for ABT uses participative budgeting. The company provides the sales forecast to its profit centers and requests a budget that shows planned expenditures and expected profits given that specific level of sales. The managers of the profit centers are fully responsible for preparing the budgets by which they will later be evaluated. Although the budgets must be approved by the president, disapproval is uncommon; the budgets are usually in line with the sales forecast and last year’s operating results adjusted for expected changes in revenues and costs.
Participative budgeting communicates a sense of responsibility to subordinate managers and fosters creativity. Since the subordinate manager creates the budget, it is more likely that the budget’s goals will become the manager’s personal goals, resulting in greater goal congruence. Advocates of participative budgeting claim that the increased responsibility and challenge inherent in the process provide nonmonetary incentives that lead to a higher level of performance. They argue that individuals involved in setting their own standards will work harder to achieve them. In addition to the behavioral benefits, participative budgeting has the advantage of involving individuals whose knowledgeof local conditions may enhance the entire planning process.
Participative budgeting has three potential problems that should be mentioned:
1. Setting standards that are either too high or too low
2. Building slack into the budget (often referred to as padding the budget)
3. Pseudoparticipation
Some managers may tend to set the budget either too loose or too tight. Since budgeted goals tend to become the manager’s goals when participation is allowed, making this mistake in setting the budget can result in decreased performance levels. If goals are too easily achieved, a manager may lose interest, and performance may actually drop. Challenge is important to aggressive and creative individuals. Similarly, setting the budget too tight ensures failure to achieve the standards and frustrates the manager. This frustration, too, can lead to poor performance. The trick is to get managers in a participative organization to set high but achievable goals.
The second problem with participative budgeting is the opportunity for managers to build slack into the budget. Budgetary slack exists when a manager deliberately underestimates revenues or overestimates costs. Either approach increases the likelihood that the manager will achieve the budget and consequently reduces the risk that the manager faces. Padding the budget also unnecessarily ties up resources that might be used more productively elsewhere.
Slack in budgets can be virtually eliminated if top management dictates lower expense budgets. However, the benefits to be gained from participation may far exceed the costs associated with padding the budget. Even so, top management should carefully review budgets proposed by subordinate managers and provide input, where needed, in order to decrease the effects of building slack into the budget. The third problem with participation occurs when top management assumes total control of the budgeting process, seeking only superficial participation from lower-level managers. This practice is termed pseudoparticipation. Top management is simply obtaining formal acceptance of the budget from subordinate managers, not seeking real input. Accordingly, none of the behavioral benefits of participation will be realized. Read developing standards for input-prices and input quantities
The second problem with participative budgeting is the opportunity for managers to build slack into the budget. Budgetary slack exists when a manager deliberately underestimates revenues or overestimates costs. Either approach increases the likelihood that the manager will achieve the budget and consequently reduces the risk that the manager faces. Padding the budget also unnecessarily ties up resources that might be used more productively elsewhere.
Slack in budgets can be virtually eliminated if top management dictates lower expense budgets. However, the benefits to be gained from participation may far exceed the costs associated with padding the budget. Even so, top management should carefully review budgets proposed by subordinate managers and provide input, where needed, in order to decrease the effects of building slack into the budget. The third problem with participation occurs when top management assumes total control of the budgeting process, seeking only superficial participation from lower-level managers. This practice is termed pseudoparticipation. Top management is simply obtaining formal acceptance of the budget from subordinate managers, not seeking real input. Accordingly, none of the behavioral benefits of participation will be realized. Read developing standards for input-prices and input quantities
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