Despite powerful hardware and software support, budgeting remains a time-consuming and expensive exercise. Preparing and finalizing cost budgets can take four to five months in some companies. Besides, the majority of a company’s staff usually participates in it in some way or the other; quite often, the entire budget process absorbs 30% and more of the senior executives’ and financial managers’ working time per year.
Generally, the usage of budgets in an organization is correct and important. The main purpose of budgeting is to create the preconditions that allow the company to comply with its market-oriented goals (e.g. reaching specific market positions or breakeven sales volumes, etc.) as well as the financial ones (e.g. realizing a significant return on investment or a minimum profit, etc.). This involves the planning of, for instance, production output, manpower requirements, turnover, costs, and capital expenditures.
Furthermore, prepared budgets provide for allocation of liquid funds and non-financial resources, securing performance-related justice and individual motivation of each employee. A further sense of responsibility is encouraged; managerial subareas are coordinated professionally as well as personally; and measures to reach the company’s targets are determined.
Describing the budget theory so far, operational practice often looks quite different. The number of companies that invest great personal and temporal resources into their budget planning, and yet have to face large variances between the actual and budgeted expenditures or revenues each year—and thus can only derive little advantage from their budgeting in terms of a management and control function—should not be underestimated.
This may have its reason in external shocks and unpredictable developments, but may also be caused by sources of error within the budgeting processes. Therefore, management accountants’ tasks do not only comprise, for instance, moderation, coordination, and consolidation of the reported budget figures. It is also important for them to know about potential sources of error while proactively trying to avoid them. So, in the following sections, we will take a closer look at several of these typical budgeting pitfalls and suggest possible solutions for management accounting to minimize those.
Pitfall #1: Budgets functioning as a status symbol
Assigned budgets are an indirect indicator of the individual esteem of each department or division within the company—the bigger the budget, the larger the influence. Therefore, clashes over capital and resources among internally competing divisions are not uncommon: Division A, which does not obtain the funds it applied for, regards division B with envy because B’s investment as well as personal requests have been accepted to the full amount.
As a consequence, not only are there conflicts between departments, but also teams or project leaders who poison the entire working atmosphere by massaging the estimated figures. For example, planned sales volumes and overall performance are falsified and overvalued simply to receive the requested budget and to outrival other departments’ budget requests. Such behavior eventually leads to short personal and financial resources being further burned in—by way of comparison—unprofitable projects, while funds fall short for the more economically promising ones.
For a management accountant dealing with budgeting processes, it is therefore quite important to create a budgeting climate (in close cooperation with the management) that is more or less free of envy, distrust, and departmental or divisional self-interests, and instead gives priority to the big picture. In other words, the management accountant also has to moderate and mediate between various departments, views and interests. Reaching the corporate objectives as a whole has to be eventually of top priority for all participants of the budgeting process.
Pitfall #2: Budget figures containing exaggerated buffers
Hiding reserves in budget requests is a well-known misconduct done by many cost centers and those responsible for preparing the budget. In case of poor business development, enough buffers are available to (over)compensate for negative variances between actual and planned figures and reach the budget allowances nonetheless. Or if, for example, the management dictates cost reductions on an investment project A in the following year to squeeze existing budgets, the project leader can easily deflate the buffers within the appropriate budget.
In case of an optimal course of business, which would in effect allow saving liquid funds and budgeted non-financial resources, the entire budget is spent nonetheless—if necessary via unprofitable projects or gratuitous expenses. Otherwise, only a smaller budget would presumably be approved for the next period (reduced by unneeded resources in the actual period), which, needless to say, budget managers seek to circumvent (following the “use it or lose it” mantra).
Of course, such behavioral patterns should be avoided under any circumstances if one is acting in the interests of the entire organization, and is not exhibiting an excessive divisional egoism. Once again, the major negative implication is that restricted capital cannot be distributed in compliance with an economic principle—buffered resources are missing in other divisions where they might contribute to much higher earnings.
The tendency to “buffer” is especially maximized when the budget is connected to a variable compensation for the budget manager. Therefore, a flexible compensation scheme should definitely not overemphasize and reward disproportionately a simple and rigid form of budget compliance. Furthermore, it is important that each management accountant develops over time a sensitive intuition for uneconomical budget reserves, which leads us directly to the following pitfall.
Pitfall #3: Day-to-day business as a black-box (from management accountant’s view)
To conduct professional budget discussions at eye level and question financial assumptions critically, all members of a budgeting process need at least a profound understanding of the basic business relations and contexts—which is especially true for management accountants.
Only under such conditions can the latter check the provided target figures in terms of plausibility, comprehend statements of employees with sales and cost responsibilities, and maybe disagree based on their sound knowledge. In most cases, management accountants acting as pure “number crunchers” are no longer of employers’ interest these days.
Understanding the company’s business is also important to avoid pitfalls No. 1 and 2. The deeper the management accountant delves into the matter, the more he is qualified to identify any attempt to buffer the budgets and massage the figures.
Read on in Part 2:
The Most Crucial Budgeting/Forecasting Pitfalls to Avoid (Part 2)
- Pitfall #4: A lack of commitment from managers with budget responsibility
- Pitfall #5: Missing link between the corporate’s goals and measures
- Pitfall #6: Only living in the here and now—neither willing to learn from past experiences nor to look ahead
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Must-read blog posts about management accounting and financial control—classical topics, as well as modern subjects, latest trends, and current challenges in the management accounting discipline. Aimed to inform, inspire, and entertain management accountants and anyone with a deeper interest in management accounting.