Practice Developments in Budgeting : An Overview and Research Perspective

Practitioners in Europe and the U.S. recently have proposed two distinct approaches to address what they believe are shortcomings of traditional budgeting practices. One approach advocates improving the budgeting process and primarily focuses on the planning problems with budgeting. The other advocates abandoning the budget and primarily focuses on the performance evaluation problems with budgeting. This paper provides an overview and research perspective on these two recent developments. We discuss why practitioners have become dissatisfied with budgets, describe the two distinct approaches, place them in a research context, suggest insights that may aid the practitioners, and use the practitioner perspectives to identify fruitful areas for research. INTRODUCTION Budgeting is the cornerstone of the management control process in nearly all organizations, but despite its widespread use, it is far from perfect. Practitioners express concerns about using budgets for planning and performance evaluation. The practitioners argue that budgets impede the allocation of organizational resources to their best uses and encourage myopic decision making and other dysfunctional budget games. They attribute these problems, in part, to traditional budgeting’s financial, top-down, commandand-control orientation as embedded in annual budget planning and performance evaluation processes (e.g., Schmidt 1992; Bunce et al. 1995; Hope and Fraser 1997, 2000, 2003; Wallander 1999; Ekholm and Wallin 2000; Marcino 2000; Jensen 2001). We demonstrate practitioners’ concerns with budgets by describing two practice-led developments: one advocating improving the budgeting process, the other abandoning it. These developments illustrate two points. First, they show practitioners’ concerns with budgeting problems that the scholarly literature has largely ignored while focusing instead 1 For example, Comshare (2000) surveyed financial executives about their current experience with their organizations’ budgeting processes. One hundred thirty of the 154 participants (84 percent) identified 332 frustrations with their organizations’ budgeting processes, an average of 2.6 frustrations per person. We acknowledge the many helpful suggestions by the reviewers, Bjorn Jorgensen, Murray Lindsay, Ken Merchant, and Mark Young. 96 Hansen, Otley, and Van der Stede Journal of Management Accounting Research, 2003 on more traditional issues like participative budgeting. Second, the two conflicting developments illustrate that firms face a critical decision regarding budgeting: maintain it, improve it, or abandon it? Our discussion has two objectives. First, we demonstrate the level of concern with budgeting in practice, suggesting its potential for continued scholarly research. Second, we wish to raise academics’ awareness of apparent disconnects between budgeting practice and research. We identify areas where prior research may aid the practitioners and, conversely, use the practitioners’ insights to suggest areas for research. In the second section, we review some of the most common criticisms of budgets in practice. The third section describes and analyzes the main thrust of two recent practiceled developments in budgeting. In the fourth section, we place these two practice developments in a research context and suggest research that may be relevant to the practitioners. The fifth section turns the tables by using the practitioner insights to offer new perspectives for research. In the sixth section, we conclude. PROBLEMS WITH BUDGETING IN PRACTICE The ubiquitous use of budgetary control is largely due to its ability to weave together all the disparate threads of an organization into a comprehensive plan that serves many different purposes, particularly performance planning and ex post evaluation of actual performance vis-à-vis the plan. Despite performing this integrative function and laying the basis for performance evaluation, budgetary control has many limitations, such as its longestablished and oft-researched susceptibility to induce budget games or dysfunctional behaviors (Hofstede 1967; Onsi 1973; Merchant 1985b; Lukka 1988). A recent report by Neely et al. (2001), drawn primarily from the practitioner literature, lists the 12 most cited weaknesses of budgetary control as: 1. Budgets are time-consuming to put together; 2. Budgets constrain responsiveness and are often a barrier to change; 3. Budgets are rarely strategically focused and often contradictory; 4. Budgets add little value, especially given the time required to prepare them; 5. Budgets concentrate on cost reduction and not value creation; 6. Budgets strengthen vertical command-and-control; 7. Budgets do not reflect the emerging network structures that organizations are adopting; 8. Budgets encourage gaming and perverse behaviors; 9. Budgets are developed and updated too infrequently, usually annually; 10. Budgets are based on unsupported assumptions and guesswork; 11. Budgets reinforce departmental barriers rather than encourage knowledge sharing; and 12. Budgets make people feel undervalued. 2 For example, in their review of nearly 2,000 research and professional articles in management accounting in the 1996–2000 period, Selto and Widener (2001) document several areas of ‘‘fit’’ and ‘‘misfit’’ between practice and research. They document that more research than practice exists in the area of participative budgeting and state that ‘‘[this] topic appears to be of little current, practical interest, but continues to attract research efforts, perhaps because of the interesting theoretical issues it presents.’’ Selto and Widener (2001) also document virtually no research on activity-based budgeting (one of the practice-led developments we discuss in this paper) and planning and forecasting, although these areas have grown in practice coverage each year during the 1996– 2000 period. Practice Developments in Budgeting 97 Journal of Management Accounting Research, 2003 While not all would agree with these criticisms, other recent critiques (e.g., Schmidt 1992; Hope and Fraser 1997, 2000, 2003; Ekholm and Wallin 2000; Marcino 2000; Jensen 2001) also support the perception of widespread dissatisfaction with budgeting in practice. We synthesize the sources of dissatisfaction as follows. Claims 1, 4, 9, and 10 relate to the recurring criticism that by the time budgets are used, their assumptions are typically outdated, reducing the value of the budgeting process. A more radical version of this criticism is that conventional budgets can never be valid because they cannot capture the uncertainty involved in rapidly changing environments (Wallender 1999). In more conceptual terms, the operation of a useful budgetary control system requires two related elements. First, there must be a high degree of operational stability so that the budget provides a valid plan for a reasonable period of time (typically the next year). Second, managers must have good predictive models so that the budget provides a reasonable performance standard against which to hold managers accountable (Berry and Otley 1980). Where these criteria hold, budgetary control is a useful control mechanism, but for organizations that operate in more turbulent environments, it becomes less useful (Samuelson 2000). Claims 2, 3, 5, 6, and 8 relate to another common criticism that budgetary controls impose a vertical command-and-control structure, centralize decision making, stifle initiative, and focus on cost reductions rather than value creation. As such, budgetary controls often impede the pursuit of strategic goals by supporting such mechanical practices as lastyear-plus budget setting and across-the-board cuts. Moreover, the budget’s exclusive focus on annual financial performance causes a mismatch with operational and strategic decisions that emphasize nonfinancial goals and cut across the annual planning cycle, leading to budget games involving skillful timing of revenues, expenditures, and investments (Merchant 1985a). Finally, claims 7, 11, and 12 reflect organizational and people-related budgeting issues. The critics argue that vertical, command-and-control, responsibility center-focused budgetary controls are incompatible with flat, network, or value chain-based organizational designs and impede empowered employees from making the best decisions (Hope and Fraser 2003). Given such a long list of problems and many calls for improvement, it seems odd that the vast majority of U.S. firms retain a formal budgeting process (97 percent of the respondents in Umapathy [1987]). One reason that budgets may be retained in most firms is because they are so deeply ingrained in an organization’s fabric (Scapens and Roberts 1993). ‘‘They remain a centrally coordinated activity (often the only one) within the business’’ (Neely et al. 2001, 9) and constitute ‘‘the only process that covers all areas of organizational activity’’ (Otley 1999). However, a more recent survey of Finnish firms found that although 25 percent are retaining their traditional budgeting system, 61 percent are actively upgrading their system, and 14 percent are either abandoning budgets or at least considering it (Ekholm and Wallin 2000). We discuss two practice-led developments that illustrate proposals to improve budgeting or to abandon it. Although the two developments reach different conclusions, both originated in the same organization, the Consortium for Advanced Manufacturing-International (CAM-I); one in 3 We note that there are several factors that inevitably contribute to the seemingly negative evaluation of budgetary controls. First, given information asymmetries, budgets operate under second-best conditions in most organizations. Second, information is costly. Finally, unlike the costs, the benefits of budgeting are indirect, and thus, less salient. 98 Hansen, Otley, and Van der Stede Journal of Management Accounting Research, 2003 the U.S. and the other in Europe. The U