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In creating a business plan, many new entrants determine not to take profits in their first period of operation. The period could be a couple years or months. Amazon.com, a former online bookstore that grows to be an online retailer of any kind including books to collectibles, for instances, recorded losses for several years in late 20th century that account for millions of dollars. Frey and Cook (2004) revealed that in 2001 alone, Amazon.com recorder huge losses up to $1.4 billion.
Although the company continues suffered from great losses for many years, we witness that Amazon.com started generating fourth quarter of 2002 profit of $5 million and in October 2003, the company announced to generate $15.6 million of profits (Frey and Cook, 2004).
The situation raises questions as how the company resists from the storm before finally making profits commencing in 2002. Jeff Bezos, the CEO and founder of Amazon.com, is the person who designs the sustainable financial strategy that causes the company to survive during the dark side of Internet business. The strategy, especially, relates to budgeting strategy.
Traditionally, many people often consider budgeting and forecasting to have similar meaning. It turns out that each has different meaning. According to Quicken (2006), budgeting enables corporations to define budget amounts and then track how the company manages those amounts. Therefore, budgeting becomes an important skill for any people conducting business to prevent a company experiences cash shortage.
Meanwhile, forecasting is a tool that enables a corporation to project cash flow for the future based on scheduled transactions and estimated amounts (Quicken, 2006). In short, a financial forecasting is a prediction of future income and expenditure.
Concerning the budgeting issue, this paper will examine the Bart (1988) statement that says, “Managers pad their budgets out of fear that senior management will arbitrarily slash their submitted budgets and the managers` own concerns about uncertainties in the competitive environment”. Therefore, this paper will discuss the definition of budgeting and reveal the role of budgeting as an evaluation tool for organizational performance.
- Theory of Budgeting
A budget explains projected expenses and revenues of an organization within a given period. Therefore, budgeting should comply with the organization’s programs and services to determine planning steps, evaluation methods, pricing for services, timing of events, and costs related to achieving the organization’s mission (Salamon, 1999).
In order to create appropriate budgeting, Arnold and Philip Olenick (1991) assert that there are four key steps in budgeting:
- Expenses are estimated first. This process involves the multiplication of the number of employees, quantity of supplies, advertising spots, etc., by the estimated cost per unit.
- Sources of income are estimated next. For companies, sources of income include revenues, foreign exchange profits, etc..
- Expenses must be brought into line with reality. Corporation must obtain balanced budget by balancing projected income and outgo.
- Board of management review and approve the final proposed budget
As measurement tools, a corporation should conduct evaluation periodically to examine whether the projected revenue and expenses are still in the course. If there is variance in the projected revenue and expense, the company must update and revise the budget accordingly.
- Slash of Submitted Budget à Role of the Budget as Evaluation tools of Organizational Performance
Hansen & Mowen (2003) reveal several functions of an ideal budgetary system. Three of which relate to their roles as evaluation tools of organization performance as following:
- Pressing Management to Plan
In this role, budgeting process will force management to plan and therefore will encourage managers to develop comprehensive direction for the organization, foresee problem and develop future policies.
- Providing necessary information to improve decision making
In this situation, budgeting can help a company to prevent from experiencing unfortunate situations. For example, if Amazon.com does not have strong budgeting method, during the dark side of Internet age in 1990s, the company may face bankruptcy immediately.
This role is inline with corporate objective to determine which activities that do not add values to the company. Upon the finding, the company may decide eliminate or reduce the budget for those activities and reallocate it to other activities that are more profitable in order to maintain the company’s performance.
In addition, a budget also helps managers to make decision based on accurate information since inaccurate information will cause bad decisions that could harm the firm. Concerning the decision-making, Emmanuel, Merchant, and Otley (1990, p. 16-18) reveals that accounting systems should provide management with appropriate information to facilitate mental model building and maintenance although it depends on several conditions such as environment and constraints of managers in an organization.
For instances, in short-term make or buy decision, programmed decision takes into account trustworthy knowledge, especially concerning the cause-and-effect relationships (Emmanuel, Merchant, and Otley, 1990, p. 15)
- It Improves Communication and Coordination
This role describes that budgeting helps corporations to communicate the plans of organization to each employee. Thus, all employees in the corporation are aware of their role in achieving these objectives. In addition, budgeting will help promoting coordination, various departments to work together to achieve organizational objectives (Hansen & Mowen, 2003).
- Budget and Uncertainties in the Competitive Environment
4.1 Choosing Suitable Budgeting Approach
This role is best described by using case of Amazon.com, Google, and other internet giants that once face difficulty in generating revenue from internet-based services in addition, concerning the uncertainties in the competitive business environment, a company must decide suitable budgeting approach since each has particular advantage.
Currently, there are two models of financial budgeting; they are functional-based budgeting and activity based budgeting. The functional-based budgeting is the old approach in financial planning strategy. Meanwhile, the latter is the new one that many corporations adopt to manage their projected expenses better.
Technically, functional-based budgeting is a budgeting strategy that considers a single cost driver as a basis of cost calculation. The single cost driver could be labor working hours or machine hours. Although this budgeting method is widely used in the past, the requirement of managerial planning that needs accurate information has put aside the use of this old budgeting approach. The disadvantages of employing functional-based budgeting are as following:
- Inaccurate financial target
- Inaccurate standards
- Inaccurate performance evaluation
In addition, activity based costing is a new method in budgeting that uses multiple cost drivers to determine costs. This attractive approach provides a corporation with more realistic and accurate model of budgeting.
The above comparison describes that appropriate use of budgeting can help a company to find and eliminate inefficiencies that occurs in the company. The inefficiencies include the wrong choice of budgeting system.
- Beyond-Budgeting and Better-Budgeting Approach
In order to perform well in uncertainties, corporations need to find appropriate budgeting approach, as mentioned above. However, many companies do not regard budgeting. Under such circumstances, Beyond Budgeting Round Table (BBRT), an organization that established in the U.K., aims at identifying corporations that discard budgeting and figuring out why they do so (Daum, 2002).
In addition, BBRT describes there are six external factors that influence the operations of today’s company and that become underlying facts driving corporation to move into the Beyond Budgeting model:
- Shareholders become demanding and only loyal to organizations that continue showing incredible performance as top companies in their respective industry.
- Brilliant people are more and more in short supply and pay attention to values and the environment.
- Innovation grows at a breakneck speed that demand corporation to consider business life cycles strategy and therefore its budgeting as well
- Prices of products and services fall and quality improved
- Corporations must perform close relationship with customers
- Investors and regulators demand honest report of corporations’ performance (Daum, 2002)
In order to cope with those demands, corporations need to improve their budgeting process. According to a data, it is found that more than 68% of companies rely on forecasts on instead of budgeting. About 56% intends to improve the accuracy of those forecasts, while the rest (about 27%) plan to lower the time spent on them. Under such circumstances, corporations should perform better budgeting including the implementation of what-if-scenario capabilities, enhance collaboration and realize driver-based forecasting.
4.3 Role of a Budget in the Uncertainties of Business Environment
In addition to choosing suitable budgeting approach, a company must understand that a business has a business life cycle as described in the figure 1. The figure shows that a company many be at a peak performance but at the other time, it will experience a recovery stage.
Whichever state a company stays at a given period, it needs strong cash flow to finance the business operation. In this situation, budgeting has significant role in helping a company to survive in the business cycle.
Figure 1 Business Cycle of A Company
4.3 Internal and External Control Mechanisms to Monitor and Evaluate the Budget
In order to evaluate whether a budget has met the intended results, a company can conduct a mechanism that monitor and evaluate the budget. In general, the control mechanism can be divided into two types: internal and external evaluation.
In internal evaluation, a company can set up a checklist that consists of several components; they are Type of agreement for the evaluation, Condition of payment, Funding source, Funding period, Budget contact, Budget limits, Condition of payment, and Preaward costs (Horn, 2001).
In addition, the external evaluation method consists of the appointment of consultants to assess whether the budget of a company is still in line or not. The employment of external evaluator is beneficial since consultants have extensive experiences in accomplishing several budget evaluations. In addition, consultants are considered as independent contractors and are not included under personnel costs (Horn, 2001).
- Budgeting as Performance Accountability and Reward Process
A budgeting can also become standard for performance evaluation by providing a set of standards that will control the use of company’s resources and motivate employees. In addition, as an inseparable part of the budgetary system, control is achieved by comparing budgeted result with actual result on a periodic basis.
For instances, if a production manager of a bread-producing company knows that 5 breads take about 1 pound of flour, then he can evaluate his employee in terms of efficiency. If the five breads use up more than 1 pound of flour, there is an ineffective use of flour within the production system (Hansen & Mowen, 2003). The condition reveals that the budgeting in the production department requires evaluation
The reason of conducting budgeting is to forestall times when a business needs to incur a great amount of expenditure before the company was paid by customers. It means that appropriate budgeting process will prevent the company from unfavorable situations such as cash shortage and business termination.
Concerning the budgeting, this paper has discussed several issues including the role budget as evaluation tools of organizational performance, budget and uncertainties in the competitive environment, choosing suitable budgeting approach, and budgeting as performance accountability and reward process.
Regarding the role of budgeting as evaluation tools of organization performance, Hansen & Mowen (2003) describes its three functions: pressing management to plan, providing necessary information to improve decision-making and improve communication and coordination.
Meanwhile, budgeting role in managing uncertainties in the competitive environment also composes of three functions/activities: choosing suitable budgeting approach, internal and external control mechanisms to monitor and evaluate the budget, and budgeting as performance accountability and reward process.
In addition, the emerging concept “beyond budgeting”, a term coined by Beyond Budgeting Round Table (BBRT), an organization that established in the U.K., aims at identifying corporations that discard budgeting and figuring out why they do so (Daum, 2002).
Daum, Juergen H. 2002, Performance Management beyond Budgeting: Why you should consider it, How it works, and Who should contribute to make it happen, The New Economy Analyst Report, June 08, 2002
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Frey, Christine and Cook, John. 2004, ‘How Amazon.com survived, thrived and turned a profit’, [Online] Available at: http://seattlepi.nwsource.com/business/158315_amazon28.html
Hammer, Lawrence H. Carter, William K. Usry, Milton F. 1994, Cost Accounting. South-Western
Hansen, Don R. Mowen, Maryanne M. 2003, Management Accounting. South-Western
Horn, Jerry. 2001, ‘A CHECKLIST FOR DEVELOPING AND EVALUATING EVALUATION BUDGETS’, [Online] Available at: http://www.wmich.edu/evalctr/checklists/evaluationbudgets.htm
Olenick, A.J. & Olenick, P.R. 1991, A Nonprofit Organization Operating Manual, New York: The Foundation Center.
Quicken. 2006, ‘What is the difference between forecasting and budgeting?’ Retrieved December 14, 2006 from http://www.quicken.co.uk/faqs/200203-07.html
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