Conflicting role in budgeting for operations

A senior design engineer for a large American automobile manufacturer recently complained to one of his colleagues.

"Those marketing guys want everything. They've decided that what they need in the next design series is 'The All-American Car.' They say it's got to be large enough for a family of five (plus dog), small enough to drive in city traffic, powerful enough to pull a camp trailer, sporty enough so that the man of the house feels that what he's driving is only a few steps removed from a Formula One, luxurious enough to be seen at the country club, safe enough to meet all the federal standards, and it must get 35 miles per gallon and list for under$3,499. What the hell do they expect? One car can't do everything."

The frustrations of the automobile design engineer are not entirely different from those of the company controller who was recently asked why he could not design a budgeting system to meet all the requirements that managers throughout his company were placing upon it. The treasurer said he wanted a budget that was realistic enough for cash planning purposes. The marketing vice president said he needed a budget that would motivate the sales force. The production chief told the controller he needed it to evaluate operating efficiency. The president asked that the budget be used as the primary coordination device to harmonize all the company's activities. Finally, a consultant came in and told the controller that he ought to be using the budget as a tool for management development. Like the design engineer, the controller rightly asked, "How can one budget be expected to do everything?"

The problems the design engineer and the company controller face in these hypothetical examples arise from the fact that both automobiles and budgeting systems serve multiple rolesat the same time they must be many things to many people. And the problems would be greatly simplified if none of these multiple roles conflicted with any of the others. Unfortunately, this is not the case. A car cannot be luxurious and powerful if at the same time it must also be inexpensive and economical. Similarly, a budget cannot fulfill equally well all the tasks that managers within an organization may wish to assign to it.

Operational Budgeting Defined

Budgeting is part of the management control process by which "managers assure that resources are obtained and used efficiently and effectively in the accomplishment of the organization's objectives."¹There are several kinds of budgets, and while specific terminology may vary from company to company, budgets generally fall into one of three categories.

Capital budgets.These budgets portray the corporation's planned and approved capital expenditures for periods from one to ten years.

Financial budgets.Such budgets typically project cash flow statements, balance sheets, and statements of sources and uses of funds.

Operational budgets.These usually consist of projected income statements and a series of supporting statementssuch as budgeted sales, budgeted production (in detail), budgeted cost of goods sold, budgeted selling expenses, and budgeted general and administrative expenses.

We shall deal solely with operational budgeting. We define it as the process of formalizing, quantifying, and expressing in a set of detailed operating plans the near-term performance expectations and objectives of a company's management.

Roles of Operational Budgets

Budgets can be called upon to play a variety of roles. We shall discuss five of these. Three are major roles: planning, motivation, and evaluation; two are minor: coordination and education.

PlanningOperational budgets are plans; they provide details of what management hopes to accomplish and how. Their value in the planning process comes from the fact that budgeting forces management to examine in detail both the general economic situation of which the company is a part and the economic interrelationships among all the company's various activities. Budgeting allows managers to explore how costs and revenues will behave under specific sets of operating assumptions.

The process often points out conflicts between top management's objectives and the realities of the company's capabilities. Through budgeting, management can both identify resources that will be necessary to achieve objectives and learn how those resources must be applied. If present resources cannot meet planned objectives, the process of operational budgeting may bring about an examination of the financial implications of additional asset procurement (capital budgeting).

MotivationManagement can use operational budgets to motivate persons to help achieve the organization's overall objectives by committing them to a predetermined plan of action. Motivation can be said to have two elements: direction and strength.²

Budgets provide the direction in that a budget represents a quantification of management's objectives. When the budgeting process is complete, each manager ends up with a specific target for which to aim. But an objective alone is rarely enough. To achieve objectives, a manager must be committed to working toward them.

Managers can gain commitment (the strength element of motivation) in a variety of ways. One frequently used technique is to link the performance evaluation of the manager with the company's incentive system. When managers realize that their level of compensation and their upward mobility depend to a large degree on their performance, their commitment to budgeted objectives may be enhanced.

EvaluationThe data in an operational budget serve as a standard against which to compare a manager's or a business unit's actual results. Without such a standard, senior management would have little but the past against which to measure the results of the present. While present-to-past comparisons may be interesting from a historical perspective, they often provide little meaningful evaluation of a company's or a manager's performance.

Evaluating present performance in terms of past performance assumes that the company's present condition and operating environment are the same as in the past. This is rarely the case.

If the purpose of the evaluation is to measure managers' operating abilities as opposed to their forecasting skills, it might also be desirable to remove the effects of uncontrollable or unforeseeable environmental changes that have occurred during the budget period. Examples of uncontrollable environmental variables might be changes in government regulations, labor unrest, and either shortages or unexpected increases in the costs of raw materials.

In the evaluation role, budgets receive support from other elements of the management control system. The budget serves as a useful standard of measurement, but it falls to the reporting system to provide data on the actual results that are to be measured against the standard. Predetermined measurement criteria (return on investment, return on assets, and so on), formal evaluation procedures, and management review meetings also support the budget's role in evaluation.

CoordinationOperational budgets also have a coordinating role. When combined with the financial budgets into an overall master budget, operational budgets help coordinate the activities of the various parts of the organization by providing a consolidated plan of action.

Budgets can coordinate in two ways. First, the budgeting of operations in a large organization must be decentralized to some extent. In most companies, managers of the various organizational elements prepare budgets for the coming year. As these budgets flow to higher levels in the organization, they are reviewed and consolidated, and, in the process, incompatibilities among the planned operations of the various organizational elements are removed.

Output is matched to projected sales, material procurement schedules are coordinated with production plans, distribution across product lines is coordinated, redundancies in the marketing or sales operations are reviewed, and so on. In short, the operational budget, once it is fully consolidated, serves as a means of harmonizing the activities of the entire organization with the purpose of seeing that resources are not over- or underused.

The second coordinating function of the operational budget comes after operations have actually begun. If each organizational element is managed so as to meet its budgeted objectives, then the coordination that was built into the budget during the planning process will not be lost. If, as is more common, conditions change and the budget is not met by all units, then the knowledge gained earlier about the economic interrelationships between the company's various activities can be useful in developing revised plans or budgets.

EducationThe budget's role in education is related to the coordination role. To prepare their budgets properly, managers at all levels of the organization must take a systematic and rigorous look at how their part of the business functions and be aware of the behavior of costs and revenues in their units. Budgets can also be useful analytical tools in determining how performance might be improved.

Consolidation of the budgets of the various organizational elements might also force managers to understand better the organizational dynamics of the company as a whole. To be able to explain and justify his portion of the overall budget, a manager must first examine the interrelationships and interdependencies among the various activities in his area of the business.

Because of the continual consolidation that occurs during the process, awareness of interdependencies may become more pronounced as the budget reaches the more senior line managers. But, in fact, managers at all levels should become more aware of how their actions and the activities of their units affect related units of the company. While in practice this is not always the case, budgeting should be viewed as a means of giving managers a better perspective on how the total organization operates.

Conflicts Between Major Roles

The requirements placed upon an operational budgeting system by virtue of its major roles make it difficult for one system to meet them all. And it is precisely because these requirements differ that role conflicts arise.

Since there are three major roles for any budgeting system, at least three major role conflicts may arise: planning versus motivation, motivation versus evaluation, and planning versus evaluation (see the Exhibit). A closer look at the difference between the requirements of each role reveals that in fact there are only two major conflicts: one between the planning and motivation roles, the other between motivation and evaluation. The third presumed conflictbetween planning and evaluationis a lesser problem.

Exhibit Conflicts Between Role Requirements

Planning versus motivation

For a budget to be most effective in the planning role, it should be based on a realistic assessment of the company's operating capabilities and on management's judgment about the most likely outcome of the company's interactions with its environment. Because the company's financial budgets and its capital budgets are, in part, based on the figures contained in the operational budget, the budget should reflect management's best estimates of revenues and expenses. If the operational budget is overly optimistic, the company may underuse its resources. If it is overly pessimistic, there may be insufficient resources to allow full exploitation of market opportunities. The budget used for planning purposes should be based on what is most probable.

Yet an operational budget based on what is most probable runs the risk of setting targets so low as to adversely affect motivation. To motivate properly, a budget should set objectives higher than those set for planning and should present objectives that are difficult yet attainable. On average, it should be unlikely that all managers in an organization will meet their budgets.

Difficult objectives are likely, however, to equate to an overly optimistic budget, and, if the budget is set at a possiblebut not probablelevel, there is a risk of falling short of the objective and underusing company resources. Clearly, the same budget is not likely to be totally effective in both its planning and its motivation roles.

The conflict between planning and motivation is sharpened if we look at the budgeting process from the perspective of the managers who prepare the budget. They may know that for planning purposes the company needs their best estimates of the probable level of activity for the coming year. They may also know from experience that their superiors are likely to raise the probable levels of activity needed for planning purposes to reflect objectives that they consider to be difficult yet attainable. Managers also know that they may encounter unanticipated difficulties in meeting the budgeted objectives.

Considering these facts, managersin their initial budget proposalsoften feel the need to pad the budget or to introduce what is sometimes referred to as "budget slack," in order to enhance the chances of favorable comparisons between budgeted and actual results. In trading off their desire to achieve with their need for security, some managers intentionally set objectives lower than the levels of performance they believe to be achievable.

If the process of budget review and approval does not remove budget slack, it may affect the budget's effectiveness in both the planning and the motivation roles. First, it is only by coincidence that a padded budget will represent objectives meeting the realistic, most probable outcome criterion. Second, a manager's motivation to maximize his own performance may be impaired, since the padded budget is not likely to present difficult yet attainable objectives.

While, in practice, budget slack is likely to be removed as budgets are consolidated in their upward movement, the potential for conflict remains. What is best for planning purposes is not best for motivational purposes.

Motivation versus evaluation

Important to understanding this conflict in roles is the widely held belief that the objectives set in the budget should be viewed by the manager as fixed standards against which performance will be judged. Supporters of this position believe that, once the objectives are identified, they should become relatively fixed so that the individual working toward them does not lose direction. In addition, it is also thought that a manager will be more committed to achieving budgeted objectives if he or she knows in advance that failure to do so might be viewed as less than satisfactory performance.

On the other hand, in evaluating individual managers, it is often desirable to remove from the budgeted standards the effects of costs or circumstances over which the manager had no control. Examples of expenses that might be termed "uncontrollable" by an individual manager are allocations of corporate overhead and of corporate research and development expenses, and gains or losses due to fluctuations in foreign exchange rates.

If the purpose of the evaluation is to measure managers' operating abilities as opposed to their forecasting skills, it might also be desirable to remove the effects of uncontrollable unforeseeable environmental changes that have occurred during the budget period. Examples of uncontrollable environmental variables might be changes in government regulations, labor unrest, and shortages or unexpected increases in the cost of raw materials.

In many situations, the budget that is most effective in the evaluation role might be called an ex post facto budget. It is one that considers the impact of uncontrollable or unforeseeable events, and it is constructed or adjusted after the fact.

The potential role conflict between the motivation and evaluation roles involves the impact on motivation of using an ex post facto standard in the evaluation process. Managers are unlikely to be totally committed to achieving the budget's objectives if they know that the performance standards by which they are to be judged may change. And yet motivation can be just as easily impaired by rigid application of a "fixed standard" philosophy. A manager who is held strictly accountable for meeting budgeted objectives regardless of what happens during the period is likely to lose enthusiasm if faced with continued large negative variances resulting from uncontrollable variables. There is a threshold of frustration that, once reached, may cause all hope of meeting the budget to disappear. Loss of hope can easily lead to loss of effort.

Planning versus evaluation

On the surface, it might appear that the planning role's requirement of providing a realistic assessment of future prospects would conflict with the need to isolate or to eliminate the effects of uncontrollable or unforeseeable environmental variables from the budget used for evaluation purposes. Yet, in fact, because they are separated in time, the conflict between these requirements is reduced considerably.

At the beginning of the budgeting period, management should prepare realistic budget reflecting its assessment of the most probable outcome of future interactions between the company and its environment. The effect on the evaluation role can be lessened, however, since it is not until the end of the budgeting period (or subdivisions thereof) that the budget will be used for evaluation.

At the end of the budget period, adjustments or modifications can be made for changing environmental conditions that occurred during the budgeting period. This can be done without adversely affecting the budget's prior role in planning. If we ignore for the moment the budget's role in motivation and focus only on the planning and evaluation roles, it seems possible to have two budgets: one for planning, the other for evaluation. Hence, there need be no conflict between these roles. The operational budget's role in motivation may preclude the use of two distinctly different versions. Note, however, that this fact does not, in itself, create conflict between the requirements of the planning and evaluation roles.

Reducing Role Conflict

Various managerial techniques have been used to reduce the conflicts inherent in an operational budget's major roles. Some of these techniques result from a conscious effort on the part of senior management to design the budgeting system so as to reduce role conflicts. In other cases, the reduction in role conflict is an accidental and perhaps unnoticed advantage of the way in which the budgeting system is designed.

We have selected six examples of techniques used by large companies to reduce or eliminate the negative effects of role conflicts. The first two deal primarily with the planning versus motivation conflict. The next two chiefly concern the conflict between motivation and evaluation. The final two have elements that might be seen as dealing with both of these two role conflicts. While we shall deal with the individual techniques in isolation, the reader should remember that it is entirely possible to combine elements from two or more of them. Many companies have, in fact, done just that.

Planning versus motivation conflict

The most common manifestation of the conflict between planning and motivation revolves around the belief that, for motivational purposes, an operational budget should contain difficult yet attainable objectives. Clearly, as we have already seen, the objectives of such a budget are not likely to be met, on average, by all managers and business units within the company. If the objectives set in the subordinate's budgets are at the difficult yet attainable level and the senior manager's budget is represented as the total of the subordinate's objectives, then for the senior manager to meet his budget his subordinates would also have to (on average) meet theirs. Where the senior manager has five or six managers reporting to him, the probability of this occurring may be quite low.

One company uses what it terms general manager's judgment (GMJ) as a means of dealing with this problem. GMJ is a form of budget slack, but it is not used in the same way as the budget slack discussed earlier. In this company, budgeted objectives are set high enough to motivate managers effectively at lower levels in the organization. Then, as the budget is consolidated upward, objectives are reduced to levels more consistent with the purposes of planning and coordination.

General managers in this company ask their subordinates to commit themselves to objectives that the general managers believe will be difficult to achieve. As the general manager consolidates the budgets of his subordinates, he reduces the total consolidated budget's objectives to levels that are, in his judgment, more realistic for purposes of financial planning. The apparent conflict between the budget's roles is therefore reduced.

By using GMJ, this company runs a risk. Subordinates may perceive that there are, in fact, two budgets: one used to motivate them and another, less optimistic, for planning and for evaluation of the senior managers' performance. In addition, they may sense that the senior managers are judged by a standard actually below that applied to them. Their motivation to achieve the original budget may thus be adversely affected.

Another approach to reducing the conflict between planning and motivation is embodied in a management control philosophy that might be called a tight ship policy. Here the objectives are set high enough to motivate and planning is based on these budgeted objectives. Budgets are not padded as with GMJ; there are no double standards. All managers are expected to achieve their budget objectives.

With the tight ship philosophy, there is only one sin greater than failing to meet the budgetknowing that the budgeted objectives will not be met and not informing top management of the fact. The senior managers of such a company believe that having advance knowledge of the fact that a business unit is not going to perform to budget allows them to reduce the impact that the shortfall may have on other operating units in the organization. They also believe that the planning and coordination benefits of the budget can often be retained by timely and effective corrective action.

Another means of reducing the possible adverse effects of planning with budgets whose objectives are set high enough to motivate is contingency planning. One company that operates with a budgeting system based on the tight ship policy has its operating units prepare contingency plans at the beginning of each budget period. These plans are written for sales levels 20%and 40%below that outlined in the operational budget.

Although the primary purpose of this type of contingency planning is to help the individual managers react more quickly to changes from planned activity levels, it may also help reduce the role conflict. By having contingency plans for several outcomes, top management has an idea how each outcome might affect the organization as a whole.

Motivation versus evaluation conflict

One technique that can reduce the motivation versus evaluation role conflict is to differentiate among the levels of the organization as to where managers will be evaluated on the basis of revised or ex post facto budgets. There are clearly fewer opportunities to predict, control, or influence random, external variables at the lower levels of an organization. Thus individual managers at these levels might not be penalized for failure to meet budgeted objectives when the shortfall is due to circumstances not easily controlled or influenced by them.

The production manager, for example, might be evaluated on the basis of his ability to meet budgeted standards for variable costs, fixed costs, delivery dates, and (product) quality standards. If a sizable emergency shipment was required of him during the period, the effects of this shipment on his reported results might be shown apart from the results of the remainder of his operations.

The higher one goes in an organization, the greater the number of external variables that can be predicted, controlled, or influenced. And senior managers are senior largely because of their ability to deal with a more complex and challenging environment. Thus the bonuses and other financial incentives offered to such managers might be tied much more closely to achieving the objectives established in the original budget. Splitting the basis for performance evaluation and reward in such a manner helps maintain both commitment to budgeted objectives at the top and motivation by people further down in the organization whose objectives are not met because of events they may feel are beyond their control.

The conflict between the motivation and evaluation roles can also be reduced by using "adjustable budgets." These are operational budgets whose objectives can be modified under predetermined sets of circumstances. Thus revision is possible during the operating period and the performance standard can be changed.

In one company that uses such a budgeting system, managers commit themselves to a budget with the understanding that, if there are substantial changes in any of five key economic or environmental variables, top management will revise the budget and new performance criteria will be set. This company automatically makes budget revisions whenever there are significant changes in any of these five variables. Naturally, the threshold that triggers a new budget will depend on the relative importance of each variable.

With this system, managers know they are expected to meet their budgets. The budget retains its motivating characteristic because it represents objectives that are possible to achieve. Uncontrollable events are not allowed to affect budgeted objectives in such a way that they stand little chance of being met. Yet revisions that are made do not have to adversely affect commitment, since revisions are agreed to inadvanceand procedures for making them are structured into the overall budgeting system.

Multiple role conflicts

Some companies use rolling budgets to reduce multiple role conflicts. With a rolling budget, each budget period is likely to be much shorter than the traditional 12-month period: a quarter or, perhaps, four months. Budgeting becomes more or less a continuous process. As each budget period ends, budgets for the periods in the future are prepared or revised.

For example, a rolling budget might work in the following manner. At the end of Period 3 (an arbitrary starting point for this example), top management compares actual results for the period with the budgeted objectives, and performance evaluations are made. At the same time, it revises the budget for Period 5 for the last time. In addition, it revises the budget for Period 6 for the first time and formulates the initial budget for Period 7. The budget for the next period, Period 4, has been completed at the end of the last period. A manager's performance during the current period must meet the budgeted objectives before a bonus will be paid.

Commitment is maintained with a rolling budget because a manager knows that, once final, the budget will not be modified for purposes of evaluation. Failure to achieve budgeted objectives results in loss of incentive compensation. Yet, because the budgeting period has been significantly shortened, the individual manager finds the financial impact of such a failure easier to tolerate. The budget undergoes two revisions before it is final. Thus it can be adjusted for what might be termed unforeseeable events under a more conventional budgeting system. The adverse effects of not revising budgets are thereby somewhat reduced.

Some companies use a second technique to reduce multiple role conflicts: they require the regular submission of revised forecasts during the year. Such companies (as well as most others), divide the period covered by the budget into months or quarters for reporting purposes. At the end of each reporting period, managers are not only responsible for seeing that the actual results of operations are reported; they also must provide a forecast of the operating results for the portion of the overall budget period that still remains.

These revised forecasts become inputs to the planning process and serve to update those plans that were based on either the original budget or the most recent forecast. These continually updated forecasts restore some of the realism needed for intelligent planning. A comparison over time of original budgets with the revised forecasts also provides an indication of the manager's ability at forecasting future operating conditions.

In one company that uses a technique similar to the one just described, evaluation of performance is based on comparisons both of original budget with actual results and of actual results with latest forecast. Thus for this company, the role conflict between motivation and evaluation is reduced in that performance evaluation is based partially on a comparison between actual results and latest forecast. The manager's results are compared both with a fixed standard and with a standard that presumably has been adjusted for uncontrollable or unforeseeable environmental changes.

General Recommendations

Resolving the conflicts between the various roles of the budgeting system can be a complicated task. In part, this is due to the fact that, while planning is basically a straightforward business activity, the concepts of motivation and evaluation are part of a complex area of the behavioral sciences. One should, therefore, be wary of generalizations about how management can best proceed to reduce such conflicts. Nonetheless, the following points might help senior managers when they are considering how to resolve or alleviate such problems:

1. Recognize that role conflicts exist. Although the adverse effects of the conflicts can often be reduced, they cannot be totally eliminated.The mere recognition that role conflicts exist is a giant step toward coming to grips with the problem. Much of the unhappiness with contemporary budgeting systems stems from attempts to make one budget serve multiple roles.

2. Remember that the relative importance of each of the budget's roles may vary with the level of the organization.The GMJ technique discussed earlier operates on the principle that the relative importance of the several roles served by a budget is a function of the level of the organization involved. The importance of planning and motivation varies with the level in the organization at which the budget is being used. At lower levels, the budget is used for motivation. At higher levels, its relevance to financial planning and intraorganizational coordination becomes more important. While GMJ does not eliminate role conflicts, setting priorities for each role at the various levels in the organization does reduce the effects of the role conflicts.

Similarly, the technique of differentiating among the levels of the organization as to where the performance of managers will be evaluated on the basis of revised or ex post facto budgets is based on the principle that particular roles of the budget do not have the same importance at all levels of the organization.

3. Remember that reliance on other elements of the management control system can be helpful in reducing role conflicts.Companies using the tight ship policy might be said to view motivation as being of paramount importance. Budget objectives are set at difficult but attainable levels for purposes of motivation. Any adverse effects that this may have on financial planning are dealt with by instituting timely and (it is hoped) effective systems of reporting, contingency planning, and other management coordinating devices.

4. Recognize that role conflicts may be reduced by restructuring the budgeting system itself.In the case of rolling budgets and adjustable budgets, role conflict is reduced by recycling the budgeting process several times during the year. This recycling allows for the input of continually updated information to the planning process. It also allows for the explicit consideration of unforeseen or uncontrollable factors that would not be part of the process of setting the budgeted objectives in a more conventional budgeting system. Motivation is maintained through the use of fixed (or, in the case of adjustable budgets, variable according to known criteria) standards.

Where regular revised forecasts are submitted, role conflicts can be reduced both by providing continually updated information for the planning process and by partially basing the evaluation of performance on a comparison of actual results with latest forecast.

1. Robert N. Anthony, John Dearden, and Richard F. Vancil,Management Control Systems: Text, Cases and Readings,rev. ed. (Homewood, Ill.: Richard D. Irwin, 1972), p. 4.

2. Charles T. Horngren,Cost Accounting: A Managerial Emphasis,3d ed., (Englewood Cliffs, N.J.: Prentice-Hall, 1972), p. 167.

A version of this article appeared in theJuly 1977issue ofHarvard Business Review.

M. Edgar Barrettis professor of business administration at Southern Methodist University in Dallas, Texas. He was formerly associate professor of business administration at Harvard Business School, assigned to the International Senior Managers Program in Switzerland.

Questions.

1. Summarize this article, pointing out its relevance and weakness in the context of budgeting and financial planning.
2. I identify the conflicting role of budgeting as discussed the authors and propose ways of resolving those conflicts to achieving the strategic plan of the organization
3. .From the article, how relevant is budgeting in addressing the various needs of the corporation.