Section B – TWO questions ONLY to be attempted
Perkin manufactures electronic components for export worldwide, from factories in Ceeland, for use in smartphones and hand held gaming devices. These two markets are supplied with similar components by two divisions, Phones Division (P) and Gaming Division (G). Each division has its own selling, purchasing, IT and research and development functions, but separate IT systems. Some manufacturing facilities, however, are shared between the two divisions.
Perkin’s corporate objective is to maximise shareholder wealth through innovation and continuous technological improvement in its products. The manufacturers of smartphones and gaming devices, who use Perkin’s components, update their products frequently and constantly compete with each other to launch models which are technically superior.
Perkin has a well-established incremental budgeting process. Divisional managers forecast sales volumes and costs months in advance of the budget year. These divisional budgets are then scrutinised by the main board, and revised significantly by them in line with targets they have set for the business. The finalised budgets are often approved after the start of the accounting year. Under pressure to deliver consistent returns to institutional shareholders, the board does not tolerate failure by either division to achieve the planned net profit for the year once the budget is approved. Last year’s results were poor compared to the annual budget. Divisional managers, who are appraised on the financial performance of their own division, have complained about the length of time that the budgeting process takes and that the performance of their divisions could have been better but was constrained by the budgets which were set for them.
In P Division, managers had failed to anticipate the high popularity of a new smartphone model incorporating a large screen designed for playing games, and had not made the necessary technical modifications to the division’s own components. This was due to the high costs of doing so, which had not been budgeted for. Based on the original sales forecast, P Division had already committed to manufacturing large quantities of the existing version of the component and so had to heavily discount these in order to achieve the planned sales volumes.
A critical material in the manufacture of Perkin’s products is silver, which is a commodity which changes materially in price according to worldwide supply and demand. During the year supplies of silver were reduced significantly for a short period of time and G Division paid high prices to ensure continued supply. Managers of G Division were unaware that P Division held large inventories of silver which they had purchased when the price was much lower.
Initially, G Division accurately forecasted demand for its components based on the previous years’ sales volumes plus the historic annual growth rate of 5%. However, overall sales volumes were much lower than budgeted. This was due to a fire at the factory of their main customer, which was then closed for part of the year. Reacting to this news, managers at G Division took action to reduce costs, including closing one of the three R&D facilities in the division.
However, when the customer’s factory reopened, G Division was unwilling to recruit extra staff to cope with increased demand; nor would P Division re-allocate shared manufacturing facilities to them, in case demand increased for its own products later in the year. As a result, Perkin lost the prestigious preferred supplier status from their main customer who was unhappy with G Division’s failure to effectively respond to the additional demand. The customer had been forced to purchase a more expensive, though technically superior, component from an alternative manufacturer.
The institutional shareholders’ representative, recently appointed to the board, has asked you as a performance management expert for your advice. ‘We need to know whether Perkin’s budgeting process is appropriate for the business, and how this contributed to last year’s poor performance’, she said, ‘and more importantly, how do we need to change the process to prevent this happening in the future, such as a move to beyond budgeting.’
Required:
(a) Evaluate the weaknesses in Perkin’s current budgeting system and whether it is suitable for the environment in which Perkin operates. (13 marks)
(b) Evaluate the impact on Perkin of moving to beyond budgeting. (12 marks)
Tutor note: This is a detailed solution and candidates would not be expected to produce an answer of this length.
(a) Weaknesses in the current budget process at Perkin
Perkin uses a traditional approach to budgeting, which has a number of weaknesses.
First of all the budgeting system does not seem aligned with Perkin’s corporate objective which focuses on innovation and continuous product improvement. Innovation is a key competitive advantage to both component and device manufacturers in this industry and the products which incorporate Perkin’s components are subject to rapid technological change as well as changes in consumer trends. The markets in which the two divisions operate appear to be evolving, as seen by the high popularity of the smartphone model which was designed for playing games. This may mean the distinction between smartphone and gaming devices could be becoming less clear cut. Management time would probably be better spent considering these rapid changes and currently the budgeting process does not facilitate that.
In reality, the budget process at Perkin is time consuming and probably therefore a costly exercise. Divisional budgets go through a lengthy process of drafting and then revision by the main board before they are approved. The approval often happens after the start of the period to which they relate, at which point the budgets are already out of date. This also means divisional managers are trying to plan activities for the next financial year without a set of finalised targets agreed, which could impact the effectiveness of decisions made.
Another weakness is that the budgets are only prepared annually, which is clearly too infrequent for a business such as Perkin. The process is also rigid and inflexible as deviations from the planned targets are not tolerated. Sticking to rigid, annual budgets can lead to problems such as P Division not being able to cope with increasing popularity of a particular product and even other short-term changes in demand like those driven by seasonal factors, or one-off events such as the factory fire. Linked to this problem of budgetary constraints is that to cut costs to achieve the budgeted net profit, managers closed one of the three research and development facilities in G Division. As identified at the outset, a successful research and development function is a key source of long-term competitive advantage to Perkin.
It also appears that Perkin fails to flex the budgets and consequently the fixed budgets had discouraged divisional managers from deviating from the original plan. P Division did not make technical modifications to its components due to the cost of doing so, which meant they were unable to supply components for use in the new model of smartphone and had to discount the inventories of the old version. It is unclear why G Division did not take on additional staff to cope with increased demand following reopening of their customer’s factory, but it may be because managers felt constrained by the budget. This then caused long-term detriment to Perkin as they lost the preferred supplier status with their main customer.
Another problem created by annual budgeting is the management of short-term changes in costs and prices. A key component of Perkin’s products is silver, which fluctuates in price, and though it is not clear how much effect this has on Perkin’s costs, any problems in supply could disrupt production even if only a small amount of silver were required. Also Perkin exports goods worldwide and probably also purchases materials, including silver, from overseas. The business is therefore exposed to short-term movements in foreign currency exchange rates which may affect costs and selling prices.
Similarly, there also seems to be considerable uncertainty in sales volumes and prices which creates problems in the forecasting process for the two divisions. P Division did not anticipate the high demand for the new component which meant P Division had to discount products it had already manufactured in order to achieve its forecast sales volumes. G Division did correctly forecast the demand, but based on past growth in the market which may be too simplistic in a rapidly changing industry. Lack of up-to-date information will hinder decision-making and overall performance at Perkin. Perkin would perhaps be better adopting a rolling basis for forecasting.
The two divisions share manufacturing facilities and are likely to compete for other resources during the budgeting process. The current budgeting system does not encourage resource, information or knowledge sharing, for example, expertise in forecasting silver requirements. Divisional managers are appraised on the financial performance of their own division and hence are likely to prioritise the interests of their own division above those of Perkin as a whole. P Division would not re-allocate its manufacturing facilities to G Division, even though G Division needed this to cope with extra demand following reopening of the customer’s factory. The current system is therefore not encouraging goal congruence between the divisions and Perkin as a whole and a budgeting system, if done effectively, should encourage co-ordination and co-operation.
Managers may find the budgeting process demotivating because it is time-consuming for them and then the directors override the forecast which they had made. It is also unfair and demotivating to staff to appraise them on factors which are outside their control. This also identifies another weakness in Perkin’s budgeting system related to control as there does not seem to be any planning and operating variance analysis performed to assess exactly where performance is lacking and so no appropriate management information is provided. In fact it is not even clear just how often divisional managers receive reports on performance throughout the year. Any budgeting system without regular feedback would be ineffective. It should even be noted that for the industry in which Perkin operates the use of only budgetary targets as a measure of performance is narrow and internal. It should be utilising information from external sources as well to assess performance in a more relevant and contextual way.
Given the rapidly changing external environment and the emphasis on innovation and continuous product development, the current traditional budgeting method does not seem appropriate for Perkin.
(b) Beyond budgeting moves away from traditional budgeting processes and is suitable for businesses operating in a rapidly changing external environment and has the following features:
1. Encourages management to focus on the present and the future. Performance is assessed by reference to external benchmarks, utilising rolling forecasts and more non-financial information. This encourages a longer term view.
2. More freedom is given to managers to make decisions, which are consistent with the organisation’s goals and achieving competitive success.
3. Resources are made available on demand, for example, to enable a division to take advantage of an opportunity in the market, rather than being constrained by budgets.
4. Management focus is switched to the customer and managers are motivated towards actions which benefit the whole organisation, not just their own divisions.
5. Effective information systems are required to provide fast and easily accessible information across the whole organisation to allow for robust planning and control at all levels.
Taking each of the elements of beyond budgeting in turn, the impact of introducing this technique into Perkin can be assessed.
At Perkin, there are rapid technological changes in the products being produced by customers and competitors as a result of changes demanded by the market, which mean that Perkin must respond and continuously innovate and develop its products. This will support Perkin’s corporate objective. Consequently, this means that Perkin must change its plans frequently to be able to compete effectively with other component manufacturers and therefore will need to move away from annual incremental budgeting to introducing regular rolling forecasts. This process will need supporting by KPIs which will have a longer term focus. The impact of this will be that Perkin will need to develop a coherent set of strategies which supports its corporate objective, which will then need to be translated into targets and appropriate KPIs selected and developed. It will also mean that performance measures at the operational level will need to be revised from annual budgetary targets to these longer term objectives. Management at all levels will require training on the production of rolling forecasts and Perkin will need to assess if additional resources will also be required to run this new system.
Beyond budgeting focuses on the long-term success of the business by division managers working towards targets which may be non-financial. The use of external benchmarks and non-financial information will mean Perkin will need to put processes in place to collect this information and analyse it to assess performance. This will be a learning process as Perkin does not currently do this. The status of preferred supplier with key customers, for example, would be important to the long-term success of the business and this could be an objective which Perkin sets for its divisional managers.
Beyond budgeting allows authority to be delegated to suitably trained and supported managers to take decisions in the long-term interests of the business. It allows managers to respond quickly and effectively to changes in the external environment, and encourages them to develop innovative solutions to external change. In Perkin, budgets proposed by divisional managers are changed by the board to reflect its overall plans for the business. This means that a change in the approach to communication between the board and the divisions will be necessary as Perkin would need to switch from the top down process currently adopted to a more devolved decision-making structure. This will again require training for management to enable them to be ready to deal with this delegated authority as it will be very different from their existing approach.
Traditional budgeting may constrain managers who are not allowed to fail to meet the approved budget. This can be seen when P Division did not adapt its components because it did not want to incur the costs of doing so, which had not been budgeted for. Similarly, prices of raw materials are known to be volatile. Beyond budgeting makes resources available for managers to take advantage of opportunities in the market, such as the smartphone designed for playing games. Managers would also be able to react to changes in the price of materials or changes in foreign currency exchange rates, for example, by having the authority to purchase silver for inventory at times when the price of silver is low. This will mean that as a result there will be fewer budgetary constraints; however, these resources and targets will still need to be effectively managed. This management will mean that strategic initiatives invested in will need monitoring rather than closely scrutinising departmental budgets, which will be a significant change in Perkin.
In Perkin, the two divisions share some manufacturing facilities and are likely to compete for other resources, for example, when setting budgets. When manufacturing facilities are in short supply, each division will prioritise its own requirements rather than those of the business as a whole. Beyond budgeting encourages managers to work together for the good of the business and to share knowledge and resources. This is important in a business such as Perkin where product innovation is key and where the activities and products of the two divisions are similar. This coordinated approach will be new to Perkin so there will be a culture change. Also, the customer-oriented element of beyond budgeting is key here and will require the setup of customer focused teams which will require more harmonised actions in the divisions.
Each division currently has its own IT systems. In order to effectively share knowledge and to be able to respond to the external environment, which are key elements of beyond budgeting, it would be preferable for them to have shared IT facilities. This will mean that Perkin may have to invest in new technology capable of sharing information across the organisation in a rapid and open fashion but also be able to collect all relevant comparative data to allow for continuous monitoring of performance. This will facilitate better planning and control across all levels of Perkin.
With appropriate training of managers and investment in information systems, it would be relevant for Perkin to adopt beyond budgeting because of the rapid changes in the external environment in which it operates.