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Zhou 1 Budgeting and the Organizational Knowledge Creation Yongyi Zhou Prof. Turnbull Knowledge Management Systems / INF 385Q December 10, 2008 Zhou 2 Introduction This paper examines the in what ways budgets can keep paces with organizational knowledge creation. It posits that budgets within innovative enterprises have the potential to move forward with organizational knowledge creation. Drawing upon an organizational intention and dovetailing of formal procedures with informal processes give managers the tools to balance the tensions between budgets and the organizational knowledge-creating process. Using research on the budgeting and existing theory of organizational knowledge creation I will examine what are the potential opportunities for firms to align budgeting with the organizational knowledge creating process. Organizational Knowledge Creation Knowledge has begun to gain a new wave of attention in the past two decades. Hamel’s (1990) article sees competencies, capabilities, skills, or strategy has been increasing in recent years. Drucker (1993) argues in his latest book that in the new economy, knowledge is not just another resource alongside the traditional factors of production ---- labor, capital, and land ---but the only meaningful resource today. Not only socio-economic theorists such call for our attention to the importance of knowledge as management resource and power, but also an increasing number of scholars in the fields of industrial organization, technology management, management strategy, and organizational theory have begun to theorize about management of knowledge. Experts of modern management and organizational theory have gotten clearer on seeing knowledge as a resource, a process and an output critical to organizational competitive advantage. The new generation of managers has to release the coils of the traditional Western view of an organization as a machine for "information processing" as they realize that Zhou 3 innovation, in a twenty-first-century environment in which the only certainty is uncertainty, has become a prerequisite for survival. According to Nonanka and Takeuchi (2005), knowledge creating can be as important as processing knowledge. In practice, organizational knowledge creation often comes through crisis, forcing companies to break away from the past and move into new and untried territories of opportunity. Nonanka and Takeuchi contend that Japanese firms are successful “because of their skills and expertise at organizational knowledge creation (2005)”. In other words, Japanese companies are innovative, that is because they create new knowledge and use it to produce successful products and technologies. Budgeting as a Control Tool Budgets started life in the 1920s as tools for managing costs and cash flows in some large industrial organizations. Management literature often describes budgets in terms of a board organizational plan referring to managerial concepts such as planning, coordinating, and control (Evans and Ward, 2005, pg. 407). In general, a finished budget usually requires considerable effort and consists of several basic steps. First, the ongoing and desirable programs will be determined and priorities will be established. Second, the costs of plans for each unit will be estimated in monetary terms so that all the plans can be combined later into a well-balanced program in tune with the institutional goals. In the end, for a given time, the estimates will be compared with the actual results in order to decide whether a major or minor shift in budget allotments is necessary. An organization’s size does not materially affect the basic steps of budgeting, although a large organization may have dozens of internal budgets subsumed under its general budget. Every fiscal year, budget officers will compare the actual performance against what was Zhou 4 expected, making corrections for any significant differences. By combining and coordinating, budgetary controls put subsidiary budgets to effective use in achieving organizational vision, strategic objectives and performance expectations. Budgeting as a Measurement Tool From the 1960s budgets mutated into fixed performance contracts. Companies increasing used accounting results such as costs, net income, or return-on-investment (ROI) not just to keep score, but also to motivate the actions of operating personnel at all levels. By the early 1970s companies began to use financial indicators to manage the business, which led to the increased use of fixed performance contracts as the basis of setting fixed targets against which performance was evaluated and rewarded. The fixed performance contract typically begins with an “earnings” contract between senior executives and external parties and then cascades down the organization in the form of “budget” contracts between senior executives and operating managers. In addition, the budget contract is usually fixed for a period of twelve months. It purpose is to commit a subordinate or team to achieving an agreed-upon outcome and then to enable a superior to control the results against that outcome reserving the right to interfere and change the terms if necessary. Thus, budget contracts range from highly authoritative to highly participative. If used in a responsible way, such contracts provide the basis for a clear understanding between organizational levels and enable senior executives to maintain control over multiple divisions and business units. Budgeting and the Organizational Knowledge Creation Knowledge conversion, according to Nonaka and Takuechi (2005), is the conversion process that brings the knowledge of individual staff members into the organization and puts this Zhou 5 knowledge to effective use in achieving organizational vision, strategic objectives and performance expectations. In order to promote the knowledge conversion/ organizational knowledge sharing, five enabling conditions are required at the organizational level. They are: 1. Intention: Aspiration to goals, fostering commitment by engaging employees in fundamental questions. 2. Autonomy: Letting people act independently as far as possible. 3. Fluctuation and creative chaos: To stimulate interaction between the organization and its outside environment; there is a breakdown that must be overcome, followed by reflection on what happened. 4. Redundancy: The intentional overlapping of information about business activities, management responsibilities and the company as a whole. 5. Requisite variety: An organization’s internal diversity can help the organization deal with the challenges posed by the environment. With these conditions in place, the organization will be providing the proper context for organizational knowledge. The following constructive ideas are based on the five enabling conditions for organizational knowledge creation as well as what I have regarded as some of the central findings from what existing research tells us about how and in what ways managers are able to innovate in a context of budgetary control. These are critical operational considerations that both top managers and front line staff at innovative enterprises, should bear in mind. Operational Considerations for Innovative Enterprises Zhou 6 Inspired by their plausible explanation of five enabling conditions for knowledge creation, in this section I will discuss how and in what ways budgets can keep paces with organizational knowledge creation process: Utilize Organizational Intension: According to the theory of organizational knowledge creation, the innovation is driven by organizational intention, which is defined as an organization’s aspiration to its goals. In other words, in order to facilitate knowledge creation every organization must have a clear direction for the future, generally expressed in terms of its vision, its long-term objectives, and the critical principles or performance expectations. Moreover, efforts to achieve the intention usually take the form of strategy within a business setting. Organizational intention, then, is a combination of lofty aspirations and hard-nosed criteria and standards. As the organizational intention serves as a combination of aspirations and standards, managers would use it at their disposal to resolve potential conflicts involving people’s targets. The emphasis is on ensuring that particular decision is taken with the company’s overall strategy in mind, rather than local targets. Such a view accommodates with the premise that the budgetary system is a central mechanism of control in an organization. As the report on the Better Budgeting forum from CIMA and ICAEW argues, budgeting “provides an overall framework of control without which it would be impossible to management.” Large organizations in particular would struggle to plan, co-ordinate and control without such a framework. In a small company, budget can also provide a roadmap detailing where the business is, where it wants to go and how it can get there. In this perspective, budget does not only server as a tool to development but also a goal for management, which is similar as organizational intention. Zhou 7 Take Matsushita’s Home Bakery as a case in point. A change in design needed to be made in the late stage of development process, which would lead to a postponement of market introduction. However, the organizational intention allowed the manager to justify the decision to incorporate the design change despite the potential loss of revenue. Owning to this decision, the final product maintained the initial quality and price requirement and made a great. In this case, the manager’s budget target might be threatened. However, agreement was to be made in the name of the bigger picture and successfully resolved the tension involving budget and innovation. Therefore, one way to resolve the tension between budget and innovation is to use an organizational intension/overall framework, which helps managers make localized sacrifices so that their budgetary expenditure kept pace with new developments. 1. Give Individuals Autonomy: Effective knowledge creation takes place when individuals within the organization are given and embrace their freedom to act, to make decisions and to have an influence on the organization. Therefore, individuals within the organization must sense that they will be called upon and will be able to answer the call to lead the organization into new territory. More generally, original ideas emanate from autonomous individuals, diffuse within the team, and then become organizational ideas. From the viewpoint of knowledge creation, such an organization is more likely to maintain greater flexibility in acquiring, interpreting, and relating information. Nevertheless, from the viewpoint of budgetary process such autonomy seems to have collided with the “command-and-control” ethos of budgeting. As already mentioned, a budget usually represents an annual fixed performance contract that defines what subordinates must deliver to superiors for the year ahead. People argue that the old command-and-control Zhou 8 ethos of budgeting is a restriction on innovation. This fixed performance contract has brought an enduring criticism of budgets because it stifles human endeavor. However, it should be noted that the autonomy in organizational knowledge-creating process is not simplified as “independence.” In fact, in the business organization the actual work flow requires individuals and groups set their task boundaries by themselves to pursue the ultimate goal. Furthermore, the autonomy is always framed within the higher intention of the organization. In many cases, while companies build mechanisms and support systems to assure the sharing of information to promote knowledge-creating activities, the cost control can also be achieved. Companies who are successful at continuous innovation have found that investments in capability and trust are paying greater dividends than investment in control. 2. Informal and Formal Approaches: Knowledge creation thrives in times of crisis – be it a crisis generated within the operating environment or a crisis generated by organizational intent. In other words, individuals and organizations tend to be more creative when some external stimulus forces them to have to rethink the way they view the world - their mental models, their paradigms, their values – and the way they interact with that world – their attitudes, behaviors, routines. This continuous process of questioning and reconsidering existing premises by individual members of the organization foster organizational knowledge creation. This view is also at variance with one of the premises of budgetary system that is the fixed performance contract. A company who employ budget planning will have to experience the annual cycle of preparing, submitting, negotiating, and finally agreeing upon a budget by department, function, business unit, division, and finally the whole organization. Fluctuation Zhou 9 seems natural to be in sharp contrast to budgeting. However, some researches response to this issue tended to have different conclusions. Based on my research, I found that in many companies managers managed to patch up the inconsistency between individual and organizational targets by emphasizing a team–based approach, with people meeting regularly to monitor the unit cost of products. It is also mentioned by many experts that managers can combine formal and informal communication approaches to influence the decisions and actions of their counterparts, thereby allowing them to achieve their own targets. While formal resolution appears to ensure that organizational needs come before individual targets, factors such as task interdependence, informal control, jurisdictional ambiguity and team-working contribute to the controllability in practice. Without a doubt, decision on whether or not to correct deviations from budget weren’t taken by individuals in a vacuum. Instead, the dovetailing of formal procedures with informal processes supports the resolution of tensions between budgeting and innovation. In the light of knowledge creation, one of the crucial parts of organizational knowledge creation is socialization which emphasis on sharing tacit, hidden knowledge. It is critical because social interaction allows all individuals in the organization to invade each other’s functional boundaries offering new advices and ideas from different perspectives. In addition, by sharing information individuals understand where they stand in the organization and which direction the company is heading to. Hence, interaction in form of discussion and negotiation seems to be a key method to ensure that the needs and implications of innovation are accommodated with in the budgetary process. To sum up, combining formal with informal communication approaches allows all individuals in the organization to invade each other’s functional boundaries and offer ideas Zhou 10 advise or provide new information from different perspectives while influencing the decisions and actions of their counterparts, thereby allowing them to achieve their own targets. Summary In conclusion, the traditional budgeting and responsibility centers, when structured around organizational intent and various support systems, actually encourage managers to interaction with their colleagues and seek the help of others, with the resulting dialogue fostering new ideas and initiatives. This gives managers the tools to reconcile the tensions between budgeting and the organizational knowledge-creating process, thus putting the knowledge to effective use in achieving its long-term objectives and performance expectation. Zhou 11 References  Better Budgeting: A Report on the Better Budgeting forum from CIMA and ICAEW (2004). [Accessed November 15, 2008]; Available: http://www.icaew.com/index.cfm/route/117649/icaew_ga/pdf  Choo, Chun Wei and Nick Bontis. (2002). The strategic management of intellectual capital and organizational knowledge: a collection of readings. New York: Oxford University Press.  Davenport, T. H. and Prusack, L. (1998) Working Knowledge: How Organizations Manage What They Know. Boston, MA, Harvard Business School Press.  Evans, G. E. and Ward, P. L. (2005) Management Basics for Information Professionals. 2nd edition. Business Information Alert.  Malone, T. W. (2004) The Future of Work. Boston, MA: Harvard Business School Press.  Marginson, D., and Ogden, S. (2005). Budgeting and Innovation. Financial Management, April: 29-31.  Nonake, I and Takeuchi, H. (1995) The Knowledge-Creating Company: How Japanese Companies Create the Dynamics of Innovation.  Weinberger, D. (2003) Small Pieces Loosely Joined: A Unified Theory of the Web. Perseus Publishing.