Kaizen is the practice of continually improving processes and reducing costs. The concept tends to yield gradual improvements over a long period of time. This concept can be applied to budgeting by incorporating expected cost reductions into the planned results of a business. This approach can be used to drive down costs below their current levels on a continual basis.
Kaizen budgeting calls for a great deal of planning by management, since they must commit sufficient time and resources to the examination of all aspects of the business, locate possible improvement projects, and ensure that these projects are successfully completed. Also, the costs of these improvement projects must be factored into the budget, along with the expected kaizen savings.
The amount of cost reductions due to kaizen activities can be budgeted based on specific planned improvement projects. However, the budget period likely covers a year, and the improvement projects may cover much shorter time periods, so it is difficult to link specific improvements to the entire budget period. An alternative is to enter the historical percentage of cost reductions into the budget, and rely upon ongoing kaizen activities to approximately match the budgeted cost reduction amount.
The inclusion of kaizen cost reductions in the budget is useful for judging the performance of managers, by matching budgeted expectations to the actual cost reductions that they generate over time. This information can be used in the consideration of promotions, as well as for bonus issuances.
There are two key problems with the use of kaizen budgeting, which are:
- It may be easier to achieve cost reductions during the first few years, when "low hanging fruit" can be located; after these initial cost reductions are achieved, the percentage of kaizen-triggered cost reductions may decline, which places increased pressure on managers to perform.
- If kaizen-related cost reductions cannot be achieved, budgeted profits and cash flows may not even be remotely achievable, resulting in considerable unfavorable variances from the budget.