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Using Budgets to Achieve Organizational Objectives

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Title: Using Budgets to Achieve Organizational Objectives


1
Using Budgets to Achieve Organizational Objectives
  • Chapter 10

2
Resource Flexibility
  • In many business decisions, especially decisions
    affecting the short-term, the firms
    capacity-related costs are considered as given
    and fixed
  • Relevant costs in the short run are flexible
    costs
  • Ideally, the supply of capacity resources is
    based on the amount needed to produce the
    projected volume of product
  • The budgeting process makes clear that some
    resources, once acquired, cannot be disposed of
    easily if demand is less than expected

3
The Budgeting Process (1 of 5)
  • The process that determines the planned level of
    most flexible costs
  • Budgeting for capacity-related resources is
    discussed as a separate topic in another chapter
  • Budgeting also includes discretionary spending
    such as for RD, advertising, and employee
    training
  • These do not supply the firm with capacity but
    they do provide support for the organizations
    strategy by enhancing its performance potential
  • Once authorized, discretionary spending budgets
    are committed or fixed they do not vary with
    level of production or service

4
The Budgeting Process (2 of 5)
  • Budgets serve as a control for managers within
    the business units of an organization
  • Planning and control are the core of the design
    and operation of management accounting systems
  • Budgets play a central role in the relationship
    between planning and control
  • Budgets reflect in quantitative terms how to
    allocate financial resources to each part of an
    organization, based on the planned activities and
    short-run objectives of that part of the
    organization

5
The Budgeting Process (3 of 5)
  • A budget is a quantitative expression of the
    money inflows and outflows that reveal whether a
    financial plan will meet organizational
    objectives
  • Budgeting is the process of preparing budgets
  • Budgets provide a way to communicate the
    organizations short-term goals to its members

6
The Budgeting Process (4 of 5)
  • Budgeting the activities of each unit can
  • Reflect how well unit managers understand the
    organizations goals
  • Provide an opportunity for the organizations
    senior planners to correct misperceptions about
    the organizations goals
  • Budgeting also serves to coordinate the many
    activities of an organization
  • In this sense, budgeting is a tool that forces
    coordination of the organizations activities and
    helps identify coordination problems

7
The Budgeting Process (5 of 5)
  • Budgets help to anticipate potential problems and
    can serve to help provide solutions
  • Budgeting reflects the cash cycle and provides
    information to help the organization plan any
    borrowing needed to finance the inventory buildup
    early in the cash cycle
  • If budget planning indicates that the
    organizations sales potential exceeds its
    manufacturing potential, then the organization
    can develop a plan to put more capacity in place
    or to reduce planned sales
  • Managers need to be able to anticipate problems
    since putting new capacity in place can take
    several months to several years

8
Forecasting Demand for Resources (1 of 2)
  • Budgeting involves forecasting the demand for
    four types of resources over different time
    periods
  • Flexible resources that create variable costs (or
    flexible costs)
  • May be acquired or disposed of in the short term
  • Intermediate-term capacity resources that create
    capacity-related costs
  • For example, forecasting the need for rental
    storage space that might be contracted on a
    quarterly, semi-annual, or annual basis

9
Forecasting Demand for Resources (2 of 2)
  • Resources that, in the intermediate and long run
    enhance the potential of the organizations
    strategy
  • Discretionary expenditures, which include
    research and development, employee training,
    maintenance of capacity resources, advertising,
    and promotion
  • Long-term capacity resources that create
    capacity-related costs
  • For example, a new fabrication facility for a
    computer chip manufacturer, which might take
    several years to plan and build and might be used
    for ten years

10
Master Budget
  • Two major types of budgets comprise the master
    budget
  • Operating budgets
  • Summarize the level of activities such as sales,
    purchasing, and production
  • Financial budgets
  • Identify the expected financial consequences of
    the activities summarized in the operating budgets

11
Operating Budgets (1 of 3)
  • The sales plan
  • Identifies the planned level of sales for each
    product
  • The capital spending plan
  • Specifies the long-term capital investments, such
    as buildings and equipment, that must be paid in
    the current budget period to meet activity
    objectives
  • The production plan
  • Schedules all required production
  • The materials purchasing plan
  • Schedules all required purchasing activities

12
Operating Budgets (2 of 3)
  • The labor hiring and training plan
  • Specifies the number of people the organization
    must hire or release to achieve its activity
    objectives, as well as all hiring and training
    policies
  • The administrative and discretionary spending
    plan
  • Includes administration, staffing, research and
    development, and advertising
  • These plans specify the expected resource
    requirements of selling, capital spending,
    manufacturing, purchasing, labor management, and
    administrative activities during the budget period

13
Operating Budgets (3 of 3)
  • Operations personnel use the plans represented in
    the operating budget to guide and coordinate the
    level of various activities during the budget
    period
  • Operations personnel also record data from
    current operations that can be used to develop
    future budgets

14
Financial Budgets
  • Planners prepare the financial budgets to
    evaluate the financial consequences of
    investment, production, and sales plans
  • Projected balance sheet
  • Projected income statement
  • Projected statement of cash flows
  • Planners use the projected statement of cash
    flows in two ways
  • To plan when excess cash will be generated
  • They can use it to make short-term investments
    rather than simply holding cash
  • To plan how to meet any cash shortages

15
Demand Forecast
  • An organizations goals provide the starting
    point and the framework for evaluating the
    budgeting process
  • To assess the plans acceptability, planners
    compare the tentative operating plans projected
    financial results with the organizations
    financial goals
  • The budgeting process is influenced strongly by
    the demand forecast
  • An estimate of sales demand at a specified
    selling price

16
Developing the Demand Forecast
  • Organizations develop demand forecasts in many
    ways
  • Market surveys conducted either by outside
    experts or by internal sales staff
  • Statistical models to generate demand forecasts
    from trends and forecasts of economic activity in
    the economy and the relation of past sales
    patterns to this economic activity
  • Assume that demand will either grow or decline by
    some estimated rate over previous demand levels
  • Regardless of the approach used, the organization
    must prepare a sales plan for each key line of
    goods and services

17
Importance of Sales Plans
  • The sales plans provide the basis for other plans
    to acquire the necessary factors of production
  • Labor
  • Materials
  • Production capacity
  • Cash
  • Because production plans are sensitive to the
    sales plans, most organizations develop budgets
    on computers
  • Planners can readily explore the effects of
    changes in the sales plans on production plans

18
Level of Detail in Budget (1 of 2)
  • Choosing the amount of detail to present in the
    budget involves making trade-offs
  • More detail in the forecast improves the ability
    of the budgeting process to identify potential
    bottlenecks and problems by specifying the exact
    timing of production flows
  • Forecasting and planning in great detail for each
    item can be extremely expensive and overwhelming
    to compute

19
Level of Detail in Budget (2 of 2)
  • Production planners use their judgment to strike
    a balance between
  • The need for detail
  • The cost and practicality of detailed scheduling
  • Planners do this by grouping products into pools
  • Each product in a given pool places roughly
    equivalent demands on the organizations
    resources
  • Planning is simplified

20
The Production Plan
  • Planners determine a production plan by matching
    the completed sales plan with the organizations
    inventory policy and capacity level
  • The plan identifies the intended production
    during each of the interim periods comprising the
    annual budget period
  • Interim periods may be defined as days, weeks, or
    months
  • Depending on how regularly the people managing
    the acquisition, manufacturing, selling, and
    distribution activities need information

21
Inventory Policy (1 of 3)
  • The inventory policy is critical and has a unique
    role in shaping the production plan
  • Planners use the inventory policy and the sales
    plan to develop the production plan
  • One policy is to produce goods for inventory and
    attempt to keep a target number of units in
    inventory at all times
  • This level production strategy is characteristic
    of an organization with highly skilled employees
    or equipment dedicated to producing a single
    product
  • Reflects a lack of flexibility

22
Inventory Policy (2 of 3)
  • Another inventory policy is to produce for
    planned sales in the next interim period within
    the budget period
  • Organizations moving toward a just-in-time
    inventory policy produce goods to meet the next
    interim periods demand as an intermediate step
    in moving to a full just-in-time inventory system
  • Each interim period becomes shorter and shorter
    until the organization achieves just-in-time
    production
  • The scheduled production is the amount required
    to meet the inventory target of the level of the
    next interim periods planned sales

23
Inventory Policy (3 of 3)
  • Another inventory policy is a just-in-time (JIT)
    inventory policy
  • In a JIT inventory strategy, demand directly
    drives the production plan
  • Production in each interim period equals the next
    interim periods planned sales
  • A JIT inventory policy requires
  • Flexibility among employees, equipment, and
    suppliers
  • A production process with little potential for
    failure

24
Aggregate Planning
  • Aggregate planning compares
  • The production plan
  • The amount of available productive capacity
  • This comparison assesses the feasibility of the
    proposed production plan
  • It does not develop a detailed production
    schedule to guide daily production in the
    organization
  • It determines whether the proposed production
    plan can be achieved by the capacity the
    organization either has in place or can put in
    place during the budget period
  • Planners may need to consider ways to modify
    existing facilities

25
The Spending Plan (1 of 4)
  • Once planners identify a feasible production
    plan, they may make tentative resource
    commitments
  • The purchasing group prepares a plan to acquire
    the required raw materials and supplies
  • Since sales and production plans change, the
    organization and its suppliers must be able to
    adjust their plans quickly based on new
    information
  • At some point the plans have to be locked in
    place and no additional changes made
  • For example, commitment to a production schedule
    in a large automotive assembly plant occurs about
    eight weeks before production takes place
  • Provides managers the time to put raw materials
    supply in place and schedule the production

26
The Spending Plan (2 of 4)
  • The personnel and production groups prepare the
    labor hiring and training plans
  • Works backward from the date when the personnel
    are needed to develop hiring and training
    schedules that will ensure the availability of
    the needed personnel
  • When an organization is contracting, it will
  • Use retraining plans to redeploy employees to
    other parts of the organization, or
  • Develop plans to discharge employees
  • Because they involve moral, ethical, and legal
    issues and may involve high severance costs,
    layoffs are usually avoided unless no alternative
    can be found

27
The Spending Plan (3 of 4)
  • Other decision makers in the organization prepare
    an administrative and discretionary spending plan
  • Summarizes the proposed expenditures on
    activities such as for RD, advertising, and
    training
  • Discretionary expenditures provide the required
    infrastructure for the proposed production and
    sales plan
  • Discretionary means the actual sales and
    production levels do not drive the amount spent
  • The senior managers in the organization determine
    the amount of discretionary expenditures
  • Once determined, the amount to be spent on
    discretionary activities becomes fixed for the
    budget period and is unaffected by product volume
    and mix

28
The Spending Plan (4 of 4)
  • The appropriate authority approves the capital
    spending plan to acquire new productive capacity
  • A long-term planning process rather than the
    one-year cycle of the operating budget drives the
    capital spending plan
  • Capital spending projects usually involve time
    horizons longer than the period of the operating
    budget

29
Choosing Capacity Levels (1 of 4)
  • Three types of resources determine capacity
  • Flexible resources that the organization can
    acquire in the short term
  • If suppliers do not deliver the resources or
    deliver unacceptable products, production may be
    disrupted
  • Capacity resources that the organization must
    acquire for the intermediate term
  • Capacity resources that the organization must
    acquire for the long term
  • The level chosen reflects the organizations
    assessment of its long-term growth trend

30
Choosing Capacity Levels (2 of 4)
  • Organizations develop sophisticated approaches to
    balance the use of short, intermediate, and
    long-term capacity to minimize the waste of
    resources
  • We may classify resource-consuming activities
    into three groups
  • Activities that create the need for resources
    (and resource expenditures) in the short-term
  • Activities undertaken to acquire capacity for the
    intermediate-term
  • Activities undertaken to acquire capacity needed
    for the long-term
  • Planners classify activities by type because they
    plan, budget, and control short, intermediate,
    and long-term expenditures differently

31
Choosing Capacity Levels (3 of 4)
  • Analysts evaluate short-term activities by
    considering efficiency and asking
  • Is this expenditure necessary to add to the
    product value perceived by customers?
  • Can the organization improve how it does this
    activity?
  • Would changing the way this activity is done
    provide more satisfaction to the customer?
  • Choosing the production plan (i.e., choosing the
    level of the short-term activities) fixes the
    short-term expenditures that the master budget
    summarizes

32
Choosing Capacity Levels (4 of 4)
  • Analysts evaluate intermediate- and long-term
    activities by using efficiency and effectiveness
    considerations and asking
  • Are there alternative forms of capacity available
    that are less expensive?
  • Is this the best approach to achieve our goals?
  • How can we improve the capacity selection
    decision to make capacity less expensive or more
    flexible?
  • Choosing the capacity plan (i.e., making the
    commitments to acquire intermediate and long-term
    capacity) commits the firm to its intermediate
    and long-term expenditures

33
Handling Infeasible Production Plans
  • Planners use forecasted demand to plan activity
    levels and provide required capacity
  • If planners find the tentative production plan
    infeasible, then they have to make provisions to
  • Acquire more capacity, or
  • Reduce the planned level of production
  • Occurs when projected demand exceeds available
    capacity

34
Interpreting The Production Plan
  • Production is the lesser of
  • Total demand
  • Production capacity
  • Demand is the quantity customers are willing to
    buy at the stated price
  • Production capacity is the minimum of
  • The long-term capacity
  • The intermediate-term capacity
  • The short-term capacity

35
The Financial Plans
  • Once the planners have developed the production,
    staffing, and capacity plans, they can prepare a
    financial summary of the tentative operating
    plans
  • The projected balance sheet serves as an overall
    evaluation of the net effect of operating and
    financing decisions during the budget period
  • The income statement serves as an overall test of
    the profitability of the proposed activities
  • A cash flow forecast helps an organization
    identify if and when it will require external
    financing

36
The Cash Flow Statement
  • The cash flow statement has three sections
  • Cash inflows from cash sales and collections of
    receivables
  • Cash outflows
  • For flexible resources that are acquired and
    consumed in the short term
  • For capacity resources that are acquired and
    consumed in the intermediate and long term
  • Results of financing operations

37
Financing Operations
  • Summarizes the effects on cash of transactions
    that are not a part of the normal operating
    activities
  • Includes the effects of
  • Issuing or retiring stock or debt
  • Buying or selling capital assets
  • Short-term financing
  • Often involves obtaining a line of credit,
    secured or unsecured, with a financial
    institution
  • The line of credit allows a company to borrow up
    to a specified amount at any time

38
Using The Financial Plans (1 of 2)
  • Organizations can raise money from outsiders by
    borrowing from banks, issuing debt, or selling
    shares of equity
  • Based on the information provided by the cash
    flow forecast, organizations can plan the
    appropriate mix of external financing to minimize
    the long-run cost of capital

39
Using The Financial Plans (2 of 2)
  • A cash flow forecast helps an organization
  • Identify if and when it will require external
    financing
  • Determine whether any projected cash shortage
    will be
  • Temporary or cyclical
  • Can be met by a line-of-credit arrangement, or
  • Permanent
  • Would require a long-term loan from a bank,
    further investment by the current owners, or
    investment by new owners (or a combination)

40
What If Analysis
  • Using a computer for the budgeting process,
    managers can explore the effects of alternative
    marketing, production, and selling strategies
  • For example, a manager may consider raising
    prices, opening a retail outlet, or using
    different employment strategies
  • Alternative proposals like these can be evaluated
    in a what-if analysis
  • The structure and information required to prepare
    the master budget can be used easily to provide
    the basis for what-if analyses

41
Sensitivity Analysis (1 of 2)
  • What-if analysis is only as good as the model
    used to represent what is being evaluated
  • The model must be complete, it must reflect
    relationships accurately, and it must use
    accurate estimates
  • Otherwise, it will not provide good estimates of
    a plans results
  • Planners test planning models by varying the
    model estimates
  • If small changes in an estimate used in the
    production plan have a dramatic effect on the
    plan, the model is said to be sensitive to that
    estimate

42
Sensitivity Analysis (2 of 2)
  • Sensitivity analysis is the process of
    selectively varying a plans or a budgets key
    estimates for the purpose of identifying over
    what range a decision option is preferred
  • Sensitivity analysis enables planners to identify
    the estimates that are critical for the decision
    under consideration

43
Variance Analysis (1 of 2)
  • To help interpret production and financial
    outcomes, organizations compare planned (or
    budgeted) results with actual results
  • A process called variance analysis
  • Variance analysis has many forms and can result
    in complex measures, but its basis is very
    simple
  • An actual cost (or revenue) amount is compared
    with a target cost (or revenue) amount to
    identify the difference

44
Variance Analysis (2 of 2)
  • Accountants call the difference a variance
  • A variance represents a departure from what was
    budgeted or planned
  • An investigation will try to determine
  • What caused the variance
  • What should be done to correct that variance

45
Sources of Budgeted Costs
  • Budgeted or planned costs can come from three
    sources
  • Standards established by industrial engineers
  • Such as cost of steel that should go into the
    door of an automobile based on the doors
    specifications
  • Previous periods performance
  • For example, the cost of steel per door that was
    made in the last budget period
  • A benchmark, the best in class results achieved
    by a competitor
  • The cost of steel per comparable door achieved by
    the competitor that is viewed as the most
    efficient

46
Variances (1 of 4)
  • The financial numbers are the product of a price
    and a quantity component
  • Budgeted amount expected price expected
    quantity
  • Actual amount actual price actual quantity
  • Variance analysis explains the difference between
    planned and actual costs by evaluating
  • Differences between planned and actual prices
  • Differences between planned and actual quantities

47
Variances (2 of 4)
  • Accountants focus separately on prices and
    quantities because in most organizations
  • One department or division is responsible for the
    acquisition of a resource
  • Determining the actual price
  • A different department uses the resource
  • Determining the quantity
  • A variance is a signal that is part of a control
    system for monitoring results
  • A variance provides a signal that operations did
    not go as planned

48
Variances (3 of 4)
  • Supervisory personnel use variances as an overall
    check on how well the people who are managing
    day-to-day operations are doing what they should
    be doing
  • When compared to the performance of other
    organizations engaged in comparable tasks,
    variances show the effectiveness of the control
    systems that operations people are using

49
Variances (4 of 4)
  • If managers learn that specific actions they took
    helped lower the actual costs, then they can
    obtain further cost savings by repeating those
    actions on similar jobs in the future
  • If they can identify the factors causing actual
    costs to be higher than expected, then they may
    be able to take the necessary actions to prevent
    those factors from recurring in the future
  • If they learn that cost changes are likely to be
    permanent, they can update their cost information
    when bidding for future jobs

50
First-Level Variances
  • The first-level variance for a cost item is the
    difference between the actual costs and the
    master budget costs for that cost item
  • Variances are favorable (F) if the actual costs
    are less than estimated master budget costs
  • Unfavorable (U) variances arise when actual costs
    exceed estimated master budget costs

51
Planning Variances
  • A flexible budget adjusts the forecast in the
    master budget for the difference between planned
    volume and actual volume
  • It reflects a cost target based on the level of
    volume that is actually achieved, rather than the
    planned volume that underlies the master budget
  • Cost differences between the master and the
    flexible budget are called planning variances
  • They reflect the difference between planned
    output and actual output
  • They arise entirely because the planned volume of
    activity was not realized

52
Flexible Budget Variances
  • Flexible budget variances are the differences
    between the flexible budget and the actual
    results
  • Reflect variances from the target level of costs
    adjusted for the actual level of activity
  • A managers focus should be on these variances to
    determine whether cost-cutting activities have
    been successful
  • Flexible budget variances reflect
  • Quantity variances -- the difference between the
    planned and the actual use rates per unit of
    output
  • Cost variances -- the difference between the
    planned and the actual price or cost per unit of
    the various cost items

53
Second Third-Level Variances
  • The second-level variances are the planning
    variance and the flexible budget variance
  • Together they add up to the first-level variance
  • The direct material flexible budget variances and
    direct labor flexible budget variances can be
    decomposed further into third-level variances
  • Efficiency variances
  • Price variances
  • Together they explain the flexible budget
    component of the second-level variance

54
Direct Material Variances (1 of 2)
  • The material quantity variance is calculated as
  • Quantity variance (AQ-SQ) x SP
  • Where
  • AQ actual quantity of materials used
  • SQ standard (estimated) quantity of materials
    required
  • SP standard (estimated) price of materials

55
Direct Material Variances (2 of 2)
  • The material price variance is calculated as
  • Price variance (AP-SP) x AQ
  • Where
  • AP actual price of materials
  • SP standard (estimated) price of materials
  • AQ actual quantity of materials used
  • The sum of these two second-level variances is
    the total flexible budget variance for direct
    materials
  • The price variance may, however, be calculated
    using the quantity purchased rather than the
    quantity used

56
Direct Labor Variances
  • The labor cost variances are determined in a
    manner similar to the material quantity and price
    variances
  • Efficiency variance (AH-SH) x SR
  • Rate variance (AR-SR) x AH
  • Where
  • AH actual number of direct labor hours
  • AR actual wage rate SR standard rate
  • SH standard (estimated) number of direct labor
    hours
  • The sum of the rate variance and the efficiency
    variance equals the total flexible budget direct
    labor variance

57
Support Activity Cost Variances (1 of 2)
  • Support costs can reflect either flexible or
    capacity-related costs
  • The quantity of capacity-related costs may not
    change from period to period, but the spending on
    them may fluctuate
  • E.g., engineers can travel, take courses,
    vacation, quit, and be replaced with someone else
  • Monitoring spending variances on capacity-related
    resources is possible and desirable
  • Even if one cannot monitor efficiency variances,
    which will show up as changes in used and unused
    capacity

58
Support Activity Cost Variances (2 of 2)
  • Flexible support costs reflect behind-the-scenes
    operations that are proportional to the volume of
    activity but are not directly a part of the
    product or service provided to the customer
  • For example, an indirect support cost in a
    factory would be the wages paid to employees who
    move work in process around the factory floor as
    the product is being made
  • Flexible support costs consist of a quantity (or
    usage) component and a price component
  • Flexible support cost variances may be analyzed
    in a manner similar to direct material or direct
    labor variances

59
Budgeting In Nonmanufacturing Organizations (1 of
3)
  • As in manufacturing organizations, budgeting
    helps nonmanufacturing organizations perform
    their planning function by coordinating and
    formalizing responsibilities and relationships
    and communicating the expected plans
  • Budgeting serves a slightly different but equally
    relevant role in natural resource companies,
    service organizations, not-for-profit
    organizations, and government agencies

60
Budgeting In Nonmanufacturing Organizations (2 of
3)
  • In the natural resources sector, the focus is on
    balancing demand with the availability of natural
    resources
  • Because the natural resource supply often
    constrains sales, success requires managing the
    resource base effectively to match supply with
    potential demand
  • In the service sector, the focus is on balancing
    demand and the organizations ability to provide
    services, which is determined by the
    organizations level and mix of skills
  • People rather than machines usually represent the
    capacity constraint in the service sector
  • Planning is critical in high-skill organizations
    because people capacity is expensive and services
    cannot be inventoried when demand falls below
    capacity

61
Budgeting In Nonmanufacturing Organizations (3 of
3)
  • In not-for-profit organizations, the focus of
    budgeting has been to balance revenues raised by
    taxes or donations with spending demands
  • In government agencies planned cash outflows, or
    spending plans, are called appropriations
  • Appropriations limit a government agencys
    spending
  • Many governments are looking for ways to
    eliminate unnecessary expenditures and to make
    necessary expenditures more efficient
  • These agencies must establish priorities for
    their expenditures and improve the productivity
    with which they deliver services to constituents

62
Periodic Budgeting
  • The basic budgeting process described in this
    chapter involves many organizational design
    decisions, such as the length of the budget
    process, the basic budget spending assumptions,
    and the degree of top management control
  • In a periodic budget cycle, the planners prepare
    budgets periodically for each planning period
  • Periodic budgeting is typically performed once
    per budget periodusually once a year
  • Planners may, however, update or revise the
    budgets

63
Continuous Budgeting
  • In continuous budgeting, as one budget period
    passes, planners drop that budget period from the
    master budget and add a future budget period in
    its place
  • Usually a month or a quarter
  • The length of the budget period reflects the
    competitive forces, skill requirements, and
    technology changes that the organization faces
  • Long enough for the organization to anticipate
    important environmental changes and adapt to them
  • Short enough to ensure that estimates for the end
    of the period will be reasonable and realistic

64
Periodic v. Continuous Budgeting
  • Advocates of periodic budgeting argue that
    continuous budgeting takes too much time and
    effort and that periodic budgeting provides
    virtually the same benefits at a smaller cost
  • Advocates of continuous budgeting argue that it
    keeps the organization planning, and assessing,
    and thinking, strategically year-round rather
    than just once a year at budget time

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Controlling Discretionary Expenditures
  • Organizations generally use one of three general
    approaches to budget discretionary expenditures
  • Incremental budgeting
  • Zero-based budgeting
  • Project funding
  • Each has benefits distinct from the others

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Incremental Budgeting
  • Incremental budgeting bases a periods
    expenditure level on the amount spent during the
    previous period
  • If the total budget for discretionary items
    increases by 10, then
  • Each discretionary item is allowed to increase
    10, or
  • All items may experience an across-the-board
    increase of, for example, 5 and the remaining 5
    increase may be allocated based on merit
  • Some people have criticized incremental budgeting
    because it does not require justification of the
    organizations goals for discretionary
    expenditures

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Zero-Based Budgeting (1 of 2)
  • Zero-based budgeting (ZBB) requires that
    proponents of discretionary expenditures
    continuously justify every expenditure
  • Zero-based budgeting is not appropriate for
    budgeting that relates to engineered costs that
    vary in proportion to production
  • The starting point for each line item is zero
  • Zero-based budgeting arose, in part, to combat
    indiscriminate incremental budgets where projects
    that take on a life of their own and resist going
    out of existence

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Zero-Based Budgeting (2 of 2)
  • Under ZBB, planners allocate the organizations
    resources to the spending proposals they think
    will best achieve the organizations goals
  • This approach to project budgeting has been used
    primarily to assess government expenditures
  • In profit-seeking organizations, ZBB has been
    applied only to discretionary expenditures
  • Even for engineered costs, ZBB could be effective
    when combined with the reengineering approach
  • Critics of ZBB complain it is expensive because
    it requires so much employee time to prepare

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Project Funding
  • Some critics of ZBB have proposed an intermediate
    solution to mitigate the disadvantages of ZBB and
    incremental budgeting
  • The intermediate solution is called project
    funding
  • A proposal is made for discretionary expenditures
    with a specific time horizon or sunset provision
  • Projects with indefinite lives (sometimes called
    programs) should be continuously reviewed to
    ensure that they are living up to their intended
    purposes
  • Requests to extend or modify the project must be
    approved separately

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Activity-Based Budgeting
  • A recent approach to budgeting is activity-based
    budgeting, which is based on activity-based
    costing
  • Activity-based budgeting uses knowledge about the
    relationship between the quantity of production
    units and the activities required to produce
    those units to develop detailed estimates of
    activity requirements underlying the proposed
    production plan
  • The two main benefits of activity-based budgeting
    are
  • It identifies situations when production plans
    require new capacity
  • It provides a more accurate way to project future
    costs

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Managing the Budgeting Process (1 of 2)
  • Many organizations use a budget team, headed by
    the organizations budget director or the
    controller, to coordinate the budgeting process
  • The budget team usually reports to a budget
    committee, which generally includes the chief
    executive officer, the chief operating officer,
    and the senior executive vice presidents
  • The composition of the budget committee reflects
    the role of the budget as the planning document
    that reflects and relates to the organizations
    strategy and objectives

72
Managing the Budgeting Process (2 of 2)
  • The danger of using a budget committee is that it
    may signal to other employees that budgeting is
    something that is relevant only for senior
    management
  • Senior management must take steps to ensure that
    the organization members affected by the budget
    do not perceive the budget and the budgeting
    process as something beyond their control or
    responsibility

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Behavioral Aspects of Budgeting
  • Because of the human factor involved in the
    process, budgets often do not develop smoothly
  • Social scientists have engaged in extensive study
    about the human factors involved in budgeting
  • Two related areas are of particular importance
    with respect to the behavioral issues they raise
  • Designing the budget process
  • Influencing the budget process

74
Designing the Budget (1 of 2)
  • How should budgets be determined and who should
    be involved in the budgeting process?
  • Three common methods of setting budgets are
  • Authoritarian
  • A superior simply tells subordinates what their
    budget will be
  • Participation
  • All parties agree about setting the budget
    targets, using a joint decision-making process
  • Consultation
  • Managers ask subordinates to discuss their ideas
    about the budget but determine the final budget
    alone

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Designing the Budget (2 of 2)
  • Research shows that the most motivating types of
    budgets are those that are tight
  • With targets that are perceived as ambitious but
    attainable
  • Recently, companies such as Boeing and General
    Electric have implemented what are known as
    stretch targets
  • Stretch targets exceed previous targets by a
    significant amount and usually require an
    enormous increase in a goal over the next
    budgeting period
  • The theory is that only in this manner will
    companies completely reevaluate the ways in which
    they develop and produce products and services

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Influencing The Budget Process
  • When incentives and compensation are tied to the
    budget, some managers have been known to play
    budgeting games in which they attempt to
    manipulate information and targets to achieve as
    high a bonus as possible (or the best evaluation)
  • Participation provides employees the opportunity
    to affect their budgets in ways that may not
    always be in the best interests of the
    organization
  • Subordinates might ask for resources above and
    beyond what they need to accomplish their budget
    objectives

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Budget Slack
  • Budget slack is created by requiring excess
    resources or distorting performance information
  • If subordinates succeed in creating budget slack,
    they will find it easy to meet or exceed their
    budgeted objectives
  • Budgeting games can never be eliminated, although
    some organizations have devised methods to
    decrease the amount of budget slack
  • Management can use a long, iterative process to
    formulate the budget to remove much slack
  • An incentive system may provide higher levels of
    bonuses based on attaining higher targets

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concerning this PowerPoint presentation, please
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