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 Demandfor 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 Demandfor 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

65
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

66
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

67
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

68
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

69
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

70
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

71
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

73
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

75
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

76
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

77
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

78
If you have any comments or suggestions
concerning this PowerPoint presentation, please
contactTerry M. Lease(terry.lease_at_sonoma.edu)S
onoma State University