BUDGETING
1. A budget
(profit plan) is a realistic plan stated in quantitative terms. Senior management
determines the mission, long-term objectives, and priorities of the entity. For example,
setting
priorities for the allocation of limited resources may entail designating
specified
objectives as
critical, necessary, or merely desirable. Accordingly,
budgets are determined
in accordance
with the mission, long-term objectives, and priorities to plan for the future.
Budgets also
communicate objectives to all levels of the organization, motivate employees,
control
activities, and evaluate performance.
a. The annual budget
is based on the objectives. Thus, it
is usually based on a
combination of
financial, quantitative, and qualitative measures.
b. The budget is a planning tool.
1) Companies that
prepare budgets anticipate problems before they occur.
a) EXAMPLE: If a company runs out of a critical raw
material, it may have to
shut down. At best, it will incur extremely high
freight costs to have the
needed materials
rushed in. The company with a budget
will have
anticipated the
shortage and planned to avoid it.
2) A firm that has
no objectives may not always make the best decisions. A firm
with an
objective, in the form of a budget, will be able to plan.
3) Strategic budgeting
by senior management is a form of long-range planning
based on
identifying and specifying organizational objectives. The organization
begins by
evaluating its strengths, weaknesses, opportunities, and threats (a
SWOT analysis)
and assessing risk levels. The
influences of internal and
external factors
are then forecasted to derive the best strategy for reaching the
organization’s
objectives.
a) Among the external
or environmental factors are general economic
conditions and
their expected trends, governmental regulatory measures,
the labor market
in the company’s locale, and the activities of
competitors.
b) Strategic budgets
and other plans are translated into measurable and
achievable
intermediate and operational plans. Thus,
these plans must
be considered
with, and contribute to achieving, the strategic objectives.
i) Strategic plans – budgets developed by senior
managers have time
frames of up to
10 years (or more).
ii) Intermediate plans – budgets developed by middle
managers have
time frames of up
to 2 years.
iii) Operational plans – budgets developed by
lower-level managers
have time frames
of 1 week to 1 year.
The budget is a control tool.
1) A budget helps a
firm control costs by setting cost standards
or guidelines.
Budgets and other
standards, including standard costs, are formal estimates
of future
performance.
a) Standard costs
are budgeted unit costs established to motivate optimal
productivity and
efficiency. A standard-cost system
is designed to alert
management when
the actual costs of production differ significantly from
target or
standard costs.
i) Standard costs
are monetary measures with which actual costs are
compared.
ii) A standard cost
is not just an average of past costs, but an
objectively
determined estimate of what a cost should be.
For
example, it may
be based on accounting, engineering, or statistical
quality control
studies.
iii) A standard-cost
system may be used with both job-order and
process costing
systems to isolate variances.
iv) Because of the
impact of fixed costs in most businesses, a standard
costing system is
usually not effective unless the company also has
a flexible budgeting system. Flexible
budgeting uses standard
costs to prepare
budgets for multiple activity levels.
b) Ideal (perfection,
theoretical, or maximum efficiency) standards are
standard costs
that are set for production under optimal conditions. They
are based on the
work of the most skilled workers with no allowance for
waste, spoilage,
machine breakdowns, or other downtime.
i) Tight standards
can have positive behavioral implications if workers
are motivated to
strive for excellence. However, they
are not in
wide use because
they can have negative behavioral effects if the
standards are
impossible to attain.
ii) Ideal, or tight,
standards are ordinarily replaced by currently
attainable
standards for cash budgeting, product costing, and
budgeting
departmental performance. Otherwise,
accurate financial
planning will be
impossible.
iii) Ideal standards
have been adopted by some companies that apply
continuous
improvement and other total quality management
principles.
c) Practical or
currently attainable standards may
be defined as the
performance that
is reasonably expected to be achieved with an
allowance for
normal spoilage, waste, and downtime. An
alternative
interpretation is
that practical standards represent possible but difficult to
attain results.
d) Benchmarking is one means of setting performance
standards. It is a
continuous
process of quantitative and qualitative measurement of the
difference
between the organization’s performance of an activity and the
performance by
the best-in-class organization. Benchmarking
also
analyzes the key
actions and root causes that contribute to the
performance gap.
e) Activity analysis
identifies, describes, and evaluates activities to
determine what
they accomplish, who performs them, the resources they
use, and their
value to the organization. Value-added
activities should
continue to be
performed and provide the basis for performance
standards.
i) Activity analysis
also is defined as the determination of the optimal or
standard methods
and inputs required to accomplish a given task.
Inputs include
the amounts and kinds of equipment, facilities,
materials, and
labor. Engineering analysis, cost
accounting,
time-and-motion
study, and other approaches may be useful.
f) Historical information
may be helpful in setting standards provided that
circumstances
have not changed materially.
g) Target costing
standards may be set when a product must be sold at a
target price. The assumption is that continuous
improvement practices
will succeed in
driving costs down to the targeted levels.
Comparing actual
performance with budgets and other standards reveals the
efficient or
inefficient use of company resources.
Budgets may also
reveal the progress of highly effective managers.
Consequently,
they should not view budgets negatively. A
budget is just as
likely to help as
to hinder a manager’s career.
A manager also
may use a budget as a personal self-evaluation tool.
For the budgetary
process to serve effectively as a control function, it must be
integrated with
the accounting system and the organizational
structure.
Such integration
enhances control by transmitting data and assigning
variances to the proper organizational subunits.
Controllability is a key concept in the use of budgets
and other standards to
evaluate
performance. It is the extent to
which a manager can influence
activities and
related revenues, costs, or other items. In
principle, controllability
is proportionate
to, but not coextensive with, responsibility.
a) Controllability is
difficult to isolate because few costs, revenues, etc., are
under the sole
influence of one manager. Thus,
separating the effects of
current
management’s decisions from those of former management is
difficult.
b) If responsibility
exceeds the extent to which a manager can influence an
activity, the
result may be reduced morale, a decline in managerial effort,
and poor
performance. Such a manager
encounters greater risk because
his/her success
depends on uncontrollable factors. Thus,
a manager in
these
circumstances should be compensated for the incremental risk
assumed.
c) However, if a
manager is accountable solely for activities over which (s)he
has extensive
influence, the manager may develop too narrow a focus.
i) For example, the
manager of a cost center may make decisions
based only on
cost efficiency and ignore the overall effectiveness
goals of the
organization. By extending the
manager’s
responsibility to
profits as well as costs, the organization may
encourage
desirable behavior congruent with overall goals, such as
improved
coordination with marketing personnel, even though the
manager still
does not control revenues.
ii) Furthermore, a
manager who does not control an activity may
nevertheless be
the individual who is best informed about it.
Thus,
a purchasing
agent may be in the best position to explain price
variances even
though (s)he cannot control them.
d. The budget is a motivational tool.
1) A budget helps to
motivate employees to do a good job.
a) Employees are particularly
motivated if they help prepare the budget.
b) A manager who is
asked to prepare a budget for his/her department will
work hard to stay
within the budget.
c) Achievement of
challenging goals has positive effects on employee
performance and self-esteem.
2) A budget must be
seen as realistic by employees before it can become a good
motivational
tool.
3) Unfortunately,
the budget is not always viewed in a positive manner. Some
managers view a
budget as a restriction.
4) Employees are
more apt to have a positive feeling toward a budget if some
degree of
flexibility is allowed.
e. The budget is a
means of communication.
1) A budget can help
tell employees what objectives the firm is attempting to
accomplish.
2) If the firm does
not have an overall budget, each department might think the firm
has different
objectives. Thus, a budget promotes goal congruence.
3) For example, the
sales department may want to keep as much inventory as
possible so that
no sales will be lost, but the treasurer may want to keep the
inventory as low
as possible so that cash need not be spent any sooner than
necessary. If the budget specifies the amount of
inventory, all employees can
work toward the
same goals.
Budgets
facilitate coordination of the activities
of a firm. The overall budget, often
called
the master or comprehensive budget,
encompasses both the operating and financial
budget processes.
A budget manual describes how a budget is to be prepared. Items usually appearing in a
budget manual
include a budget planning calendar and distribution instructions for all
budget schedules. Distribution instructions are important
because, once a schedule is
prepared, other
departments in the organization use the schedule to prepare their own
budgets. Without distribution instructions,
someone who needs a particular schedule might
be overlooked.
a. The budget planning calendar is the
schedule of activities for the development and
adoption of the
budget. It should include a list of
dates indicating when specific
information is to
be provided to others by each information source.
b. The preparation
of a master budget usually takes several months. For instance, many
firms start the
budget for the next calendar year in September, anticipating its
completion by the
first of December. Because all of
the individual departmental
budgets are based
on forecasts prepared by others and the budgets of other
departments, it
is essential to have a planning calendar to integrate the entire
process.
Participative budgeting
(grass-roots budgeting) and standard setting use input from
lower-level and
middle-level employees.
a. Participation
encourages employees to have a sense of ownership of the output of the
process. The result is an acceptance of, and
commitment to, the goals expressed in
the budget.
1) A purely top-down approach (an imposed budget that sets authoritative rather
than
participative standards) is much less likely to foster this sense of
commitment.
b. Participation
also enables employees to relate performance to rewards or penalties.
c. The actual impact
of budgetary participation depends on cultural, organizational,
interpersonal,
and individual variables, such as personality.
d. A further
advantage of participation is that it provides a broader information base.
Lower- and
middle-level managers have knowledge that senior managers and staff
may lack.
1) Thus, a key
decision in the budget and standard-setting process is to identify
who in the
organization can provide useful input.
e. Disadvantages of
participative budgeting and standard setting include its cost in terms
of time and
money. Furthermore, the quality of
participation is affected by the goals,
values, beliefs,
and expectations of those involved.
1) A manager who
expects his/her request to be reduced may inflate the amount.
2) If a budget is to
be used as a performance evaluator, a manager asked for an
estimate may
provide one that is easily attained.
f. Management-by-objectives (MBO) is a behavioral,
communications-oriented,
responsibility,
and participative approach to management and employee self
direction. Accordingly, MBO stresses the need to
involve all affected parties in the
budgeting
process.
1) MBO is a top-down
process because the organization’s objectives are
successively
restated into objectives for each lower level.
For example, the
budgets
(quantitative statements of objectives) at each successive level of the
organization have
a means-end relationship. One level’s
ends provide the
next higher level’s
means for achieving its objectives. Ideally,
the means-end
chain ties
together the parts of the organization so that the various means all
focus on the same
ultimate ends (objectives).
2) MBO is based on
the philosophy that employees want to work hard if they know
what is expected,
like to understand what their jobs actually entail, and are
capable of
self-direction and self-motivation. Thus,
MBO is also a bottom-up
process because of the participation of
subordinates.
3) The following are
the four common elements of MBO programs:
a) Establishment of
objectives jointly by the superior and subordinate
b) Specificity of
objectives. Multiple performance
measures are agreed upon
so that the
subordinate will not neglect other facets of his/her job to
concentrate on a
single objective.
c) Specificity of
the time within which objectives are to be achieved
d) Ongoing feedback
that permits an individual to monitor and adjust his/her
performance
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