Accounting 6310 Chapter 6 – Budgeting

Definition Budget – Management’s formal quantification of the operations of an organization for a future period. It is an aggregate forecast of all transactions expected to occur.

Functions of Budgets There is a trade-off between these two functions. It helps to have different people in charge of each of the two functions.

Nature of Budget Generally covers one year Often broken down into monthly or quarterly budgets Sometimes have revolving or continuous budgets; one quarter ends and another quarter is added Can prepare longer term budgets (3-5 years) to avoid short-term focus

Relation to Strategic Planning Precedes budgeting Provides the framework for the annual budget Budget is a “slice” of the strategic planning pie Budget focuses on individual responsibility centers; not whole company like strategic plan

Purposes of Budgeting To fine-tune the strategic plan To help coordinate the activities of the several parts of the organization To assign responsibility to managers, to authorize the amounts they are permitted to spend, and to inform them of the performance that is expected of them To obtain a commitment that is a basis for evaluating a manager’s actual performance

Advantages of Budgeting Translate strategy into a detailed plan Communicate plans throughout organization Think about and plan for the future Advantages Coordinate activities Serves as a means of allocating resources Uncover potential bottlenecks

Questions for Managers Does the organization’s strategy create economic value? Does the organization have enough cash to fund the strategy and remain solvent? Does the organization create enough value to attract the financial resources that it needs to fund long-term investment in new assets? Is there sufficient resources to implement the intended strategy?

Issues in Budgeting Budgetary Slack Budgeting Revisions Participation in the Budgeting Process Human Factors in Budgeting Difficulty in Meeting Budget New Approaches to Budgeting

Budgetary Slack Budgeting revenues lower than expected Budgeting expenses or costs higher than expected Represent easier targets to achieve Budgeting superiors must attempt to find this slack and eliminate it

Budgetary Slack Some companies: Ratchet effect Reward managers for meeting exact budgets Automatically decrease expense figures and increase revenue figures for slack Penalize managers more for large unjustified increases in actual income than for decreases in actual income Ratchet effect Basing next year’s standard of performance on this year’s actual performance Causes employees to underperform

Budgeting Revisions Too many changes in the budget renders it a useless control tool Must establish procedures for changing the budget during the period Some companies use sensitivity analysis with best, worst, and most likely cases. Managers are expected to discuss what decisions they would make in the best and worst cases.

Participation in the Budgeting Process Top down Top management determines the budget and passes it down throughout the organization Bottom up Lower level management formulates the budget and top management makes changes if necessary More successful than top down

Participative Budget System – Bottom Up Flow of Budget Data

Participation in the Budgeting Process Bottom up Must make sure budgets meet the company’s strategy Must make sure slack is limited Participative budgeting is especially helpful for responsibility centers that operate in dynamic environments since lower level managers have more information about their operations.

Human Factors in Budgeting The success of budgeting depends upon: The degree to which top management accepts the budget program as a vital part of the company’s activities. The way in which top management uses budgeted data. When rewarded for meeting/not meeting the budget, employees may take risky actions.

Degree of Budget Target Difficulty Budget should be challenging but attainable. Achievable budgets reduce data manipulation. Achievable budgets create positive attitudes among workers. If too difficult, budgets are often ignored. Overly difficult budgets may cause over commitment of resources. If too easy, managers may coast when budget is met.

New Approaches to Budgeting Line-item budgets Managers can spend only up to the specified amount on each line item (no borrowing from other areas). Budget lapsing No carryover of unused amounts to future years Zero-based Budgets Every line item must be justified

New Approaches to Budgeting Beyond Budgeting (Break the annual performance trap!) Do not use budgets in performance evaluation or reward systems; use them only for PLANNING purposes. Evaluate employees on other measures, including benchmarking or nonfinancial factors

Examples of Budgets Revenues Production costs and cost of goods sold Variable and fixed costs Other budgets

Revenue Budgets Estimate level of sales First and most important budget Drives all other budgets If sales are too low, inventory may build up Can start with past sales and adjust for economic and other factors Often very uncertain

Cost Budgets Budgeted production cost and cost of sales Often represent the standard cost of items produced or acquired Includes budgets for the necessary production materials, labor and overhead Includes inventory assumptions

Cost Budgets Variable costs Nonvariable costs Often vary by sales Delivery costs, commissions, order taking Nonvariable costs Committed costs - costs already determined by previous decisions in the short-run; salaries, rent, depreciation, past advertising commitments

Cost Budgets Nonvariable costs Discretionary costs - costs that can be incurred or not depending on available resources; training, advertising, travel, research and development Activity-based indirect costs - costs that vary with some other cost driver than sales or production volume

Other Budgets Capital Budget Planned spending on capital projects Budgeted Balance Sheet – contains revised balances after previous budgets prepared Budgeted Cash flow Statement – shows how much cash will be needed and whether outside financing sources will be needed Management by Objective – management objectives are quantified and managers are held accountable for them.

Homework Computer Budget Project #1 – 50 points DUE WEDNESDAY, APRIL 8