Chapter 24: Strategic Planning and Budgeting

Strategic Planning = programming = long range planning = the process of making decisions on upcoming major programs, formulating long range plans. Purpose of management control is to implement an organization’s strategies.

Strategy Formulation Process of identifying, evaluating, and deciding on strategies. Because it is impossible to determine when there will be a need to reconsider strategies, strategy formulation cannot be a systematic process that is carried out according to a predetermined schedule.

Strategic Planning Systematic and consists of 3 main parts: Reviewing ongoing programs. Considering proposals for new programs. Coordinating programs by means of a formal strategic planning system.

Zero-based Review (Zero-based Budgeting) A systematic way of analyzing ongoing programs. Cost estimates are built up from scratch or zero. Contrasts with taking the current level of costs as the starting point as is customarily done in the budgeting process (i.e., an incremental approach). May overcome complacency.

Limitation of Zero-base Review Time consuming and upsetting to normal functioning. Cannot be effectively conducted every year.

Other Names for Zero-base Review Also called process analysis, process reengineering, activity-based management, and (in Japan) functional analysis.

Raises Basic Questions Questions of a product line or other activity: Should this activity be performed at all? Is too much or too little being done? Should it be done internally or outside the firm? Is there a better way of obtaining the desired results? How much should it cost?

Zero-base Review and Government Particularly appropriate for government agencies and other non-profit organizations. Required periodically by sunset laws.

Proposed New Programs Sometimes a new program is analyzed by a benefit-cost analysis. Costs estimates are usually straightforward. Benefits may be difficult to quantify. Even if benefits are difficult to quantify, costs should be estimated.

Formal Strategic Planning Systems Formal systems in which financial and other consequences of programs are projected for a number of years. Long range plan = the financial projection from this process/system. Usually 5 years, could be more or less. Usually done annually, several months before budgets are prepared.

Budgeting Process of planning the activities of the organization’s responsibility centers for the next period, usually the next year. Budget = profit plan = a plan expressed in quantitative, usually/mostly in monetary, terms covering a specified period of time, usually one year.

Budget Uses: 1 of 2 Aid in coordinating short run plans. Essentially a refinement of strategic plans. A device for communicating plans. A way of motivating managers.

Budget Uses: 2 of 2 A benchmark for controlling ongoing activities. Actual compared to budget provides a “red flag.” Directs attention where needed. A basis for evaluating performance of responsibility centers and their managers. A means of educating managers about detailed workings of their responsibility centers, and interrelationships with other centers.

Multiple Use Complications Budget preparation is a complicated process. Managers may introduce bias. Negotiation helps to eliminate bias (also helps in achieving each of the above uses).

The Master Budget Complete budget package. 3 principal parts, with budgeted balance sheet Operating budget = Revenues, expenses, and changes in inventory and other working capital items for the coming year. Cash budget = anticipated sources and uses of cash in the coming year. Capital expenditure budget = planned changes in property, plant and equipment. Budgeted balance sheet is derived from other budgets.

The Operating Budget (OB) First-year of long range plan. Long range plan is structured in terms of programs. A given responsibility centers activities cut across a number of programs. OB is a control device used to compare to actual. Variances are identified. Responsibility budgets are broken into cost elements, e.g., materials, labor, supplies.

Project budgets Projects may require efforts of several responsibility centers. Personnel in these centers may have 2 bosses, department head and project head. This is a matrix organization (i.e., overlapping responsibility).

Flexible (Variable) Budgets Shows planned behavior of costs at various volume levels. Usually expressed in terms of a cost-volume relationship (Chapter 16). Costs at one particular level, budgeted or planned level, are used in the operating budget. Usually same level used for setting standard costs.

Management by Objectives (MBO) Budget emphasizes short run financial performance. Accounting information alone cannot provide an adequate benchmark for responsibility center performance. If used alone, could lead to dysfunctional management behavior. Encouraging short- not long-run decisions. MBO system states specific objectives that the responsibility center manager is expected to achieve during the period covered by the budget. E.g., Open new sales office, develop a new training program, identify and develop a replacement (so you can get promoted).

Balanced Scorecard Broader performance focus than only financial. Allows complex cause and effect performance models.

Operating Budget Budgeted statements: income statement, balance sheet, statement of cash flows. Identical in format to the actual financial statements. Budget committee consisting of member of top management prepares guidelines. Generally, line positions make the significant decisions. Budget Timetable Budgets are usually prepared once a year, covering the next fiscal year, and are broken down by month. Some companies preparing a rolling 12-month budget in which every three months, the quarter just completed is dropped and three additional months are added on.

Budget Timetable Steps Setting guidelines. Preparing the sales budget. Initial preparation of budget components. Negotiation to agree on final plans for each component. Coordination and review of components. Final approval. Distribution of the approved budget.

Setting Guidelines Major program decisions are not made through the budget process. Budget process helps implement broader planning decisions on programs previously approved. Guidelines may include: assumptions about economic conditions, expected % of pay increase, allowable promotions.

Preparing the Sales Budget Sale affects most other plans. Sales budget is a commitment by responsibility center manager to take actions necessary to achieve budgeted levels. Forecast is a more informal and more passive prediction. Approaches to sales budget: Statistical forecast: mathematically determined from historical relationships and general business conditions, product growth. Judgmental estimate: Opinions of managers and sales persons. Purchase industry forecast from market research/consulting firm. Combination of above (most commonly used). Incremental Budgeting. Focuses on differences between current year’s activity and coming (budget) year. Adjusts accordingly.

Negotiation Between Managers and Superiors Crucial to usefulness of budget. Most effective when budget is tight but attainable. Slack Difference between potential output and actual output. A certain amount is desirable otherwise too much pressure on employees. Challenge is to keep slack to a reasonable level.

Negotiating Tactics Arbitrary cuts. Can be countered by padding. Affects good and bad forecasters alike. Require a full explanation from managers for differences from previous year. Top manager prepares his/her own estimate/expectations and requires clear reason for differences. End product of a negotiation is a commitment.

Coordination and Review Negotiation process is repeated at successively higher levels in organization. Significant changes are recycled downwards. Budget may have to be rebalanced due to changes.

Final Approval Approved by CEO and BOD. Then transmitted down through the organization.

Revisions Should the budget be revised during the year to reflect changing conditions? If it is not revised, it may no longer be a realistic benchmark. If it is revised: Time consuming. May obscure objectives. May reduce credibility of the process for the future (rubber baseline).

Variations in Practice Imposed or top down budget: less effective motivation. Nonprofit organizations have no profit incentive so budgeting is even more important. Merchandising companies have no production so simpler budgeting. Open-to-buy procedure: Can purchase up to defined limit.

Cash Budget Revenues and expenses from the operating budget translated into cash inflows and outflows for cash planning.

Two Approaches to Cash Budgeting Determine sources and uses of cash from budgeted balance sheet and income statement. Directly estimate inflows and outflows.

Direct Estimation of Cash Flows Determine collections of accounts receivable and payments for materials with a lag factor; e.g., 30 days from sale to collection. Most other expenses assumed paid in period incurred. Capital expenditures (i.e., expenditures on long-term asset are taken from the capital expenditures budget).

The Capital Expenditure Budget List of investments that management plans to make in long-term (= fixed = property, plant, and equipment) assets in the coming year. Usually separated from preparation of operating budget.

Capital Expenditure Classification Cost reduction. Replacement. Expansion. New Products. Health and safety. Other.

Authorization Specific authorization request. Supported by discussion and analysis. Higher $$ involvement requires higher level of approval and evaluation.

Post-Completion Audits Compares actual costs and results to estimates in specific authorization request.

Beyond Budgeting Radical decentralization and adaptive performance measurement. No annual budget or target setting. Autonomous profit centers with key performance indicators. Rewards based on relative performance measures. Rolling strategic reviews.