Lecture 1: Budgeting
Lecture 1: Budgeting 08 November 2010
Topics • Budgets • Responsibility Accounting • Biased Budgets
Reading
Key Points • 4 roles of budgets • Budgets • Responsibility accounting
Budgets Roles of budgets: a. Communication and coordination b. Motivation c. Strategic planning d. Performance measurement Types of budgets: ○ Master Budget: Provides financial-projected framework for other budgets in the organisation ○ Operating Budgets (Revenue Budgets): Predict income and costs ○ Capital Budgets: Used for planning investments to aid financing decisions ○ Activity-Based Budgeting: Cost of activities that make up a project What are budgets? ○ Budgets set out amounts of resources and outputs that are expected to be consumed and produced ○ Targets to be achieved ○ Key component of the organization's planning and control system ○ In planning decisions, budgets communicate specialized knowledge from one part of the organization to another ○ For control, budgets serve as benchmarks for performance measurement systems ○ Require a trade-off between the two ○ It is an informal set of contracts between the different units of the organization ○ They encourage a 'bottom-up' flow of information ○ i.e. head office requesting budgeting information from departments ○ Participative budgeting = A bottom-up budget process, in which the person ultimately held responsible for meeting the target makes the initial budget forecast ○ Enhances motivation for lower-level workers to accept the targets ○ Used more frequently when lower-level managers had specialized knowledge ○ Budgets also play an important role in control ○ Used to assign responsibilities by allocating resources to different managers ○ Some experts argue that the budget should be 'tight' but achievable ○ Sometimes annual budgets do not provide meaningful goals because of a fast-changing industry ○ In such a case, rolling forecasts can be used to update the budget each month etc. ○ e.g. Avon Automotive (a global automotive component designer and manufacturer) How do responsibilities relate to budgets? ○ They set out areas of responsibility ○ i.e. what and how much of a resource to use to achieve a set result How do budgets affect the behaviour of managers? ○ Would setting demanding performance targets push managers to perform better? ○ Managers often spend up to 20 per cent of their time on budgeting Questions to ask when budgeting ○ How achievable are the cost/revenue figures? ○ What are the implications of not achieving the goals? ○ What are the implications of achieving the goals? How do budgets relate to goals? ○ Budgets tell managers what goals are expected to be achieved ○ They don't say how to achieve them ○ Translates organizational goals into financial terms
Conflict between planning and control ○ Conflict between planning decisions and control is particularly severe in marketing ○ To manage conflict, many organizations put the CEO in charge of the budgeting process ○ Signals the important of the budgeting process ○ Resolving disagreements among departments requires making trade-offs and the CEO, who has an overall view of the entire firm, is best able to make these trade-offs ○ Firms also use budget committees Responsibility Accounting Responsibility Accounting ○ Responsibility Accounting = comparing budgets to actual results to account for how well managers perform ○ Identifies different responsibility centres through the type of data compiled in the budget: ○ Cost centre ○ Revenue centre ○ Profit centre ○ Investment centre Controllability of Costs ○ Responsibility accounting traces costs to activities that caused the cost ○ This implies that costs are controllable because this relates the cost to the people most knowledgeable about the cost ○ Responsibility for costs tends to cut across domains and across time ○ Responsibility accounting is aimed at tracing costs ○ Controllability cannot always be achieved on time or allocated unambiguously ○ The person made responsible for the costs may not control them ○ They do however have the best knowledge of how they were accrued ○ Cross-Domain Responsibility: Sometimes one department may control the costs of another department by enforcing that a sale goes through for example Departments can charge the accounts of the department responsible for executing the cost
Course Notes Page 1
• Cross-domain responsibility
• Biased budgets • Budgetary slack Definitions • Activity-Based Budgeting: Cost of activities that make up a project • Budgetary Slack = The intentional underestimation of revenues and productive capabilities and/or overestimation of costs and resources required to complete a budgeted task • Capital Budgets: Used for planning investments to aid financing decisions
• Cross-Domain Responsibility: Sometimes one department may control the costs of another department by enforcing that a sale goes through for example • Master Budget: Provides financial-projected framework for other budgets in the organisation • Operating Budgets (Revenue Budgets): Predict income and costs • Responsibility Accounting = comparing budgets to actual results to account for how well managers perform
○ Departments can charge the accounts of the department responsible for executing the cost General Practices of Responsibility Accounting ○ The person responsible are asked by responsibility accounting to be sources of expert information Questions that may be asked include: ○ Why are budgeted revenues lower or higher than actual ones? ○ What factors affect costs? ○ This information is collected and will affect future budgets Biased Budgets Biased Budgets ○ Budgetary Slack = The intentional underestimation of revenues and productive capabilities and/or overestimation of costs and resources required to complete a budgeted task ○ Dunk and Nouri (1998) said that subordinates may use budgetary slack to "ease their work or obtain personal rents" What are the reasons for biased budgets? ○ The more bonuses and promotion rely on the budget, the more incentive there is to introduce bias ○ Participation is an opportunity to manipulate the budget ○ There are informational advantages associated with biased budgets (subordinates know more than managers) ○ Because of uncertainty about information, there is more place for interpretation ○ Biased budgets may be functional for the organisation: ○ The slack can serve as a buffer ○ Can help to improve managerial performance when budgets are significant and there is uncertainty ○ Isolates risk-averse subordinates from excessive risk ○ Increases job satisfaction by protecting from the consequences of budget targets
How do organisations create budgetary slack? ○ Labelling a cost as variable when it is only semi variable ○ They may include a fixed element What are the benefits of budgetary slack? ○ May help to put budgets in perspective ○ Reduce budget emphasis and allow subordinates to allocate attention to goals other than meeting the budget ○ i.e. quality or customer service ○ May help to allocate resources more efficiently
Course Notes Page 2
Topics • Budgets • Responsibility Accounting • Biased Budgets
Reading
Key Points • 4 roles of budgets • Budgets • Responsibility accounting
Budgets Roles of budgets: a. Communication and coordination b. Motivation c. Strategic planning d. Performance measurement Types of budgets: ○ Master Budget: Provides financial-projected framework for other budgets in the organisation ○ Operating Budgets (Revenue Budgets): Predict income and costs ○ Capital Budgets: Used for planning investments to aid financing decisions ○ Activity-Based Budgeting: Cost of activities that make up a project What are budgets? ○ Budgets set out amounts of resources and outputs that are expected to be consumed and produced ○ Targets to be achieved ○ Key component of the organization's planning and control system ○ In planning decisions, budgets communicate specialized knowledge from one part of the organization to another ○ For control, budgets serve as benchmarks for performance measurement systems ○ Require a trade-off between the two ○ It is an informal set of contracts between the different units of the organization ○ They encourage a 'bottom-up' flow of information ○ i.e. head office requesting budgeting information from departments ○ Participative budgeting = A bottom-up budget process, in which the person ultimately held responsible for meeting the target makes the initial budget forecast ○ Enhances motivation for lower-level workers to accept the targets ○ Used more frequently when lower-level managers had specialized knowledge ○ Budgets also play an important role in control ○ Used to assign responsibilities by allocating resources to different managers ○ Some experts argue that the budget should be 'tight' but achievable ○ Sometimes annual budgets do not provide meaningful goals because of a fast-changing industry ○ In such a case, rolling forecasts can be used to update the budget each month etc. ○ e.g. Avon Automotive (a global automotive component designer and manufacturer) How do responsibilities relate to budgets? ○ They set out areas of responsibility ○ i.e. what and how much of a resource to use to achieve a set result How do budgets affect the behaviour of managers? ○ Would setting demanding performance targets push managers to perform better? ○ Managers often spend up to 20 per cent of their time on budgeting Questions to ask when budgeting ○ How achievable are the cost/revenue figures? ○ What are the implications of not achieving the goals? ○ What are the implications of achieving the goals? How do budgets relate to goals? ○ Budgets tell managers what goals are expected to be achieved ○ They don't say how to achieve them ○ Translates organizational goals into financial terms
Conflict between planning and control ○ Conflict between planning decisions and control is particularly severe in marketing ○ To manage conflict, many organizations put the CEO in charge of the budgeting process ○ Signals the important of the budgeting process ○ Resolving disagreements among departments requires making trade-offs and the CEO, who has an overall view of the entire firm, is best able to make these trade-offs ○ Firms also use budget committees Responsibility Accounting Responsibility Accounting ○ Responsibility Accounting = comparing budgets to actual results to account for how well managers perform ○ Identifies different responsibility centres through the type of data compiled in the budget: ○ Cost centre ○ Revenue centre ○ Profit centre ○ Investment centre Controllability of Costs ○ Responsibility accounting traces costs to activities that caused the cost ○ This implies that costs are controllable because this relates the cost to the people most knowledgeable about the cost ○ Responsibility for costs tends to cut across domains and across time ○ Responsibility accounting is aimed at tracing costs ○ Controllability cannot always be achieved on time or allocated unambiguously ○ The person made responsible for the costs may not control them ○ They do however have the best knowledge of how they were accrued ○ Cross-Domain Responsibility: Sometimes one department may control the costs of another department by enforcing that a sale goes through for example Departments can charge the accounts of the department responsible for executing the cost
Course Notes Page 1
• Cross-domain responsibility
• Biased budgets • Budgetary slack Definitions • Activity-Based Budgeting: Cost of activities that make up a project • Budgetary Slack = The intentional underestimation of revenues and productive capabilities and/or overestimation of costs and resources required to complete a budgeted task • Capital Budgets: Used for planning investments to aid financing decisions
• Cross-Domain Responsibility: Sometimes one department may control the costs of another department by enforcing that a sale goes through for example • Master Budget: Provides financial-projected framework for other budgets in the organisation • Operating Budgets (Revenue Budgets): Predict income and costs • Responsibility Accounting = comparing budgets to actual results to account for how well managers perform
○ Departments can charge the accounts of the department responsible for executing the cost General Practices of Responsibility Accounting ○ The person responsible are asked by responsibility accounting to be sources of expert information Questions that may be asked include: ○ Why are budgeted revenues lower or higher than actual ones? ○ What factors affect costs? ○ This information is collected and will affect future budgets Biased Budgets Biased Budgets ○ Budgetary Slack = The intentional underestimation of revenues and productive capabilities and/or overestimation of costs and resources required to complete a budgeted task ○ Dunk and Nouri (1998) said that subordinates may use budgetary slack to "ease their work or obtain personal rents" What are the reasons for biased budgets? ○ The more bonuses and promotion rely on the budget, the more incentive there is to introduce bias ○ Participation is an opportunity to manipulate the budget ○ There are informational advantages associated with biased budgets (subordinates know more than managers) ○ Because of uncertainty about information, there is more place for interpretation ○ Biased budgets may be functional for the organisation: ○ The slack can serve as a buffer ○ Can help to improve managerial performance when budgets are significant and there is uncertainty ○ Isolates risk-averse subordinates from excessive risk ○ Increases job satisfaction by protecting from the consequences of budget targets
How do organisations create budgetary slack? ○ Labelling a cost as variable when it is only semi variable ○ They may include a fixed element What are the benefits of budgetary slack? ○ May help to put budgets in perspective ○ Reduce budget emphasis and allow subordinates to allocate attention to goals other than meeting the budget ○ i.e. quality or customer service ○ May help to allocate resources more efficiently
Course Notes Page 2
