Budgeting and the Planning and Control

Process
Goal setting helps mangers in their day-to-day operations. For example, a goal may
be to attain a specific percentage of market share. Objectives provide the steps toward
this goal. These steps might include sales goals by territory and by product divisions.
Objectives should be:

• Results-oriented rather than activity-oriented. For example, increase sales in the

eastern region by 5 percent.
• Stated in measurable terms such as dollars or percent increase so that a performance
evaluation is feasible.
• Stated clearly so that confusion is avoided.
• Time-specific to provide deadlines for accomplishment.
• Attainable in management's opinion.

Many corporations have developed detailed formal systems to force managers to

plan since managers have an aversion to doing it. The budget is, of course, a
component of this system.
The budget can be defined as a financial plan showing how the organi-zation will
acquire resources and use them in operations during a specified time period, usually one
year. A budget takes the form of a pro forma set of financial statements and supporting
schedules. Pro forma means that figures are expected amounts as opposed to actual historical
amounts. The budget is typically compiled on a monthly basis. Budgets are explained by
detailed descriptions of what managers expect to do in the short run.

Control Systems
Results-oriented objectives are the basis for controlling operations. Controlling also involves
monitoring the implementation of plans through performance reviews. They are used to
compare actual results with objectives. The frequency depends upon the time-specific nature
of the objectives. For example, some objectives involve daily operations, and obvi-ously
daily performance reporting is appropriate. To illustrate, an objective might be to reduce
spoilage to less than 1 percent per day for an ice cream manufacturer. Daily, or even hourly,
reporting may be used for feedback in this case. The nature of the factors under
management's control will also influence the frequency.

Weekly, monthly, and quarterly performance reports measure how successful the
organization has been in achieving its financial goals and objectives. Variances from
budget are typically presented in a performance report so that unexpected results can be
quickly identified. Performance reports have to be timely so that the manager
responsible for an activity becomes aware of variances as soon as possible. They also
have to be atten-tion-directing in nature, highlighting the most significant variances.
The manager responsible for a particular variance should be empowered to take
corrective action with regard to a variable under the firm's control .
ADVANTAGES OF BUDGETING
Having a budgeting system does not guarantee that the organization's plan-ning efforts
will be improved. In some organizations, the budget is used as a planning process, but
there is little emphasis on using it to control opera-tions. Budgeting is a cost-benefit
proposition; the system has to be designed to be cost-effective.

The advantages of budgeting must be emphasized periodically so that managers

at various levels take the process seriously and maximum benefit is attained. As
mentioned earlier, there sometimes is an aversion to planning. By emphasizing the
advantages of planning and budgeting on a continuous basis, this aversion should be
overcome.

Forced Planning
The most important advantage of budgeting is, of course, that it forces man-agers to
plan ahead. As a result of the corporate restructuring in the 1980s
and early 1990s, many managers have had to make, and are still making, many
changes in their day-to-day operations. Simply stated, managers are very busy. Today's
world is changing so fast that managers are not simply dealing with routine situations
on a day-to-day basis. Instead, they must deal with complex problems without easy or
known solutions. Working within the framework of a plan facilitates tough decision-
making responsibilities.
A formalized budgeting system forces managers at all levels to plan. The critical
review of their proposed budget at higher managerial levels raises questions about the
way things are being done at lower levels. Managers must step back from daily
operations and take a wider view of what's really happening in their areas of
responsibility.

Coordination of Activities
As you know, organizations are composed of many segments covering many functions
and programs. During the budgeting process the plans and related financial budgets of
the various segments are brought together in one place. Typically, a budget committee
will review these plans and try to integrate them into a total plan to achieve the
organization's goals. During this process, many questions are asked of the various
managers in the organiza-tion. As a result, there is communication up the organization
from subordi-nates to superiors. There is also communication between managers
across section and department lines. For example, if marketing plans to sell one
million units, production must have plans and a budget to produce these units. In turn,
purchasing must have plans to acquire the necessary raw materials to meet production
schedules. It is inevitable that the plans of the various departments will change during
this process. This revision process forces coordinated and continuous planning at the
various levels in the organization.
Performance Evaluation
Performance evaluation is not an easy task. Obviously, managers desire a fair
evaluation of their performance. They want to know what is expected of them in
advance.
When investors evaluate a company's performance, a common tech-nique is to
compare the current with historical results. While this is a useful technique for an
investor, for evaluating managers' performance the firm has a better option. This is to
use the budget as a benchmark. Of course a manager's performance can be fairly
evaluated only by identifying the con-trollable and uncontrollable factors that cause a
significant variance between planned and actual results. If a variance is caused by an
uncontrollable fac-tor, we can ask whether it was predictable. Perhaps it wasn't and
nothing could have been done. Alternatively, the manager could have been prepared to
take other actions. While the results cannot be changed, competencies of managers can
be assessed and lessons are learned.
For example, a division manager may have earned a profit of $600,000 last year.
A historical benchmark approach for this division manager would
be to expect profits to increase by the same proportion in the coming year. Perhaps
management might simply say we expect profits to increase by 10 percent to
$660,000. The problem with using this approach is that no attempt is being made to
adjust for changes due to uncontrollable and con-trollable factors. Perhaps an
investment was made in new technology toward the end of last year that should result
in substantial efficiencies. This factor would cause us to expect a more substantial
increase in profits. Using a bud-geted income statement as a benchmark forces the
divisional manager to factor in all the variables that are expected to change. A
stringent headquar-ters' review of the division manager's plans and analysis can result
in agree-ment on a realistic target for the next year. As a result, planning is integrated
with performance evaluation.

Control Environment
Successful organizations create a control environment. They have an effec-tive set of
internal controls to assure compliance with management's policies and procedures.
Controls must assure compliance by employees at all levels. Managers must
understand and follow the limits on their authority to expend the organization's
resources.
Monthly budgetary control reports on spending document the man-ager's actions
in using the authority granted. Of course, the budgetary control system should allow
for changes during the budget period. These authorized changes should be
documented as part of the management con-trol system.

Resource Allocation
During the budget planning phase many resource allocation decisions are made. A
good example is capital expenditures. The various segments of an organization will
request a budgeted dollar amount for these expenditures. Invariably, the total amount
requested exceeds the organization's ability to finance that total. Consequently, a
capital rationing process is used. Typically, the organization will use either the internal
rate of return or net present value method of evaluating the competing proposals for
capital expenditures. Both of these methods are described in Chapter 4. These methods
enable management to look at how the competing requests will further the
organization's capability to achieve its strategic plan.
Another example involves a nonprofit organization. It may have three or four
different programs that it is pursuing. During the budget planning phase, the board of
directors will have to decide whether resources should be diverted from one program
to another. For example, an environmental organization has programs oriented toward
improving water quality, improving air quality, and preserving the forests. The basic
question of resource allocation facing the directors each year is what proportion of its
resources to allocate to each of the three programs. After several years of giving
priority to improving water quality, the board may decide that it is time to redirect
resources toward improving air quality. This decision is, of course, documented in the
budget.
Motivation
Budgets can be used by management to motivate managers and employees. If
managers participate in the planning process and budget preparation, they are likely to
develop more of a commitment to achieving the budget's objec-tives. In the process
they also realize more fully that their piece of the bud-get is important in coordinating
the overall plan. If an organization can develop a fair budget review process (and a fair
performance evaluation process), managers will be motivated to achieve desired
results. Conversely, if these processes are not perceived as fair, the budgetary system
will have a negative effect on motivation. Unfortunately this is a common occurrence.
In many organizations promotions, raises, and bonuses are affected by managers'
performance in achieving budgetary targets. In many larger firms, for example,
division managers can earn a bonus by achieving the budgeted profit for the division.
Unfortunately, there are many pitfalls in using bud-gets as a motivator. For example, a
division manager may resort to tech-niques such as speeding up sales order processing
at the end of the budget period to increase sales and earn a bonus.

BUDGETING :Planning and administration

An organization's budgeting system is goal oriented. In many firms, the bud-get,
designed to attain short-run goals, is prepared in conjunction with a five-year financial
plan designed to achieve long-run goals. It is important to understand how an effective
budgeting system fits into a firm's strategic and long-run planning process. While
some firms don't have a very formalized strategic long-run planning process, at a
minimum, top management has a basic strategy.

THE BUDGET ADMINISTRATION PROCESS

A variety of approaches can be used to administer the budget. They vary in the way
top management controls the budget process. Most large organiza-tions use some type
of budget committee format. Another important ingre-dient is a budget manual, which
describes policies and procedures and the all-important timetable for completion.

Budget Committee
Most large organizations appoint a budget committee. The advantage of having a
budget committee is that members can be selected from the various functional areas of
the organization. Since a basic purpose of the committee is to coordinate activities
throughout the organization, members of the committee must have expertise in the
various functional areas. These areas should include marketing, production, personnel,
finance, and accounting.
The committee is chaired by the budget director, who has ultimate responsibility
for formulating the budget. Exhibit 1-3 lists responsibilities that might be assumed by
the budget director. The budget director's
position in the organization and the responsibilities assigned will affect the
perceived importance of the budget by organization members. In some
organizations the budget director has significant strategic authority.

Degree of Participation
There is an old saying, "People support what they help create." We have seen
this idea applied to the budgeting process. A high degree of participa-tion is
often called the "bottom-up approach." The budgeting process is ini-tiated at the
bottom of the organization, and budgets are transferred up the organization from
one level to another for review and modification. At each level, the manager
discusses the plans with subordinates to understand their thinking. Thus,
operating managers with detailed knowledge of the environ-ment, competitive
forces, and the marketplace are incorporated into the plans at lower levels. This
approach empowers employees at lower levels to set targets and be innovative.

The bottom-up approach is compatible with the total quality manage-ment

movement of the 1980s and 1990s. Managers at lower levels are empowered to
assess performance and identify opportunities for continuous improvement.
Lower-level managers better understand business processes, subprocesses, and
activities. They are also more likely to be attuned to the needs of customers.
This approach also allows for quick response to changes in competitive forces.
 Exhibit 1-4 portrays the two basic approaches to budgeting. At the authoritarian
extreme we have the "top-down" approach. It allows the man-agers at the top of the
organization to use their comprehensive understand-ing of the environment and the
organization as a basis for preparing the budget. Top management sets targets for the
various functional areas based upon its knowledge of the company's strategies, goals, and
resources. Strict application of this approach involves no negotiation with managers at
lower levels.

A variation that lies somewhere between the two extremes is the case where the top-
down approach is modified to allow for negotiation with managers at middle levels in the
organization.
Which approach is best? The bottom-up approach allows the budget to be influenced
by managers who are closer to the customers. Thus customer needs can be recognized and
prioritized more effectively. The main disad-vantage of this approach is that it is very time
consuming and thus a more costly budgeting practice. And in some types of businesses
lower-level man-agers do not have the desire or capability to contribute to the budgeting
process.

The top-down approach has the major advantage of simplicity and con-sistency. It
often works best in smaller organizations where the owner-manager really knows the
business. It is also often used when a firm is in a financial crisis and cannot afford the cost
of bottom-up budgeting. However, there is a risk of incompleteness due to the lack of
information about opera-tional details. Also, managers may be dissatisfied with the budget
and may not support achieving it.
Exhibit 1-5 illustrates the cycle-up, cycle-down process usually associ-ated with the
bottom-up approach. Initially the budgets are passed up from level 1 through 5 for review
until they reach the budget committee.
The budget committee is responsible for coordinating the budget requests of the
various sections of the organization. Inevitably, the pieces will not fit together.
Consequently, the committee will suggest revisions to the budget requests and cycle them
down to some middle level of the orga-nization. This may be to the third or fourth level. A
cycle-up, cycle-down process will continue until agreement is reached on a final master
budget for the organization.