1
Nature of a Budget
Budgets are an
important tool for
effective short
term planning and
control in
organizations
An operating
budget usually
covers one year
and states the
revenue and
expenses planned
for that year
2
Nature of a Budget
Budget has these characteristics :
• Estimates the profit potential of the business
unit
• It is stated in monetary terms
• It generally covers a period of one year
• It is a management commitment
• The budget proposal is reviewed and approved
by an authority higher than the budgetee
• Once approved, the budget can be changed
only under specified conditions
• Periodically, actual financial performance is
compared to budget, and variances are
analyzed and explained
3
Nature of a Budget
Relation to Strategic Planning
• The budgeting process focuses on a
single year whereas strategic planning
focuses on activities that extend over
a period of several years.
• Strategic plan is essentially structured
by product lines or other programs,
while budgeting is structured by
responsibility centers.
4
Nature of a Budget
Contrast with Forecasting
• As contrasted with a budget, a forecast has the
following characteristic :
• A forecast may or may not be stated in monetary
units
• It can be for any time period
• The forecaster does not accept responsibility for
meeting the forecasted results
• Forecasts are not usually approved by higher
authority
• A forecast is updated as soon as new information
indicates there is a change in conditions
• Variances from forecast are not analyzed formally or
periodically.
5
Nature of a Budget
Use of a Budget :
Preparation of an operating budget has four
principal purposes :
1. To fine tune the strategic plan
2. To help coordinate the activities of the several
parts of the organization.
3. 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
4. To obtain a commitment that is a basis for
evaluating a manager’s actual performance.
6
Nature of a Budget
Content of an Operating
Budget :
• Next slide shows the content of a
typical operating budget and
contrasts the operating budget with
other types of planning documents,
the strategic plan and the capital
budget, the cash budget, and the
budgeted balance sheet.
7
Nature of a Budget
Types of Plans and Their Contents
Strategic Plan
• Revenue and
expense for each
major program
• Not necessarily by
responsibility
centers
• Not as much detail
as operating budget
• More expenses are
variable
• For several years
• Total reconciles to
operating budget
Operating Budget
• For organization as a whole
and for each business unit
• Classified by responsibility
centers
• Typically includes :
Revenues, Production cost
and cost of sales, Marketing
expense, Logistics expense,
General & administrative,
Research&development
Income taxes, Net income
• Expenses may be
Flexible,Discretionary,
Committed,
• For one year divided into
months or quarters
• Total reconciles to strategic
plan
Capital
Budget
• Each major
capital project
listed
separately
• Total project
expenditures
by quarters
8
Nature of a Budget
Operating Budget Categories
Revenue Budgets
• A revenue budget consist of unit sales
projection multiplied by expected selling
prices
• The revenue budget is the most critical
• The element of budget revenue is subject
to the greatest uncertainty
• The revenue budget usually is based on
forecasts of some conditions for which the
sales manager cannot be held responsible.
9
Nature of a Budget
Operating Budget Categories
Budgeted Production Cost and Cost of Sales
• Production managers make plans for obtaining
quantities of material and labor, and they may
prepare procurement budgets for long lead
times
• Production managers also develop production
schedules to ensure that resources needed to
produce the budgeted quantities will be
available
• The cost of sales reported in the summary
budget is the standard cost of the products
budgeted to be sold.
10
Nature of a Budget
Operating Budget Categories
Marketing Expenses
• Marketing expenses are expenses incurred
to obtain sales
• Logistic expenses usually are reported
separately from order getting expenses
• Many companies include logistic expenses
in the marketing budget, because they
tend to be the responsibility of the
marketing organization
11
Nature of a Budget
Operating Budget Categories
General and Administrative Expenses
• These are G&A expenses of staff units,
both at headquarters and at business
units.
• Overall, they are discretionary
expenses, although some components
are engineered expenses.
12
Nature of a Budget
Operating Budget Categories
Research and Development Expenses
• The R&D budget uses two approaches
• In one approach, total amount is the focus.
This may be the current level of spending,
or it may be a larger amount
• The alternative approach is aggregating the
planned spending on each approved project
13
Nature of a Budget
Operating Budget Categories
Income Taxes
• Some companies do not take income taxes
into account in preparing the budgets for
business units, because income tax policies
are determined at corporate headquarters.
14
Other Budgets
Capital Budget
• The capital budget states the approved
capital projects, plus a lump sum amount
for small projects that do not require high
level approval
• For the projects that remain, an estimate of
the cash that will be spent each quarter is
prepared. This is necessary in order to
prepare the cash flow statement.
15
Other Budgets
Budgeted Balance Sheet
• The budgeted balance sheet shows the
balance sheet implications of decisions
included in the operating budget and the
capital budget.
16
Other Budgets
Budgeted Cash Flow Statement
• The budgeted cash flow statement shows
how much of the cash needs during the
year will be supplied by retained earnings
and how much, if any, must be obtained by
borrowing or from other outside sources.
• It is, of course, important for financial
planning
17
Other Budgets
Management by Objectives
• Some companies make their objectives
explicit
• The process is doing so is called
management by objectives in the literature
• Unfortunately, some management by
objectives (MBO) systems are separated
from the budget preparation process. MBO
and budgeting should be two parts of the
same planning process.
18
Budget Preparation Process
Organization
Budget Department
• The budget department, which normally,
reports to the corporate controller, administers
the information flow of the budgetary control
system. The budget department performs the
following function :
- Publishes procedures and forms
- Coordinates and publishes the basic corporate
wide assumption
- Make sure that information is properly
communicated between organization units
19
Budget Preparation Process
Organization
Budget Department
- Provides assistance to budgetees in the
preparation of their budgets
- Analyzes proposed budgets and make
recommendation to the budgetee
- Administers the process of making budget
revisions during the year
- Coordinates the work of budget departments in
lower echelons
- Analyzes reported performance against budget,
interprets the results and prepare summary
reports for senior management
20
Budget Preparation Process
Organization
The Budget Committee
• The budget committee consists of members
of senior management
• The budget committee reviews and either
approves or adjusts each of the budgets.
21
Budget Preparation Process
Issuance of Guidelines
• The first step in budget preparation process is
to develop guidelines that govern the
preparation of the budget, for dissemination
for all managers
• All responsibility centers must follow some of
these guidelines, such as inflation, etc
• Other guidelines are specific to certain
responsibility centers
• The budget staff develops the guidelines and
senior management approves them.
22
Budget Preparation Process
Initial Budget Proposal
• Budget is based on the existing levels, which
are then modified in accordance with the
guidelines.
• Changes from the current level of
performance can be classified as :
a. Changes in external forces
b. Changes in internal policies and practices
23
Budget Preparation Process
Initial Budget Proposal
a. Changes in external forces
• Changes in general level of economic
activity as it affects the volume of sales
• Expected changes in the price purchased of
materials and services
• Expected changes in labor rates
• Expected changes in the cost of
discretionary activities
• Changes in selling prices
24
Budget Preparation Process
Initial Budget Proposal
b. Changes in internal policies and practices
• Changes in production costs, reflecting
new equipment and methods
• Changes in discretionary costs
• Changes in market share and product mix
25
Budget Preparation Process
Negotiation
• The budgetee discusses the proposed
budget with his or her superior.
• This is the heart of the process
26
Budget Preparation Process
Review and Approval
• The proposed budgets go up through
successive levels in the organization
• In part, the analyst studies consistency
• In part, the examination asks whether the
budget will produce satisfactory profit
• Final approval is recommended by the
budget committee to the CEO
27
Budget Preparation Process
Budgets Revision
• One of the principal considerations in budget
administration is the procedure for revising a
budget after it has been approved.
• There two general types of budget revisions :
1. Procedures that provide for a systematic
updating the budgets
2. Procedures that allow revisions under special
circumstances
• Budget revisions must be justified on the basis
of significantly changed conditions from those
existing when the original budget was approved
28
Budget Preparation Process
Contingency Budgets
• Some companies routinely prepare
contingency budgets that identify
management actions to be taken if there is
a significant decrease in the sales volume
from what was anticipated at the time of
developing the budget.
• The contingency budget provides a way of
quickly adjusting to changed conditions if
the situation arises.
29
Behavioral Aspects
Participation in the Budgetary Process
• A budget process is either “ top down “. The
top down approach rarely works, however
• Actually, an effective budget preparation
process blends the “ bottom up “
• Research has shown that budget participation
has positive effects on managerial motivation
for two reasons :
a. There is likely to be greater acceptance of
budget goals if they are perceived as being
under manager’s personal control.
b. Participative budgeting results in effective
information exchanges.
30
Behavioral Aspects
Degree of Budget Target Difficulty
There are several reasons why senior management
approves achievable budgets for business units
a. If the budgeted target is too difficult, managers
are motivated to take short term actions that
may not be in the long term interests of the
company
b. Achievable budget targets reduce the
motivation for managers to engage in data
manipulation
c. If business unit profit budgets represent
achievable targets, senior management can, in
turn, divulge a profit target to security analyst
31
Behavioral Aspects
Degree of Budget Target Difficulty
There are several reasons why senior management
approves achievable budgets for business units
d. A profit budget that is very difficult to attain
usually implies an overly optimistic sales target
e. When business unit managers are able to meet
and exceed their targets, there is a “winning”
atmosphere and positive attitude within the
company
32
Behavioral Aspects
Senior Management Involvement
• Senior management involvement is necessary
for any budget system to be effective in
motivating budgetees
• Management must participate in the review and
approval of the budgets, and the the approval
should not be a rubber stamp
33
Behavioral Aspects
The Budget Department
• The budget department has a particularly
difficult behavioral problem
• To perform their function effectively, the
members of the budget department must have
a reputation for impartiality and fairness
34
Quantitative Techniques
Simulation
• Simulation is a method that constructs a model
of a real situation and then manipulates this
model in such a way as to draw some
conclusions about the real situation.
• With a computer simulation, senior
management can ask what the effect of
different types of changes would be and
receive almost instantaneous answers
35
Quantitative Techniques
Probability Estimates
• Some authors have proposed budgets be
prepared initially using probability distributions
instead of point estimates, that is, the budget
committee would approve a number of
probability distributions, rather than specific
amounts.
36
Financial Service Organizations
Financial service
organizations include
commercial bank and
thrift institutions,
insurance companies and
securities firms
37
Service Organizations in General
Characteristics :
• Absence of inventory
buffer
• Difficulty in controlling
quality
• Labor intensive
• Multi unit organizations
38
Service Organizations in General
a. Absence of inventory buffer
• Goods can be held in inventory but services
cannot be stored
• Although a manufacturing company can earn
revenue in the future from products that are on
hand today, a service company cannot do so. A
service company must try to minimize its
unused capacity
• The cost of service organizations are essentially
fixed in the short run
• A key variable in most service organizations,
therefore, is the extent to which current
capacity is matched with demand.
39
Service Organizations in General
b. Difficulty in Controlling
Quality
• A manufacturing company can
inspect its products before they
are shipped to the customer, and
their quality can be measured
visually or with instruments
• A service company cannot judge
product quality until the moment
the service is rendered, and then
judgments are often subjective
40
Service Organizations in General
c. Labor Intensive
• Manufacturing companies add equipment
and automate production lines, thereby
replacing labor and reducing costs.
• Most service companies are labor intensive
and cannot do this
d. Multi Unit Organizations
• Some service organizations operate many
units in various locations, each unit
relatively small.
41
Financial Service Organizations
Special Characteristics :
While the general principles and concepts of
management control systems apply, they need
to be adapted to the following special
characteristics of the financial services
industry :
a.
b.
c.
d.
Monetary Assets
Time Period for Transactions
Risk and Reward
Technology
42
Financial Service Organizations
The Financial Service Sector
General observations can be made about the financial
sector :
a. Financial services are very important in the overall
performance of economy
b. 30 years ago, financial services, existed as distinct and
separate industries.
c. Financial services firms have used the IT revolution to
innovate new products and discover new methods of
trading
d. The need for controls in the financial services sector
has become paramount.
e. During the 1990s, new form of financial instruments
(such as derivatives) designed by financial service
firms sometimes resulted in millions of dollars of losses
43
Financial Service Organizations
The Financial Service Sector
The corporate scandals during 2000 have created a huge
push for investment banks to spin off their Research
Department. The arguments for spin off are many :
a. This separation will ensure objective research data.
b. At present, cost of research is being subsidized by
investment banks
c. Investor confidence will improve if they are convinced
that research is unbiased.
On the other hand, arguments against such a spin off, are
a. The cost of research will go up if they are set up as
separate firms
b. To keep costs down, research departments may issue
short reports instead of a rich.
44
Financial Service Organizations
Special Characteristics :
While the general principles and concepts of
management control systems apply, they need
to be adapted to the following special
characteristics of the financial services
industry :
a.
b.
c.
d.
Monetary Assets
Time Period for Transactions
Risk and Reward
Technology
45
Corporate Strategy
Implications for Management
Control
Strategic planning
• Conglomerates tend to use
vertical strategic planning
systems
• Related diversified firms tend
to be both vertical and
horizontal
• Single industry firms tend to
be both vertical and
horizontal
46
Business Unit Strategy
Mission
• The mission of existing
business should “pure
build” at one end and
“pure harvest” at the other
hand.
• To implement the strategy
effectively, there should be
congruence between the
mission chosen and the
types of controls used.
47
Business Unit Strategy
Competitive
Advantage
A business unit can
choose to compete
either as a
differentiated
player or as a low
cost player.
48
Top Management Style
Implications for
Management Control
• The various dimensions
of management style
significantly influence
the operations of
control systems
• Style affect the
management control
process
49
Top Management Style
Implications for Management Control
Personal versus Impersonal Controls
• Some managers are “number oriented”,
and they deriving tentative conclusions
from it.
• Other managers are “people oriented”,
they usually arrive at their decision by
talking with people
50
Top Management Style
Implications for Management
Control
Tight versus Loose Controls
• A manager’s style affects the
degree of tight versus loose
control in any situation.
• The manager of a routine
production responsibility center
can be controlled relatively
tightly or loosely.
• The actual control reflects the
style of the manager’s superior