Chapter 9:
Profit Planning
Cornerstones of Managerial Accounting, 4e
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Learning Objectives
1. Define budgeting and discuss its role in planning, control,
and decision making.
2. Define and prepare the operating budget, identify its major
components, and explain the interrelationships of its various
components.
3. Define and prepare the financial budget, identify its major
components, and explain the interrelationships of its various
components.
4. Describe the behavioral dimension of budgeting.
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1
Description of Budgeting
►All businesses should prepare budgets.
►Budgets help business owners and managers to
plan ahead, and later, exercise control by
comparing what actually happened to what was
expected in the budget.
►Budgets formalize managers’ expectations
regarding sales, prices, and costs.
►Even small businesses and nonprofit entities can
benefit from the planning and control provided
by budgets.
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Budgeting and Planning and Control
► Planning and control are linked.
► Planning is looking ahead to see what actions should be taken to
realize particular goals.
► Control is looking backward, determining what actually happened
and comparing it with the previously planned outcomes.
► Budgets are financial plans for the future and are a key
component of planning. They identify objectives and the actions
needed to achieve them.
► Before preparing a budget, an organization should develop a
strategic plan.
► The strategic plan plots a direction for an organization’s future
activities and operations; it generally covers at least five years.
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1
Planning, Control, and Budgets
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1
Advantages of Budgeting
A budgetary system gives an organization
several advantages.
Planning
Information for Decision Making
Standards for Performance
Evaluation
Improved Communication
& Coordination
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1
The Master Budget
►The master budget is the comprehensive financial plan
for the organization as a whole.
►Typically, the master budget is for a one-year period,
corresponding to the fiscal year of the company.
►Yearly budgets are broken down into quarterly and
monthly budgets.
►The use of smaller time periods allows managers to
compare actual data with budgeted data more
frequently, so problems may be noticed and resolved
sooner.
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The Master Budget
(continued)
►Some organizations have developed a continuous
budgeting philosophy.
►A continuous budget is a moving 12-month budget.
►As a month expires in the budget, an additional month
in the future is added so that the company always has a
12-month plan on hand.
►Proponents of continuous budgeting maintain that it
forces managers to plan ahead constantly.
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Master Budget:
Directing and Coordinating
►Most organizations prepare the master budget for the
coming year during the last four or five months of the
current year.
►The budget committee reviews the budget, provides
policy guidelines and budgetary goals, resolves
differences that arise as the budget is prepared,
approves the final budget, and monitors the actual
performance of the organization as the year unfolds.
►The controller usually serves as the budget director, the
person responsible for directing and coordinating the
organization’s overall budgeting process.
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Master Budget:
Major Components
►A master budget can be divided into operating and financial
budgets:
►Operating budgets describe the income-generating activities of a
firm: sales, production, and finished goods inventories. The ultimate
outcome of the operating budgets is a pro forma or budgeted
income statement.
►Financial budgets detail the inflows and outflows of cash and the
overall financial position. Planned cash inflows and outflows appear
in the cash budget. The expected financial position at the end of the
budget period is shown in a budgeted, or pro forma, balance sheet.
►Since many of the financing activities are not known until
the operating budgets are known, the operating budget is
prepared first.
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1
The Master Budget and
Its Interrelationships
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Preparing the Operating Budget
►The operating budget consists of a budgeted income
statement accompanied by the following supporting
schedules:
►sales budget
►production budget
►direct materials purchases budget
►direct labor budget
►overhead budget
►selling and administrative expenses budget
►ending finished goods inventory budget
►cost of goods sold budget
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2
Sales Budget
►The sales budget is approved by the budget committee
and describes expected sales in units and dollars.
►Because the sales budget is the basis for all of the other
operating budgets and most of the financial budgets, it
is important that it be as accurate as possible.
►The first step in creating a sales budget is to develop the
sales forecast.
►The sales forecast is just the initial estimate, and it is
often adjusted by the budget committee.
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Cornerstone 9-1
2
Preparing a Sales Budget
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2
You Decide
Budgeting in a Service Industry
You are the controller for a large, regional medical center. The chief of cardiology has been pushing
to have a free-standing heart hospital built on the medical center campus. However, you are
concerned that taking the heart cases away from the main hospital will hurt its bottom line. While the
medical center is nonprofit, it does need to cover all of its costs to stay in business. You also wonder
whether the heart hospital will break even.
What information do you need to forecast revenues and costs of the heart
hospital?
This is a two part problem. The first question, what impact will the heart hospital have on the main
hospital’s revenues, requires knowledge of the number and types of heart cases seen at the main
hospital each year. This information could come from the sales revenue budget from the previous
year, assuming that the total number of patient days and procedures are broken out by type of case
and procedure. Since so many of the costs of a hospital are fixed, there will probably be little
decrease in costs as those heart patients leave for the freestanding heart hospital. The second
question requires a forecast of the number of patients and probably reimbursement rates expected
for procedures to be performed by the heart hospital. This information can be compared with
budgeted operating costs to see if the heart hospital’s revenues can cover its costs.
Forecasts of sales revenues and costs are dependent on detailed information provided by
sources like the marketing or sales department and past accounting information and need to
be revised and updates as new information or circumstances dictate.
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2
Production Budget
►The production budget tells how many units must be
produced to meet sales needs and to satisfy ending
inventory requirements.
►To compute the units to be produced, both unit sales
and units of beginning and ending finished goods
inventory are needed:
Units to be produced = Expected unit sales + Units in
desired ending inventory (EI) – Units in beginning
inventory (BI)
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Cornerstone 9-2
2
Preparing a Production Budget
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2
Cornerstone 9-2
Preparing a Production Budget (continued)
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2
Direct Materials Purchases Budget
►After the production budget is completed, the budgets
for direct materials, direct labor, and overhead can be
prepared.
►The direct materials purchases budget tells the amount
and cost of raw materials to be purchased in each time
period.
►The formula used for calculating purchases is as follows:
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2
Cornerstone 9-3
Preparing a Direct Materials Purchases
Budget
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Cornerstone 9-3
2
Preparing a Direct Materials Purchases Budget
(continued)
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Cornerstone 9-3
2
Preparing a Direct Materials Purchases Budget
(continued)
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2
Direct Labor Budget
►The direct labor budget shows the total direct
labor hours and the direct labor cost needed for
the number of units in the production budget.
►As with direct materials, the budgeted hours of
direct labor are determined by the relationship
between labor and output.
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Cornerstone 9-4
2
Preparing a Direct Labor Budget
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Overhead Budget
►The overhead budget shows the expected cost of all
production costs other than direct materials and
direct labor.
►Many companies use direct labor hours as the driver
for overhead.
►Then costs that vary with direct labor hours are
pooled and called variable overhead.
►The remaining overhead items are pooled into fixed
overhead.
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Cornerstone 9-5
Preparing an Overhead Budget
Information:
Refer to the direct labor budget below. The variable overhead rate is $5
per direct labor hour. Fixed overhead is budgeted at $1,645 per quarter
(this amount includes $540 per quarter for depreciation).
Required:
Prepare an overhead budget.
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2
Cornerstone 9-5
Preparing an Overhead Budget (continued)
Solution:
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Ending
Finished
Goods
Inventory
2
Budget
►The ending finished goods inventory budget
supplies information needed for the balance sheet
and also serves as an important input for the
preparation of the cost of goods sold budget.
►To prepare this budget, the unit cost of producing
finished goods must be calculated by using
information from the direct materials, direct labor,
and overhead budgets.
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Cornerstone 9-6
2
Preparing an Ending
Finished Goods Inventory Budget
Information:
Refer to the direct materials, direct labor,
and overhead budgets prepared previously
and shown here.
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Cornerstone 9-6
2
Preparing an Ending
Finished Goods Inventory Budget (continued)
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Cost of Goods Sold Budget
►Assuming that the beginning finished
goods inventory is valued at $1,251, the
budgeted cost of goods sold schedule
can be prepared using information from
Cornerstones 9-3 to 9-6.
►The cost of goods sold budget reveals
the expected cost of the goods to be
sold.
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2
Cornerstone 9-7
Preparing a Cost of Goods Sold Budget
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2
Selling and Administrative
Expenses Budget
►The selling and administrative expenses budget
outlines planned expenditures for nonmanufacturing
activities.
►As with overhead, selling and administrative
expenses can be broken down into fixed and variable
components.
►Such items as sales commissions, freight, and
supplies vary with sales activity.
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Cornerstone 9-8
Preparing a Selling and Administrative
Expenses Budget
Information:
Refer to the sales budget below. Variable expenses are $0.10 per unit sold. Salaries
average $1,420 per quarter; utilities, $50 per quarter; and depreciation, $150 per
quarter. Advertising for Quarters 1 through 4 is $100, $200, $800, and $500,
respectively.
Required:
Prepare a selling and administrative expenses budget.
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Cornerstone 9-8
Preparing a Selling and Administrative
Expenses Budget (continued)
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2
Budgeted Income Statement
►With the completion of the budgeted cost of
goods sold schedule and the budgeted selling
and administrative expenses budget, a
company has all the operating budgets
needed to prepare an estimate of operating
income.
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Cornerstone 9-9
Preparing a Budgeted Income Statement
Information:
Refer to Cornerstones 9-1, 9-7, 9-8, and 9-12 for the sales budget, the cost of
goods sold budget, the selling and administrative expenses budget, and the cash
budget. Assume that the tax rate is 40 percent.
Required:
Prepare a budgeted income statement.
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Preparing the Financial Budget
►The remaining budgets found in the master
budget are the financial budgets.
►The usual financial budgets prepared are:
►cash budget
►budgeted balance sheet
►budget for capital expenditures
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3
Cash Budget
► Understanding cash flows is critical in managing a business.
► Often, a business successfully produces and sells products but fails
because of timing problems associated with cash inflows and
outflows.
► Because cash flow is the lifeblood of an organization, the cash
budget is one of the most important budgets in the master budget.
► The basic structure of a cash budget includes cash receipts,
disbursements, any excess or deficiency of cash, and financing as
shown below:
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Cash Budget: Cash Available
► Cash available consists of the beginning cash balance and the
expected cash receipts. Expected cash receipts include all
sources of cash for the period being considered.
► The principal source of cash is from sales.
► Since a large proportion of sales is usually on account, a major
task of an organization is to determine the pattern of
collection for its accounts receivable.
► If a company has been in business for a while, it can use past
experience to determine what percentage of credit sales are
paid in the month of and months following sales.
► This is used to create a schedule of cash collections on
accounts receivable.
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3
Cornerstone 9-10
Preparing a Schedule for Cash Collections
on Accounts Receivable
Information:
From past experience, Texas Rex expects that, on average, 25 percent of total sales
are cash and 75 percent of total sales are on credit. Of the credit sales, Texas Rex
expects that 90 percent will be paid in cash during the quarter of sale, and the
remaining 10 percent will be paid in the following quarter. Recall from Cornerstone
9-1 that Texas Rex expects the following total sales:
Quarter
Quarter
Quarter
Quarter
1
2
3
4
$10,000
$12,000
$15,000
$20,000
The balance in accounts receivable as of the last quarter of 2011 was $1,350. This
will be collected in cash during the first quarter of 2012.
Required:
1. Calculate cash sales expected in each quarter of 2012.
2. Prepare a schedule showing cash receipts from sales expected in each quarter of
2012.
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Cornerstone 9-10
Preparing a Schedule for Cash Collections
on Accounts Receivable (continued)
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3
Cash Budget:
Cash Disbursements
► The cash disbursements section lists all planned cash outlays
for the period.
► All expenses that do not require a cash outlay are excluded
from the list (e.g., depreciation is never included in the
disbursements section).
► Just as sources of cash may require a schedule of cash
collections on accounts receivable to calculate cash expected
from credit sales, the disbursements section may require care
in handling payments on account.
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Cornerstone 9-11
Determining Cash Payments
on Accounts Payable
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Cornerstone 9-11
Determining Cash Payments
on Accounts Payable (continued)
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Cash Budget:
Cash Excess or Deficiency
► Some companies expand the basic cash budget format by
adding lines to show any borrowing or repayment necessary
to achieve a minimum desired cash amount.
► When this is done, the preliminary ending cash balance is
called cash excess or deficiency.
► The cash excess or deficiency line is compared to the
minimum cash balance (or lowest amount of cash acceptable
as noted by company policy).
► If a cash deficiency exists with less cash on hand than is
needed, the company usually obtains a short-term loan.
► A cash excess is usually used to repay loans or used to make
temporary investments.
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Cash Budget: Borrowings and Repayments,
Ending Cash Balance
► Borrowings and Repayments: If a company converts its
preliminary cash balance line to a cash excess (deficiency)
line, it may be borrowing or repaying money. If there is a
deficiency, this section shows the necessary amount to be
borrowed. When excess cash is available, this section shows
planned repayments, including interest expense.
► Ending Cash Balance: The last line of the cash budget is the
ending cash balance. This is the planned amount of cash to be
on hand at the end of the period after all receipts and
disbursements, as well as borrowings and repayments, are
considered.
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3
Cornerstone 9-12
Preparing a Cash Budget
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Cornerstone 9-12
Preparing a Cash Budget (continued)
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3
You Decide
Cash Budgeting for a Small Painting Company
You are the accountant for a number of small businesses in your
town, one of which is Ramon’s Paint and Plaster. Ramon has been
through a tough year as construction in the town has been down.
However, new home construction is picking up and Ramon has been
asked to bid on twice as many jobs in the past month as he was last
year at this time. Ramon needs to know what his cash flow will be
for the coming year. You are starting to amass information to help
you forecast monthly cash inflows and outflows for the next six
months.
What information do you need to forecast cash inflows and
outflows for the paint and plaster business for the next six
months?
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You Decide
Cash Budgeting for a Small Painting Company
(continued)
This is a two part problem. The first question, what inflows of cash are expected, depends on
the number and size of the jobs Ramon can successfully bid on. Ramon’s business has been
primarily residential, so you’ll need to know the number of housing starts (or the number of
building permits applied for) and the number of remodeling jobs expected. You will also need
to consider the price Ramon charges as well as the probability of prompt payment. Some
builders have a good reputation for paying promptly in the first ten days of the month following
work by Ramon’s crew. Others lag behind. While you can encourage Ramon to work primarily
with the better builders, he may be forced to accept some jobs with contractors who
frequently pay later.
The second question requires a forecast of the potential cash outflows. Ramon has a crew of
six workers and the hourly rate is known. He also can figure out the cost of the paint and
plaster materials fairly accurately, once the size of the job is known. It will be difficult to
forecast the cash inflows and outflows too far in advance. As a result, you will probably want to
set up the cash budget for one to three months in advance and then update the forecasted
numbers as the year progresses.
Forecasts of cash inflows and outflows depend on the economic conditions, the reputation of
the payment patterns of the customers, and the prices charged both for the jobs obtained as
well as for the supplies used. Information from the past year can be used as a baseline,
however, changing economic conditions will affect future amounts.
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3
Budgeted Balance Sheet
►The budgeted balance sheet depends on
information contained in the current balance
sheet and in the other budgets in the master
budget.
►Explanations for the budgeted figures are
typically provided in the footnotes.
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4
Using Budgets for Performance Evaluation
► Budgets are often used to judge the performance of
managers.
► Bonuses, salary increases, and promotions are all affected by
a manager’s ability to achieve or beat budgeted goals.
► Positive behavior occurs when the goals of each manager are
aligned with the goals of the organization and each manager
has the drive to achieve them.
► The alignment of managerial and organizational goals is often
referred to as goal congruence.
► If the budget is improperly administered, subordinate
managers may subvert the organization’s goals.
► Dysfunctional behavior is individual behavior that is in basic
conflict with the goals of the organization.
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4
Positive Behavior
►Key features that promote a reasonable degree of
positive behavior include:
►frequent feedback on performance
►monetary and nonmonetary incentives
►participative budgeting
►realistic standards
►controllability of costs
►multiple measures of performance
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4
Frequent Feedback on
Performance
►Managers need to know how they are doing
as the year progresses.
►Frequent, timely performance reports allow
managers to know how successful their
efforts have been, to take corrective actions,
and to change plans as necessary.
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4
Monetary and Nonmonetary
Incentives
► Incentives are the means an organization uses to influence a
manager to exert effort to achieve an organization’ s goal.
► Traditional organizational theory assumes that employees
are primarily motivated by monetary rewards, they resist
work, and they are inefficient and wasteful.
► Thus, monetary incentives are used to control a manager’s
tendency to shirk and waste resources by relating budgetary
performance to salary increases, bonuses, and promotions.
► Nonmonetary incentives, including job enrichment, increased
responsibility and autonomy, and recognition programs can
be used to enhance a budgetary control system.
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4
Participative Budgeting
► Rather than imposing budgets on subordinate managers,
participative budgeting allows subordinate managers
considerable say in how the budgets are established.
► The increased responsibility and challenge inherent in the
process provide nonmonetary incentives that lead to a higher
level of performance.
► However, participative budgeting has three potential
problems:
► setting standards that are either too high or too low
► building slack into the budget (often referred to as padding the
budget)
► pseudoparticipation
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4
Standard Setting
► Some managers may tend to set the budget either too loose
or too tight.
► Since budgeted goals tend to become the manager’s goals
when participation is allowed, making this mistake in setting
the budget can result in decreased performance levels.
► The trick is to get managers in a participative setting to set
high but achievable goals.
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4
Budgetary Slack
► The second problem with participative budgeting is the
opportunity for managers to build slack into the budget.
► Budgetary slack (or padding the budget) exists when a
manager deliberately underestimates revenues or
overestimates costs in an effort to make the future period
appear less attractive in the budget than they think it will be
in reality.
► Either approach increases the likelihood that the manager will
achieve the budget and consequently reduces the risk that
the manager faces.
► The act of padding the budget is questionable when
considering what is viewed as ethical professional practice. It
is certainly not communicating information fairly and
objectively and constitutes a violation of the credibility
standard.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
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4
Pseudoparticipation
►The third problem with participation occurs
when top management assumes total control
of the budgeting process, seeking only
superficial participation from lower-level
managers.
►This practice is termed pseudoparticipation.
►Top management is simply obtaining formal
acceptance of the budget from subordinate
managers, not seeking real input.
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4
Realistic Standards
► Budgets should reflect operating realities, including the
following:
► Actual Levels of Activity: Flexible budgets are used to ensure that
budgeted costs can be realistically compared with costs for actual
levels of activity.
► Seasonal Variations: Interim budgets should reflect seasonal effects.
Toys ‘‘R’’ Us, for example, would expect much higher sales in the
quarter that includes Christmas than in other quarters.
► Efficiencies: Budgetary cuts should be based on planned increases in
efficiency and not simply arbitrary across-the-board reductions.
Across-the-board cuts without any formal evaluation may impair the
ability of some units to carry out their missions.
► General Economic Trends: General economic conditions also need to
be considered. Budgeting for a significant increase in sales when a
recession is projected is not only foolish but also potentially
dangerous.
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4
Controllability of Costs
►Ideally, managers are held accountable only for costs
that they can control.
►Controllable costs are costs whose level a manager
can influence.
►If noncontrollable costs are put in the budgets of
subordinate managers to help them understand that
these costs also need to be covered, then they
should be separated from controllable costs and
labeled as noncontrollable.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
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4
Multiple Measures of Performance
►Often, organizations make the mistake of using budgets
as their only measure of managerial performance.
►While financial measures of performance are important,
overemphasis can lead to a form of dysfunctional
behavior called milking the firm or myopia.
►Myopic behavior occurs when a manager takes actions
that improve budgetary performance in the short run but
bring long-run harm to the firm.
►Budgetary measures alone cannot prevent myopic
behavior.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.