Using Budgets to Achieve
Organizational Objectives
Chapter 10
Resource Flexibility
• For decisions affecting the short-term, the firm’s
capacity-related costs are considered as given
and fixed
• The supply of capacity resources is based on the
amount needed to produce the projected volume
of product
• The budgeting process makes clear that some
resources, once acquired, cannot be disposed of
easily if demand is less than expected
The Budgeting Process
• The process that determines the planned level
of most flexible costs
• Budgeting also includes discretionary spending
such as for R&D, advertising, and employee
training


These do not supply the firm with capacity but they do
provide support for the organization’s strategy by
enhancing its performance potential
Once authorized, discretionary spending budgets are
committed or fixed; they do not vary with level of
production or service
The Budgeting Process
• Budgets serve as a control for managers within
the business units of an organization
• Budgets play a central role in the relationship
between planning and control
• Budgets reflect in quantitative terms how to
allocate financial resources to each part of an
organization, based on the planned activities
and short-run objectives of that part of the
organization
The Budgeting Process
• A budget is a quantitative expression of the
money inflows and outflows that reveal whether
a financial plan will meet organizational
objectives
• Budgeting is the process of preparing budgets
• Budgets provide a way to communicate the
organization’s short-term goals to its members
The Budgeting Process
• Budgeting the activities of each unit can
 Reflect how well unit managers understand
the organization’s goals
 Provide an opportunity for the organization’s
senior planners to correct misperceptions
about the organization’s goals
• Budgeting also serves to coordinate the many
activities of an organization
The Budgeting Process
• Budgets help to anticipate potential problems
 Budgeting reflects the cash cycle and
provides information anticipate borrowing
needed to finance the inventory buildup early
in the cash cycle
 If budget planning indicates that the
organization’s sales potential exceeds its
manufacturing potential, then the organization
can develop a plan to put more capacity in
place or to reduce planned sales
Forecasting Demand
for Resources
Budgeting involves forecasting the demand for four
types of resources over different time periods:
1.
2.
3.
4.
Flexible resources that create variable costs
Intermediate-term capacity resources that create
capacity-related costs
Resources that, in the intermediate and long run
enhance the potential of the organization’s strategy
Long-term capacity resources that create capacityrelated costs
Master Budget
• Two major types of budgets comprise the
master budget:
 Operating budgets - summarize the level of
activities such as sales, purchasing, and
production
 Financial budgets - identify the expected
financial consequences of the activities
summarized in the operating budgets
Operating Budgets
•
•
•
•
Sales plan - identifies the planned level of
sales for each product
Capital spending plan - specifies the longterm capital investments that must be paid in
the current budget period to meet activity
objectives
Production plan - schedules all required
production
Materials purchasing plan - schedules all
required purchasing activities
Operating Budgets
•
•
Labor hiring and training plan - specifies the
number of people the organization must hire or
release to achieve its activity objectives
Administrative and discretionary spending
plan - includes administration, staffing,
research and development, and advertising
Operating Budgets
• Operations personnel use the operating budget
to guide and coordinate the level of various
activities during the budget period
• Operations personnel also record data from
current operations that can be used to develop
future budgets
Financial Budgets
• Planners prepare the financial budgets to evaluate
the financial consequences of investment,
production, and sales plans
• Planners use the projected statement of cash
flows in two ways:
 To plan when excess cash will be generated
 To plan how to meet any cash shortages
Demand Forecast
• An organization’s goals provide the starting point
and the framework for evaluating the budgeting
process
• Comparison of the tentative operating plan’s
projected financial results with the organization’s
financial goals
• Influence of the demand forecast
Developing the Demand Forecast
• Organizations develop demand forecasts in
many ways:



Market surveys
Statistical models
Assume that demand will either grow or decline by
some estimated rate over previous demand levels
• Require a sales plan for each key line of goods
and services
Importance of Sales Plans
• The sales plans provide the basis for other plans
to acquire the necessary factors of production:
 Labor
 Materials
 Production capacity
 Cash
Level of Detail in Budget
• Choosing the amount of detail to present in the
budget involves making trade-offs:
 More detail in the forecast improves the
ability of the budgeting process to identify
potential bottlenecks and problems by
specifying the exact timing of production
flows
 Forecasting and planning in great detail for
each item can be extremely expensive and
overwhelming to compute
Level of Detail in Budget
• Production planners use their judgment to strike
a balance between
 The need for detail
 The cost and practicality of detailed
scheduling
• Planners do this by grouping products into pools
The Production Plan
• Planners determine a production plan by
matching the completed sales plan with the
organization’s inventory policy and capacity level
• The plan identifies the intended production
during each of the interim periods comprising
the annual budget period
Inventory Policy
• The inventory policy is critical and has a unique
role in shaping the production plan
• One policy is to produce goods for inventory and
attempt to keep a target number of units in
inventory at all times
 Characteristic of an organization with highly
skilled employees or equipment dedicated to
producing a single product
 Reflects a lack of flexibility
Inventory Policy
• An alternative policy is to produce for planned
sales in the next interim period within the budget
period



Organizations moving toward a just-in-time inventory
policy produce goods to meet the next interim period’s
demand as an intermediate step in moving to a full
just-in-time inventory system
Each interim period becomes shorter and shorter until
the organization achieves just-in-time production
The scheduled production is the amount required to
meet the inventory target of the level of the next
interim period’s planned sales
Inventory Policy
• Just-in-time (JIT) inventory policy:
 Demand directly drives the production plan
 Production in each interim period equals the
next interim period’s planned sales
• JIT requires:
 Flexibility among employees, equipment, and
suppliers
 A production process with little potential for
failure
Aggregate Planning
• Aggregate planning compares:
 The production plan
 The amount of available productive capacity
• Assesses the feasibility of the proposed
production plan
The Spending Plan
• Once planners identify a feasible production plan,
they may make tentative resource commitments
• The purchasing group prepares a plan to acquire
the required raw materials and supplies
• Since sales and production plans change, the
organization and its suppliers must be able to
adjust their plans quickly based on new
information
The Spending Plan
• The personnel and production groups prepare the
labor hiring and training plans
• When an organization is contracting, it will:
 Use retraining plans to redeploy employees to
other parts of the organization, or
 Develop plans to discharge employees
The Spending Plan
• Discretionary expenditures provide the required
infrastructure for the proposed production and
sales plan
 “Discretionary” means the actual sales and
production levels do not drive the amount spent
 The senior managers in the organization
determine the amount of discretionary
expenditures
 Once determined, the amount to be spent on
discretionary activities becomes fixed for the
budget period and is unaffected by product
volume and mix
The Spending Plan
• A long-term planning process rather than the oneyear cycle of the operating budget drives the
capital spending plan
 Capital spending projects usually involve time
horizons longer than the period of the operating
budget
Choosing Capacity Levels
Three types of resources determine capacity:
1. Flexible resources that the organization can
acquire in the short term
2. Capacity resources that the organization must
acquire for the intermediate term
3. Capacity resources that the organization must
acquire for the long term
Choosing Capacity Levels
• Organizations develop sophisticated approaches
to balance the use of short, intermediate, and
long-term capacity to minimize the waste of
resources
• Three types of resource-consuming activities:
 Activities that create the need for resources
(and resource expenditures) in the short-term
 Activities undertaken to acquire capacity for the
intermediate-term
 Activities undertaken to acquire capacity
needed for the long-term
Choosing Capacity Levels
•
Analysts evaluate short-term activities by
considering efficiency and asking:



•
Is this expenditure necessary to add to the product
value perceived by customers?
Can the organization improve how it does this activity?
Would changing the way this activity is done provide
more satisfaction to the customer?
The production plan fixes the short-term
expenditures that the master budget summarizes
Choosing Capacity Levels
•
Analysts evaluate intermediate- and long-term
activities by using efficiency and effectiveness
considerations and asking:



•
Are there alternative forms of capacity available that
are less expensive?
Is this the best approach to achieve our goals?
How can we improve the capacity selection decision
to make capacity less expensive or more flexible?
The capacity plan commits the firm to its
intermediate and long-term expenditures
Handling Infeasible Production Plans
• Planners use forecasted demand to plan activity
levels and provide required capacity
• If planners find the tentative production plan
infeasible, then they have to make provisions to:
 Acquire more capacity, or
 Reduce the planned level of production
Interpreting The Production Plan
• Production is the lesser of:
 Total demand
 Production capacity
• Demand is the quantity customers are willing to
buy at the stated price
• Production capacity is the minimum of:
 The long-term capacity
 The intermediate-term capacity
 The short-term capacity
The Financial Plans
• Financial summary of the tentative operating
plans
 The projected balance sheet serves as an
overall evaluation of the net effect of operating
and financing decisions during the budget
period
 The projected income statement serves as an
overall test of the profitability of the proposed
activities
 The projected cash flow forecast helps an
organization identify if and when it will require
external financing
The Cash Flow Statement
The cash flow statement has three sections:
1. Cash inflows from cash sales and collections
of receivables
2. Cash outflows
•
•
For flexible resources that are acquired and
consumed in the short term
For capacity resources that are acquired and
consumed in the intermediate and long term
3. Results of financing operations
Financing Operations
• Summarizes the effects on cash of transactions
that are not a part of the normal operating
activities
• Includes the effects of:
 Issuing or retiring stock or debt
 Buying or selling capital assets
 Short-term financing
Using The Financial Plans
• Organizations can raise money from outsiders
by borrowing from banks, issuing debt, or selling
shares of equity
• Organizations can plan the appropriate mix of
external financing to minimize the long-run cost
of capital
Using The Financial Plans
• A cash flow forecast helps an organization
 Identify if and when it will require external
financing
 Determine whether any projected cash
shortage will be:
• Temporary or cyclical
• Permanent
What If Analysis
• Explore the effects of alternative marketing,
production, and selling strategies
• Alternative proposals like these can be
evaluated in a what-if analysis
• The structure and information required to
prepare the master budget can be used easily to
provide the basis for what-if analyses
Sensitivity Analysis
• What-if analysis is only as good as the model
used to represent what is being evaluated
• Planners test planning models by varying the
model estimates
• If small changes in an estimate used in the
production plan have a dramatic effect on the
plan, the model is said to be sensitive to that
estimate
Sensitivity Analysis
• Sensitivity analysis is the process of
selectively varying a plan’s or a budget’s key
estimates for the purpose of identifying over
what range a decision option is preferred
• Sensitivity analysis enables planners to identify
the estimates that are critical for the decision
under consideration
Variance Analysis
Variance analysis – comparison of planned (or
budgeted) results with actual results
 Variance analysis has many forms and can
result in complex measures, but its basis is
very simple: actual cost (or revenue) amount
is compared with a target cost (or revenue)
amount to identify the difference
Variance Analysis
• Variance – difference between planned and
actual results
• Should be investigated to determine:
 What caused the variance
 What should be done to correct that variance
Sources of Budgeted Costs
• Budgeted or planned costs can come from three
sources:
 Standards established by industrial engineers

Previous period’s performance

A benchmark, the best in class results
achieved by a competitor
Variances
• The financial numbers are the product of a price
and a quantity component:


Budgeted amount = expected price * expected quantity
Actual amount = actual price * actual quantity
• Variance analysis explains the difference between
planned and actual costs by evaluating:


Differences between planned and actual prices
Differences between planned and actual quantities
Variances
• Accountants focus separately on prices and
quantities because in most organizations:
 One department or division is responsible for
the acquisition of a resource and determining
the actual price
 A different department uses the resource and
determining the quantity
• A variance is a signal that is part of a control
system for monitoring results
Variances
• Supervisory personnel use variances as an
overall check on how well employees managing
day-to-day operations are performing
• When compared to the performance of other
organizations engaged in comparable tasks,
variances show the effectiveness of the control
systems that operations
Variances
• If managers learn that specific actions they took
helped lower the actual costs, then they can
obtain further cost savings by repeating those
actions on similar jobs in the future
• If the factors causing actual costs to be higher
than expected can be identified, then actions
may be taken to prevent those factors from
recurring in the future
• If cost changes are likely to be permanent, cost
information can be updated for future jobs
First-Level Variances
• The first-level variance for a cost item is the
difference between the actual costs and the
master budget costs for that cost item
• Variances are favorable (F) if the actual costs
are less than estimated master budget costs
• Unfavorable (U) variances arise when actual
costs exceed estimated master budget costs
Planning Variances
• A flexible budget adjusts the forecast in the
master budget for the difference between
planned volume and actual volume
• Cost differences between the master and the
flexible budget are called planning variances


Reflect the difference between planned output and
actual output
Arise entirely because the planned volume of activity
was not realized
Flexible Budget Variances
• Flexible budget variances are the differences
between the flexible budget and the actual results
• Flexible budget variances reflect:
 Quantity variances -- the difference between
the planned and the actual use rates per unit of
output
 Cost variances -- the difference between the
planned and the actual price or cost per unit of
the various cost items
Second & Third-Level Variances
• The second-level variances are the planning
variance and the flexible budget variance
• The direct material flexible budget variances and
direct labor flexible budget variances can be
decomposed further into third-level variances:
 Efficiency variances
 Price variances
Direct Material Variances
• The material quantity variance is calculated as:
Quantity variance = (AQ-SQ) x SP
Where:
AQ = actual quantity of materials used
SQ = standard (estimated) quantity of
materials required
SP = standard (estimated) price of materials
Direct Material Variances
• The material price variance is calculated as:
Price variance = (AP-SP) x AQ
Where:
AP = actual price of materials
SP = standard (estimated) price of materials
AQ = actual quantity of materials used

The price variance may, however, be calculated
using the quantity purchased rather than the
quantity used
Direct Labor Variances
Efficiency variance = (AH-SH) x SR
Rate variance = (AR-SR) x AH
Where:
AH = actual number of direct labor hours
AR = actual wage rate & SR = standard rate
SH = standard (estimated) number of direct
labor hours
• The sum of the rate variance and the efficiency variance
equals the total flexible budget direct labor variance
Support Activity Cost Variances
• Support costs can reflect either flexible or
capacity-related costs
• The quantity of capacity-related costs may not
change from period to period, but the spending on
them may fluctuate
• Monitoring spending variances on capacityrelated resources is possible and desirable
Support Activity Cost Variances
• Flexible support costs reflect behind-the-scenes
operations that are proportional to the volume of
activity but are not directly a part of the product
or service provided to the customer
• Flexible support costs consist of a quantity (or
usage) component and a price component
• Flexible support cost variances may be analyzed
in a manner similar to direct material or direct
labor variances
Budgeting In Nonmanufacturing
Organizations
• Budgeting helps nonmanufacturing
organizations perform their planning function by
coordinating and formalizing responsibilities and
relationships and communicating the expected
plans
• Budgeting serves a slightly different but equally
relevant role in natural resource companies,
service organizations, not-for-profit
organizations, and government agencies
Budgeting In Nonmanufacturing
Organizations
• In the natural resources sector, the focus is on
balancing demand with the availability of natural
resources
 Success requires managing the resource
base effectively to match supply with potential
demand
• In the service sector, the focus is on balancing
demand and the organization’s ability to provide
services, which is determined by the
organization’s level and mix of skills
Budgeting In Nonmanufacturing
Organizations
• In not-for-profit organizations, the focus of
budgeting has been to balance revenues raised
by taxes or donations with spending demands
• In government agencies planned cash outflows,
or spending plans, are called appropriations
Periodic Budgeting
• In a periodic budget cycle, the planners prepare
budgets periodically for each planning period
 Periodic budgeting is typically performed once
per budget period—usually once a year
 Planners may, however, update or revise the
budgets
Continuous Budgeting
• In continuous budgeting, as one budget period
passes, planners drop that budget period from the
master budget and add a future budget period in
its place
• The length of the budget period reflects the
competitive forces, skill requirements, and
technology changes that the organization faces
Periodic v. Continuous Budgeting
• Advocates of periodic budgeting argue that
continuous budgeting takes too much time and
effort and that periodic budgeting provides
virtually the same benefits at a smaller cost
• Advocates of continuous budgeting argue that it
keeps the organization planning, and assessing,
and thinking, strategically year-round rather than
just once a year at budget time
Controlling Discretionary Expenditures
• Organizations generally use one of three
general approaches to budget discretionary
expenditures:
 Incremental budgeting
 Zero-based budgeting
 Project funding
• Each has benefits distinct from the others
Incremental Budgeting
• Incremental budgeting bases a period’s
expenditure level on the amount spent during the
previous period
• If the total budget for discretionary items
increases by 10%, then:
 Each discretionary item is allowed to increase
10%, or
 All items may experience an across-the-board
increase of, for example, 5% and the
remaining 5% increase may be allocated
based on merit
Zero-Based Budgeting (1 of 2)
• Zero-based budgeting (ZBB) requires that
proponents of discretionary expenditures
continuously justify every expenditure
• The starting point for each line item is zero
• Zero-based budgeting arose, in part, to combat
indiscriminate incremental budgets where
projects that take on a life of their own and resist
going out of existence
Zero-Based Budgeting
• Organization’s resources are allocated to the
spending proposals they think will best achieve the
organization’s goals
• Used primarily to assess government expenditures
• In profit-seeking organizations, ZBB has been
applied only to discretionary expenditures
• For engineered costs, ZBB could be effective
when combined with the reengineering approach
Project Funding
• Project funding – intermediate solution to mitigate
the disadvantages of ZBB and incremental
budgeting



A proposal is made for discretionary expenditures with a
specific time horizon or sunset provision
Projects with indefinite lives (sometimes called
programs) should be continuously reviewed to ensure
that they are living up to their intended purposes
Requests to extend or modify the project must be
approved separately
Activity-Based Budgeting
• Activity-based budgeting - based on activitybased costing
• Uses knowledge about the relationship between
the quantity of production units and the activities
required to produce those units to develop
detailed estimates of activity requirements
underlying the proposed production plan
• Two main benefits of activity-based budgeting:
 Identifies situations when production plans
require new capacity
 Provides a more accurate way to project
future costs
Managing the Budgeting Process
• Many organizations use a budget team, headed
by the organization’s budget director or the
controller, to coordinate the budgeting process
• The budget team usually reports to a budget
committee, which generally includes the chief
executive officer, the chief operating officer, and
the senior executive vice presidents
• The composition of the budget committee
reflects the role of the budget as the planning
document that reflects and relates to the
organization’s strategy and objectives
Managing the Budgeting Process
• Using a budget committee may signal to other
employees that budgeting is something that is
relevant only for senior management
• Senior management must take steps to ensure
that the organization members affected by the
budget do not perceive the budget and the
budgeting process as something beyond their
control or responsibility
Behavioral Aspects of Budgeting
• Because of the human factor involved in the
process, budgets often do not develop
smoothly
• Two related areas are of particular importance
with respect to the behavioral issues:


Designing the budget process
Influencing the budget process
Designing the Budget
• How should budgets be determined and who
should be involved in the budgeting process?
• Three common methods of setting budgets:

Authoritarian - superior simply tells subordinates what
their budget will be
 Participation - all parties agree about setting the
budget targets, using a joint decision-making process
 Consultation - managers ask subordinates to discuss
their ideas about the budget but determine the final
budget alone
Designing the Budget (2 of 2)
• Research shows that the most motivating types
of budgets are those that are tight

With targets that are perceived as ambitious but
attainable
• Recently, some companies have implemented
what are known as stretch targets

Stretch targets exceed previous targets by a
significant amount and usually require an enormous
increase in a goal over the next budgeting period
 The theory is that only in this manner will companies
completely reevaluate the ways in which they develop
and produce products and services
Influencing The Budget Process
• When incentives and compensation are tied to
the budget, some managers have been known to
play budgeting games in which they attempt to
manipulate information and targets to achieve as
high a bonus as possible (or the best evaluation)
• Participation provides employees the opportunity
to affect their budgets in ways that may not
always be in the best interests of the organization
Budget Slack
• Budget slack is created by requiring excess
resources or distorting performance information
• If subordinates succeed in creating budget slack,
they will find it easy to meet or exceed their
budgeted objectives
• Budgeting games can never be eliminated,
although some organizations have devised
methods to decrease the amount of budget slack