Managerial Accounting Final Paper


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Managerial Accounting Final Paper

  1. 1. Profit Planning Created by: David Foust For: Dr. Ahmed El-Zayaty MBA 670.N2 15 November 2009
  2. 2. Contents Introduction .................................................................................................................................................. 3 Advantages of a budget ................................................................................................................................ 3 Responsibility Accounting ............................................................................................................................. 6 Budget Period ............................................................................................................................................... 8 Self Imposed Budget ..................................................................................................................................... 9 Human Factors in Budgeting ....................................................................................................................... 14 Budget Committee ...................................................................................................................................... 16 Conclusion ................................................................................................................................................... 18 Work Cited .................................................................................................................................................. 19 2
  3. 3. Introduction Profit planning, usually stated as budgeting, is used by every company. Budgeting allows for companies to plan for costs that are associated with running a business. By budgeting and profit planning, companies can forecast the future spending of each department. The budget determines the complete guidance of a company. Many crucial decisions such as hiring, firing, raises, cost cuts, and purchases are determined by the budget. A budget is more than number crunching, but rather a strategy a company can use to determine which products and services would be successful in different markets. Also, by budgeting a company, the comparison to what a company is spending to what it thinks it is spending is determined. This allows corrections in areas that bottleneck the company efficiency. Budgets can range from personal budgeting to corporate corporate budgeting. People use budgets in their home lives to measure if they can afford to do a certain event or purchase a certain product. Corporations use budgeting to measure the success and accuracy of each department. Budgets aren’t just limited to companies. Government agencies use budgets to allocate spending of the citizens tax dollars. Start up companies use budgets to determine if they can stay in business long enough a profit. In this paper, the focus is on the human interaction between members of a company in determining the proper development of a budget. Advantages of a budget What is a budget? A budget is a quantitative plan for acquiring and using resources over a specified time. Budgets are used by organizations from healthcare to military defense with the idea in mind that by indentifying cost, they can budget their 3
  4. 4. costs accordingly. Budgeting allows the company to plan its goals around these budgets. Each department in the organization can plan a budget and then work towards hitting those goals set. The only way this is done is through controlling. Controlling involves the steps taken by manager of a company in order to stay on track to match the proposed budget. An advantage of controlling allows the managers to plan for the future rather than dealing with each problem on a day to day basis. Without a budget, many companies wouldn’t be able to decide on purchasing of resources. To many and the company would be losing money, not enough could put a stop to production. On a broader spectrum, budgeting makes sure everyone in the organization is pulling in the same direction. By budgeting, each department can review their budget and make sure they are following the goals of the company. Let’s first take a look at the top down approach to budgeting The top down method of budgeting is the act of top or senior level management imposing the budget of each department below them. This method is done in most traditional companies still to this day. Top down budgeting allows the senior management to make all the decisions without having several other influences.(Thornbory, Farley, 2007) The cost of this method is minimal compared to the bottom up method. The senior level can review the previous year budget against the current year and decide what it should flex in order to fulfill the needs of that department. However, the top down method has been a proven failure in recent years. For one, the senior level does not have the knowledge of the local management in fulfilling the needs of each department. Another reason top down budgeting has failed is through 4
  5. 5. lack of involvement causing poor motivation. Management at a lower level is not going to feel motivated to accomplish a budget if it knows from the beginning that the budget goal is unattainable. The bottom up method, which allows management at each level of the organization be involved is a more realistic approach to budgeting. Bottom up budgeting has management participate in the budgeting process which allows the local knowledge to transfer to a more accurate goal. Motivation of an entire department can depend on involvement. If these managers don’t feel that they contribute to the company, the motivation of their self, along with motivating employees below them is lost. The bottom up budget gives a level of trust to those managers in making corporate level decisions. Just like the top down method, the bottom up method has its flaws. First, the bottom up method allows managers to protect their own interest by over-estimating their needs. This gives room for flexibility of failure for these managers, as well as not proving accurate to the company’s overall budget. As the top down method was quick and efficient, the bottom up is the opposite. Time consuming and costly, the bottom up method seeks more attention from each department. This attention takes away from the day to day operations by hosting several meetings to discuss each departments own budget. The new and innovative idea when it comes to budgeting revolves around the new concept of parallel budgeting. Parallel budgeting is a combination of top down and bottom up budgeting. This process involves both senior level and department level management. The senior level management sets the original goal of the budget for 5
  6. 6. each department. Then, the department managers negotiate the process of resource allocation. Adjustments can be made accordingly, but with the input of the senior management. This allows each department manager to have more control over its budget. The understanding of where the senior level is coming from is laid out which allows for unification of the entire organization. Some other benefits include: performance can be monitored, staff motivation/ participation, money management, resource allocation, improved decision making, and future planning. So what’s the downside? Not much actually. The real downfall with parallel budgeting is time consumption. The process of the senior management proposing the goal vs. department level negotiation can take time and money. On the other hand, the final company budget is more accurate and an understanding of each department is reached. Responsibility Accounting Responsibility accounting, which is sometimes called, budgetary control systems, is the basic understanding that a manager should be held responsible for those items, and only those item that the manager can actually control. Lehman’s terms, if you can change it, you are in charge of it. First let’s look how responsibility accounting affects our everyday lives.(Rowland, 2005) When you are out shopping, you have complete control over what you purchase. Therefore you are responsible for any purchase made. How do you decide what to buy? Price, quality, need vs. want, cash flow, demand, these are all decisions that have to be made before purchasing that one item. Each item you purchase effects the next item you purchase.(Nursing Management, 2003) The saying “rob Peter to pay Paul” comes into play. This is budgeting your personal finance 6
  7. 7. to determine the level of need for these products or services. What does it look like on a larger scale? A hospital uses a number of budgetary control systems throughout its organization in which each control system decides what to spend its allocated money on. A budget manager could be in charge a number of different sub control systems such as: nursing, ER, OBGYN, maintenance, security, etc. Each of these sub systems relies on a budget manager, usually in reference to department manager, to decide on how to allocate spending to maximize efficiency. To have an effective budgetary control system, these managers are able to account for the money it has received along with the money its department spends. (Nursing Management, 2003) The budget control systems help the managers of these departments follow the organizations guidelines on how the money can be spent, as well as assisting to create a more streamlined division. In today’s hospitals, the responsibility is moving farther and farther down the chain of command. Junior level management is now given responsibility from the budget control system. By doing so, it is believed that the money will be accounted for more precise. Also, because of such trust, financial losses through incompetence, error, negligence, or fraud can be pinpointed down to the one person responsible. One issue that is a blur when it comes to responsibility accounting is; who is responsible for what costs? When a company uses one department for purchasing and one for controlling, the cost responsibility is blurred. Many organizations use this blur as an advantage to make each department work together. It is often seen that a department is more worried about allocation of money instead of the overall goal of an organization. It is up to the senior level management to define the responsibilities of 7
  8. 8. each department, while stressing the concept that the manager is only responsible for what it can control. Often times a budget does not match actual results. Budget managers have to be able to identify why this is happening to senior management. Usually this means to identify the variances that are occurring over a period of time. Small variances can be overlooked, but when certain areas are over budget by large amounts, a budget manager must step in and identify the source. In the example used by (Nursing Management, 2003) a food service manager is over its predicted budget at 6 months. The salaries of its employees has stayed the same roughly, but the food consumption has increased by 50%. It is the job of the budget manager to identify why the food consumption spending has risen so dramatically. In this case, it wasn’t the mismanagement of spending, but rather the increase in patience it has to feed. Therefore, the budget manager will identify the variance and correct its budget accordingly. These fluctuations happen in every business, but by identifying cause, budget managers have the leeway to update the projected budget. Budget Period The budget period of any organization is crucial to the spending and projection of any department. Some companies use a continuous or perpetual budget period, while others stick to a strict one year budget period. In any event, the budget period allows for an organization to plan ahead according to their theory. The budget period is often broken down into smaller, more feasible budget periods. Such as, a quarter is broken down into a three month span. Many companies use these quarters to project a budget for the next quarter. The continuous budget uses the quarter budget concept in 8
  9. 9. conjunction with yearly budget that instead of using a fixed time period, a new quarter is added as one ends.(Ulkumen, Thomas, Morwitz, 2008) This often gives a rough estimation of projected spending, but can have an immediate impact on what needs changed to hit the target numbers. In tough economic times, managers often have to make tough decisions on what to cut and what to keep.(Don,2004) Knowing who is in charge of what decisions, policies of the organization, structure, and who to influence for such decisions can be a key factor for department managers. If the manager is hitting the end of his/ her budget period, influence on the next budget period becomes crucial. Many times, the department manager and senior management don’t have the same agenda. Therefore, the department manager needs to have a plan to ensure his/ her budget is still feasible. Self Imposed Budget A self imposed is merely a budget that was created by the people who use them. As discussed earlier in this paper, their several different kinds of budgets. The self imposed budget focuses on the bottom up approach. This more in depth analysis is the result of how effective this method of budgeting is. When manager are active in the budget process, their expectations to fulfill that budget is much higher. Companies that place the trust of their financial development in the hands of their employees is much more likely to hit stride for stride in achieving their goals. Empowerment. This single word is what changes the outcome from a good company and a great company. Self imposed budget does just this. It empowers its managers to be part of a team. When a manager sets his/ her own budget, the outcome 9
  10. 10. lies solely on themselves. Let’s take a second and review that, the outcome lies solely on themselves. The problem with most budgets is a senior level executive creates the budget for each department, then relies on them to hit the numbers he has set. The only problem with this is even if the numbers are matched, the reward isn’t on the manager, but more on the executive for having the insight to set the right number. The self imposed budget is a live or die method. The department manager is either going to live or die by his/ her own intellect. A self imposed budget is more than empowerment, but also motivation. Managers are proud when they show they can create a budget. Who do think would try to motivate their employees more, a manager who was given a budget, or a manager who created a budget? Self imposed budgets create self motivation. For instance, if a manager is given a stipulation, it is now up to them to decide how to achieve that goal. If the manager and all of her employees want to receive a raise the following year, they must meet the goal set my upper management. This seems like a top down method, but in actuality, the freedom to choose how it reaches the goal is left up to the manager. These types of motivation pure monetary, but creates a more focused manager. Instead of using three workers to do one job that only requires two, the manager is going to maximize the efficiency and place that one extra worker on another project. This in fact acts in a two form benefit by reducing cost on one project, and increasing work on another. That work can then be transformed into higher sales. These self imposed budgets usually come in the form of sub budgets. These sub budgets, as discussed earlier are more in depth budget centers. A manager is now fully in charge of staying with the boundaries set. Motivating employees to participate in this saving can also add 10
  11. 11. to the overall goal. If the manager can motivate an employee to follow the same principles that he/ she is using, efficient, maximized sub budgets will show effect. Most budget meeting are orchestrated compromises says Jack Welch (Welch, Welch, 2006). Why? Because most budget meetings are negotiations that both parties exaggerate to hit a middle ground. If the department manager comes to the meeting say that “the economy is down I only believes I can hit a 6% sales goal”, the senior level is going to be upset. Therefore, the senior level negotiates back saying that, “even in the down economy we believe you should be able to reach 14% sales.” Both parties came to the meeting knowing very well that they each believe the sales of 10% could be done. However, the lack of trust between both parties winds up with each negotiating with extreme numbers. So, 8 hours later both parties walk out of the meeting believing they have successfully won the budget war. Those 8 hours could have been spent coming up with idea to expand their market, offer new products or services, figure out partnerships, etc. However, because the lack of trust was made clear from the beginning, a perfect opportunity to use the company’s leaders for creative purposes was wasted. Accountability; everybody wants it, nobody does it. The self imposed budget is just a factor in a larger strategy known as the management accountability framework (MAF).(Calof, 2007) The MAF is a collaboration of all business intelligence in an organization. Companies have a hard time at centralizing their intelligence for a competitive advantage because of accountability. By putting the budget in the hands of the managers, the accountability has now changed sides. Before, managers were just the person carrying out the task that upper management had given. Now, management 11
  12. 12. is accountable for developing the budget, therefore, putting the blame on themselves. Managers can no longer blame upper management for a failure in his/ her department. The accountability of the managers drives success. When the failure is rested solely on one person’s shoulders, it is their nature to do everything in their power to succeed. The MAF gathers budgets from each department, created by the managers of each department, to combine into a MAF. The MAF is now a resource that each department can review and have a more accurate reading of how each department will do. The business intelligence of the organization has gone up dramatically. Senior management can utilize this new data to make strategic decisions for the future of the company. Colof states “Intelligence is not information, in fact, only 20 percent of the intelligence process involves collecting information. Intelligence is about focusing on what is required to make key decisions, gathering the needed information, assessing it, and coming up with meaningful insights that are then used in decision making.” The self imposed budget is now more than numbers, but strategy. Future decisions can be made more accurately when based off a self imposed budget. Every organization that requires a budget generates budgetary slack. It’s the nature of human beings to want a cushion when making decisions. This cushion allows for mistakes, emergencies, poor evaluation, and less than superior management. Where does all this fit in? To continue on with the self imposed budget, senior level management understands the use of budgetary slack. Therefore, the top down method is used to prevent middle managers to cushion a budget, creating inaccurate profitability. The self imposed budget allows room for such cushioning. However, for an 12
  13. 13. organization to have complete control over its resources, trust has to be given in order to receive accurate data. In a study done by Huang and Chen (2009), more positive attitudes towards the budgetary process cause less favorable attitudes towards budgetary slack. And less favorable attitudes towards budgetary slack result in fewer incidences of behaviors to create budgetary slack. What this means is, the attitude that each manager has towards budgetary slack is shown in direct correlation towards how the manager creates his/ her budget. To prevent budgetary slack, senior level management needs to utilize certain strategies to do so. First, senior level management needs to instill a trust between themselves and those who create the budget. Once trust is established,(Huang, Chen, 2009) educating each manager on the importance of accurate budgets is the next step. By educating, senior management must allow budget managers to understand the importance of these accurate budgets. For example, budgetary slack causes a loss of profits in which upper management can’t accurately maximize resources. Those who choose to use underhanded tactics cause the firm to loss its competitive advantage. Lastly, senior management must provide a proper platform for the managers to communicate his/ her needs. Such as, if a manager underestimated his/ her budget, he/ she have the opportunity to plead a case for extensions. Will this happen often? More than likely it won’t. But having the opportunity to do so does send the message to the budgeting managers to create a more precise budget. Budgets must be strategic! In the case of nursing, budgets must be created using a unit based system. On the other hand, manufacturing must base their budget on a per product cost. Therefore, knowing exactly what it cost to make a product is the first step 13
  14. 14. the budget strategy. Secondly, understanding the variables that could influence change needs to be recognized. Such variables as cost of raw material, labor cost, overhead fluctuation, volume, (Kirkby, 2003)etc. need to be accounted for. Such changes can be based on current economic trend as well as using resources such as past budget cost vs. actual cost statistics. With accurate data coming into your department, a strategy can be designed to designate costs to proper areas and the right times. Human Factors in Budgeting Like anything that involves setting limits, budgeting in companies revolves around politics. As we speak about individual companies, it’s the micro politics of each that determines a budget. The balance of the social, financial, and managerial aspect all comes into play. Many companies find that certain departments receive favorable amenities compared to others. This is just one factor in social networking of budgeting. Middle management can find that becoming socially involved with certain upper management can be rewarding in many ways. An example if these types of micro politics can be seen in college campuses. Deans may find it beneficial to become friends with those who are members of the board of trustees, legislators, or long time administrators. By befriending such individuals, the dean seeks to manipulate the system in order for better allocation of funding (Birdsall, 1995). This is true for all companies, not just the university setting. Some managers could abuse such friendship into having low targeted sales revenue. By doing so, the pressure to obtain such goal is lowered at which point the manager would receive a bonus for hitting his/ her target. The budget is crucial to managers in areas outside of their department. Managers are compensated bonuses usually by their ability to stay below a budget, or achieve higher 14
  15. 15. revenue that the budget predicted. Therefore, when the budget committee is deciding on the proper allocation of funding as well as target sales numbers, the manipulation of those who create such goals is extensive. Managers will feel the need to undermine their past performance consequently to deter the committee from setting such extreme limits. If a manager is informed before a budget meeting that the committee is looking for 8% sales, he/ she may strive to persuade the committee that he/ she can only obtain 6% sales. The manager knows that they can make the 8% goal, but by arguing otherwise, the flexibility in the department is increased. Now the manager has 2% cushion in which he/ she can “slack off” when performing sales. The push vs. pull between upper and middle management come back to compromise. Middle management wants a budget that is highly attainable where upper management wants the budget pushed to its limits. Stretching every dollar of the company, reducing cost with efficiency, and overall greater profit drives these upper managers to negotiate such harsh budgets. Moral of company can be seen through each culture. Confidence in a manager is weighed many times on the budget. If a manager doesn’t feel that he/ she can hit the target goals, the confidence is lost. Motivating employees doesn’t seem so relevant when they feel that the goal is out reach even with strong performance numbers. Budget committees understand this catch 22 of budgeting. Making a budget that is out of reach will result in an even lower performance than one that is close. For that reason, many committees target a goal that is attainable at which point the manager with push his/ her employees to stay within the constraints. 15
  16. 16. Some companies are steering away from the budget process because of its lack of accuracy. This is due to the gaming of the system by managers in order to manipulate the budget. Gaming the system is the term used to describe how managers set their budget low or high prior to negotiation, in order to add cushion to their department. By steering away from traditional budget processes, companies have found that when managers penalized for going over budget, they have no need to game the system. The use of forecasting models and competitive performance allows managers to spend accordingly to stay competitive. However, the spending is still under review, and is now rested solely in the hands of the department manager. Therefore, when a purchase is needed, the manager can do a self evaluation in regards to the necessity of such purchase. Budget Committee Consisting of the president, vice president, and controllers, this basic set up is how most companies base their budget committee. It is believed that these members, as well as several others that differ in each organization, are the last stop on deciding a budget. These members have proven experience in setting budgets, as well as the respect of each to make critical decisions when deciding what is cut and what is improved. The final approval of a department budget is decided by the budget committee. This however doesn’t mean that the entire decision rests in their hands. As discussed earlier, micro politics influence the decision of those on the budget committee. In the education system, teachers, parents, and community members are often social with those who decide. The budget committee is supposed to be even on all levels when 16
  17. 17. deciding where each dollar is allocated. However, as with any human interaction, the budget committee members have self serving agenda’s that stem from outside influence. These agenda’s could be to improve the department of a friend, as well as departments they feel need more attentions based on personal bias. If a budget committee member has previously been a professor of biology for the past 20 years, he/ she might feel that the biology department needs more money allocated to improve services. This personal bias isn’t based on any hard facts, but rather the decision of that committee member to improve his/ her field of choice. The personal agenda of committee members is often looked upon negatively do to the lack of interest for the entire organization (Goldring, 2003). As a result, the committee is often reevaluating its members in order to find a group who is level in the decision making process. Disputes over budget constraints should be negotiated with an overview of the organization, rather than one area. Also, the committee needs to be aware when budget managers are trying to game the system. As discussed previously, gaming the system is lowballing or highballing budget bids in order to meet in the middle. The budget manager has predetermined where he/ she wants the budget, then relies on the negotiation process to inflate the budget offer in order to reach the desired numbers. If the committee is aware of such tactics, they can be tactful in deciding the department’s final budget. If the committee feels that the manager is using such tactics, staying firm to their decision is much easier to justify. 17
  18. 18. Conclusion A budget is sometimes stressful, strenuous, and time consuming, but plays a major role in a company. As you have seen, the human interaction at all levels of the budget process can evoke different agendas and directions each person is taking. The negotiation process, allocation, and final comparison are all just small parts of the entire process. It has been discussed the importance of each type of budget process. Sometimes the self imposed is the better choice, as is the top down approach. Every company chooses its process differently based on their own experience. The one thing all budget process have in common is the human interaction, social network of its employees. A successful budget comes down to proper allocation of resources based on unbiased decision of those who hold the final decision. 18
  19. 19. Work Cited Thornbory, G., & Farley, L. (2007). Budget basics. Occupational Health, 59(8), 7. Retrieved from Academic Search Complete database. (2003). Budgeting: Part Two. Nursing Management - UK, 10(2), 32. Retrieved from Academic Search Complete database. Don, C. (2004). Sailing in Stormy Seas: Navigating Departments Through Turbulent Times. Academic Leader, 20(4), 7. Retrieved from Academic Search Complete database. ÜLKÜMEN, G., THOMAS, M., & MORWITZ, V. (2008). Will I Spend More in 12 Months or a Year? The Effect of Ease of Estimation and Confidence on Budget Estimates. Journal of Consumer Research, 35(2), 245-256. Retrieved from Academic Search Complete database. Rowland, M. (2005). Budget Basics. NEA Today, 23(4), 48. Retrieved from Academic Search Complete database. Welch, J., & Welch, S. (2006). Stop the B.S. Budgets. BusinessWeek, (3990), 114. Retrieved from Academic Search Complete database. Calof, J. (2007). COMPETITIVE INTELLIGENCE AND THE MANAGEMENT ACCOUNTABILITY FRAMEWORK. Optimum Online, 37(4), 3. Retrieved from Academic Search Complete database. Birdsall, D. (1995). The micropolitics of budgeting in universities: Lessons.. Journal of Academic Librarianship, 21(6), 427. Retrieved from Academic Search Complete database. Goldring, L. (2003). budget advisory committees: Making sense of complex issues. Leadership, 32(4), 12. Retrieved from Academic Search Complete database. 19