Lecture 7 budgeting

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Lecture 7 budgeting

  1. 1. Budgets and budgeting
  2. 2. BUDGETING Generic Budgeting Systems Trade-off Between Decision Making and Control Resolving Organizational Conflicts
  3. 3. BUDGETING A budget is management’s forecast of revenues, expenses, and profits in the future. Knowledge: Budgets communicate key planning assumptions such as product prices, units sales, and input prices. Decision Rights: Budgets set guidelines regarding resources available for each segment. Performance Evaluation: A responsibility center’s actual performance is compared to budget.
  4. 4. BUDGETING Responsibility Centers: profit center or cost center. Measurement: Monthly reports compare actual revenues and expenses to budget. Budget process separates decision rights: ◦ Initiation by management. ◦ Ratification and monitoring by Board of Directors.
  5. 5. BUDGETING Budgets are used for both decision making and control. Decision making requires managers to reveal private knowledge about production and market conditions during budget negotiations. When budgets are used for performance evaluation, managers have an incentive to make biased budget forecasts so that their actual performance will look good relative to budget.
  6. 6. BUDGETING Ratchet effect: Basing next year’s budget on this year’s performance. Disadvantages: ◦ Performance targets are adjusted upward. ◦ Employees reduce output to avoid being held to higher standards in the future. Possible Solution: ◦ Eliminate budget targets. ◦ Estimate next year’s sales. ◦ More frequent job rotation.
  7. 7. BUDGETING Top-down budgets:  Knowledge: Top management can make accurate aggregate forecasts.  Decision rights: Begin with aggregate forecasts for firm, and then disaggregate down to lower levels.  Control more important than decision management. Bottom-up budgets (participative budgeting):  Knowledge: Lower levels have more knowledge than top.  Decision rights: Person being held responsible for meeting the target makes the initial budget forecast.  Decision making more important than decision control.
  8. 8. BUDGETING Building the budget in two steps: ◦ Step 1: Construct budgets in operational terms (Lowest levels of the organization). ◦ Step 2: Develop a financial plan based on the operational plan from Step 1. Budgets should be used for financial planning (decision making), but not for performance evaluation (control). ◦ Units should be judged by comparing their actual performance with the actual performance of defined “peer units”. ◦ Rewards can include consideration of both financial and non-financial performance measures.
  9. 9. BUDGETING Top executive officers of firms have final decision rights over the budget process. Top executives resolve disputes among lower levels. After adoption, the budget is an informal set of contracts among the various units of the firm.
  10. 10. BUDGETING Firms that use annual budgets do not create adequate incentives for long-term planning and responding to new opportunities. Strategic planning requires long-term budgets (2, 5, or 10 years). Banks often require cash flow projections for the length of any proposed borrowing. Many firms require managers to prepare both short-term and long-term budgets as part of the periodic budget review.
  11. 11. BUDGETING Line-item budgets authorize managers to spend up to a specified amount on each line item. Advantages:  Tight control reduces opportunities for managers to take actions inconsistent with firm goals. Disadvantages:  Not flexible in responding to unanticipated needs.  Little incentive for cost savings.
  12. 12. BUDGETING An 18-month rolling budget versus a static budget. Advantages:  Keeps the budget more in a changing environment.  Managers may react in a more timely manner by integrating planning and execution. Disadvantages:  Costs of software and management time.
  13. 13. BUDGETING Lapsing occurs when funds allocated for a particular year cannot be carried over to the following year. Advantages: ◦ Tighter control than budgets that do not lapse. ◦ Prevents risk-averse managers from accumulating funds. Disadvantages: ◦ Encourages wasteful spending near end of fiscal year.
  14. 14. BUDGETING Static budgets: ◦ Do not vary with volume. ◦ Volume changes may create budget variances. Since managers are not insulated from volume changes, they will try to mitigate the impact of adverse volume changes.
  15. 15. BUDGETING Flexible budgets: ◦ Adjust for changes in volume. ◦ Evaluate performance after adjusting for volume effects. Manager is not held responsible for volume changes.
  16. 16. BUDGETING Incremental budgeting: ◦ Begin with current year’s core budget and make incremental changes. ◦ Review focuses on incremental changes and may ignore inefficiencies in core budget. Zero-based budgeting (ZBB): ◦ Each line in budget is set to zero each year. ◦ Motivates managers to eliminate inefficient expenses. ◦ Useful when firm is changing strategic direction. ◦ Becomes less useful when same justifications are used each year.

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