Chapter 1: Overview of Budgeting

and Control
 Budget Defined
• Budgeting is the process of preparing budgets

• A budget is a tool used by accountants to assist

management in the planning and controlling process.
• A budget is a detailed plan outlining the acquisition
and use of financial and other resources over some
given time period.
• A budget is a formal quantitative expression of a
proposed plan of action by management for a
specified period (usually for the forthcoming year or
less).
• A budget is a quantitative expression of the
money inflows and outflows that reveal whether
a financial plan will meet organizational
objectives
• Budgets reflect in quantitative terms how to
allocate financial resources to each part of an
organization, based on the planned activities
• Most people associate budget with limitations
on spending. For example, governments often
approve spending budgets for their various
agencies.
• But it is an aid to coordinating what needs to be
done to implement management plan
• May include both financial and non-financial
data
• 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
• Study after study has shown the budget to
be the most widely used and highest rated
tool for cost reduction and control.
• Advocates of budgeting go so far as to
claim that
…the process of budgeting forces a
manager to become a better administrator
and puts planning in the forefront of the
manager’s mind.
 Budgetary Control
• The use of budgets to control a firm’s activities
is known as budgetary control.
• The tool used by accountants to assist
management in the controlling process is the
performance report.
• It compares the budget (or planned results) to
actual results to see if the objectives have been
achieved.
– Thus, budgets help managers with their control
functions not only by looking forward but also by
looking backward.
 Budgeting and Management
Management and its components include the following:

Objective Setting

Strategy Formulation

Management Control
 Objective setting
• Objectives are
• a necessary prerequisite for any purposeful activities.

• Without objectives, it is impossible

• to assess whether the employees’ actions are
purposive;
• to make claims about an organization’s success.
• Objectives can be
• financial versus non-financial;
• quantified, explicit versus implicit;
• economic, social, environmental, societal.
 Strategy formulation
• Strategies define how organizations
should
use their resources to meet their
objectives
– innumerable
ways of attaining its objectives.
• Hence, strategies put constraints on
employees to focus activities on what the
organization does best or areas where it
has an advantage over competitors.
 Management Control
• Management control refers to strategy
implementation or execution
• Important questions addressed include:
– Are our employees likely to behave appropriately?

– Do they understand what we expect of them?

– Will they work consistently hard and try to do what

is expected of them?

– Are they capable of doing what is expected of

them?
 Planning and Control (continued…)
Accounting information helps plan and control
the organization’s operations
(perform the overall management processes)

Planning: Control:
Setting Implementing plans
objectives and and using feedback to
outlining how the evaluate the
objectives will be attainment of
obtained. objectives.
 The Nature of Planning and Controlling

Management Process Internal Accounting System

Budgets, Other information
Planning Special systems
Increase Reports Customer
Corrections and revisions of

Profitability
surveys

Accounting Competitor
analysis
plans and actions

System

Control Advertising
impact
– Actions Performance
– Evaluations Reports New items
report
 Planning and budgeting
• Budgeting must be based on the planning process
• Produce written plans that specify:
– Where the organization wishes to go? ……Goals
– How it intends to get there?............Strategies
– What results should be expected?.......Budgets
• Purposes of the planning and budgeting process are:
– To engage in longer-term thinking.
– To achieve coordination (top-down, bottom-up,
sideways).
– To enhance management control.
– To arrive at challenging but realistic performance
targets.
 Planning cycle
• The planning cycle consists of the following:
• Relatively broad processes of thinking
Increasingly specific, detailed, short-term, and

Strategic about the missions, goals and strategies.

Planning
dispersed at all organizational levels

• Normally a top-management process.

• Specification of specific action programs

Programming to be implemented over the next few years
and specification of the resources each
Capital will consume.
Budgeting • It involves many more people at different
organizational levels (top-down/bottom-up).

• Short-term financial planning.

Operational • Budgets match the organization’s
Budgeting responsibility structure.
• Emphasis on quantitative data.
 Characteristics of a budget
• It is usually stated in monetary/quantitative terms.
• It generally covers a period of one year.
• It contains an element of management commitment,
i.e., the managers agree to accept the responsibility
for attaining the budgeted objectives.
• The budget is 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.
Benefits of Budgets

Provide an opportunity to
reevaluate existing activities
and evaluate new ones.

Budgeting provides
benchmarks to evaluate
subsequent performance.
 Dysfunctional Incentives
Dysfunctional incentives lead
managers to make poor decisions.

Lying can arise if the budget process

creates incentives to bias the budget
information.

Budgetary Slack (budget padding) is the

overstatement or understatement of
budgeted revenue to create a goal that is
easier to achieve.

Budgeting games can never be eliminated,

although some organizations have devised
methods to decrease the amount of budget
slack
 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 includes the chief executive officer,
the chief operating officer, and the senior Vice Pres.
• The composition of the budget committee reflects the
role of the budget as the planning document
….reflecting the organization’s strategy and objectives
• 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/the budgeting
process as beyond their control or responsibility
• The role of stakeholders’ participation in budgeting
shall be considered
 The budgeting process (continued…)

Budget Committee
Top-Down

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3. Negotiation

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Bottom-Up
Business Managers

The budgeting process takes about four months in most firms.

 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
 Budget target difficulty
Motivation/Performance

Easy Goal Difficulty Impossible

 Challenging but achievable
• To minimize dysfunctional management actions.
• Myopic behavior, data manipulation

• To increase manager’s commitment to budget

targets.

• To reduce the cost of organizational interventions.

• Management-by-exception

• To protect against the cost of optimistic revenue

projections.
• Over-commitment of resources

• To create a “winning” atmosphere and positive

attitude.
• 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
What is a “good” budget target?
Purpose of Budgeting Target Difficulty

• Motivation
• Conservative
• Planning

• Coordination • Best guess

• Cost control
• Optimistic
• Evaluation
Target should be after-the-fact assessment of what could
have been accomplished, not any of the three choices listed.
 Budgeting and Forecasting
• 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
• 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
• 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
• 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
 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
 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
Major Influences on Budgeting and Control

Advances in technology:
E-commerce
Enterprise resource planning (ERP)
B2C and B2B

Business process reengineering:

Just-in-time (JIT) philosophy
Lean manufacturing
Computer-integrated manufacturing
Six sigma
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 Unethical Behavior Temptations
1. Emphasis on short-term results:
Pressure to meet expected profit numbers.

2. Ignoring the small stuff:

Large misdeeds often result from many small ones.

3. Economic cycles:
Downturn markets reveal what an upturn market conceals.
Vigilance in all stages of economic markets maintains high
ethical standards.

4. Accounting rules:
Avoid creative interpretations of the rules. Practice full and
fair disclosure to convey company’s performance.
• The End