Zimmerman chapter 6 Budgeting

Budget = managements formal quantification of the operations of an organization for a future period.
It is an aggregate forecast of all transactions expected to occur.

Budgets are part of the firms organizational architecture; they partition decision rights and
control behavior.

Budgetary control involves:

1. the statement of the plans of all departments of the business for a certain period of time in the
form of estimates
2. the coordination of these estimates into a well-balanced program for the business as a whole
3. The preparation of reports showing a comparison between the actual and the estimated
performance, and the revision of the original plans when these reports show that such revision
is necessary.
A. Generic budgeting systems
Organizational architecture consists of administrative systems that assign decision rights and evaluate
and reward performance. Each of these three administrative systems is used to reduce agency
problems.
Budgets are a performance measurement system.

Budget variances are indicators of whether managers are meeting expectations and they are
used in the performance reward system to determine pay increases or, in the case of extremely
unfavourable variances, the need to terminate the responsible manager.
One danger inherent in annual budgets in their tendency to focus managers attention on next
years operations only, ignoring the long-term well-being of the organization.
o To reduce this tendency, many organizations prepare long-term budgets of 3-5 year
duration at the same time as the short-run budgets.

Budgeting systems are bottom-up: lower levels in the organization prepare the initial budgets because
they have much of the specialized knowledge. As the budget moves through the decision ratification
process, higher levels review the budget and bring to bear their specialized knowledge.

This show budgeting primarily as a process by which knowledge is assembled vertically, from
both lower levels and higher levels in the organizations hierarchy. BUT budgeting is also an
important device for assembling specialized knowledge horizontally within the firm.
Example: In a large complex corporation, its a major challenge to disseminate specific
knowledge. Getting managers to share their knowledge among superiors and subordinates
(vertically), as well as among peers in other parts of the organization (horizontally) and giving

managers incentives to acquire valuable knowledge are important aspects of the budgeting
system.
As the budget is passed from one level of the organization up to a higher level, potential
bottlenecks are uncovered before they occur.
o For example: if one departments budget calls for 10,000 units of a part and the parts
fabrication department can only produce 7,500 units, this bottleneck is identified before
production actually begins.

Large corporations use budgets to:

1. Assign decision rights
2. Communicate information both vertically and horizontally
3. Set goals through negotiation and internal contracting
4. Measure performance

B. Trade-off between Decision Management and Decision Control

1. Communicating specialized knowledge vs. performance evaluation
Budgeting systems perform several functions within firms, including:
-

Decision Management: budgets serve to communicate specialized knowledge about one part of
the organization to another part.
Decision Control: budgets are part of the performance measurement system.

If too much emphasis is placed on the budget as a performance benchmark, then managers with the
specialized knowledge will stop disclosing unbiased forecasts of future events and will report
conservative budget figures that enhance their performance measure.
Whenever budgets are used to evaluate managers performance and then to compensate (or promote)
them based on their performance relative to the budget target, strong incentives are created for these
managers to game the system.

Gaming occurs in both the budget-setting process and in the actions managers take during the
year to achieve the budgeted targets.

Most companies report that budgeting induces dysfunctional behaviors, including:

-

Negotiating easier targets to help ensure they will receive bonuses (sandbagging=
Spending money at the end of the year to avoid losing it in the next budget period
Deferring needed spending (maintenance and advertising) to meet the budget
Accelerating sales near the end of the period to achieve the budget

2. Budget ratcheting
Ratchet effect= basing next years standard of performance on this years actual performance.

But: performance targets are usually only adjusted upwards

ratcheting up causes employees to temper this years better-than-budgeted performance to
avoid being held to a higher standard in future periods.

Alternatives for ratcheting up:

1. Ask salespeople to estimate next years sales.
Problem: they will forecast next years sales far below what they expect to sell, thereby
increasing their expected compensation and communicating too low an expected sales forecast
to manufacturing.
2. Central planning group can prepare top-down budgets by using past sales and cost patterns,
macro trends, and customer surveys.
Problem: Too expensive. The direct costs of preparing budgets centrally could exceed the
indirect costs from dysfunctional decision making induced by the ratchet effect.
3. More frequent job rotation, which will lead to higher actual sales.
Problem: destroys job-specific human capital like customer-specific relationships.

3. Participative budgeting
The trade-off between decision management and decision control is often viewed as a trade-off
between bottom-up budgeting (also called participative budgeting, the budgets submitted by the lower
levels of the organization to higher levels) and topdown budgeting (provides greater decision control).
Participative budgeting:
-

Enhances the motivation of the lower-level participants by getting them to accept the targets
More frequently observed when managers rewards are based on the performance against the
budget

4. New approaches to budgeting

Budgets are often criticized (for being time-consuming, no value adding, infrequent updating, rarely
strategic, focus on cost reduction, etc.)
Alternative approaches are:
1. Build the budget in two different steps:

a. Construct budgets in operational, not financial terms.

b. Develop a financial plan based on the operational plan
Problem: more costly than traditional budgets. It also doesnt involve a third step where the
organization iterates between steps 1 and 2 until all the various inconsistencies are resolved.
2. Annual performance trap

Doesnt use budgets as performance targets, but it is still constructed for financial planning
Firms use relative performance targets of other units or firms and compare these peer-units
performance to the actual performance achieved by the unit being judged.
This approach decouples financial planning, information communication, and coordination
(decision management) from performance evaluation and performance rewards (decision
control).
Problem: managers have incentives to game how benchmarks are chosen

5. Managing the trade-off (between decision mgmt. and decision control)

Many organizations put the CEO in charge of the budgeting process, so that he has final decision
rights because:
o It signals the importance of the budgeting process
o The CEO has specialized knowledge and the overall view of the firm to make the tradeoffs needed to resolve disagreements among departments regarding key planning
assumptions or coordination of activities.

C. Revolving organizational problems

Budgets help:
a. Link knowledge with the decision rights.
b. Measure and reward performance
1. Short-run vs. Long-run budgets

Annual budgets are Short-run because they project only one year at a time
Most firms also project 2,5 and sometimes 10 years in advance. These Long-run budgets are a
key feature of the organizations strategic planning process
o Strategic planning= managers select the firms overall objectives and the tactics to
achieve them
In Short-run budgets, the key planning assumptions include quantities and prices. In Long-run
budgets, the key planning assumptions involve what markets to be in and what technologies to
acquire.

Short-run budgets involve both decision mgmt. and decision control. Long-run budgets are
hardly ever used as a decision control (performance evaluation) device; rather, they are used for
decision management.

2. Line-item budgets

Refer to budgets that authorize the manager to spend only up to the specified amount on each
line item.
Give managers less incentives to look for savings.
Reduce agency problems and possible managerial opportunism
Very common in governments

3. Budget Lapsing

Lapsing= when unspent funds do not carry over to the next year
Creates incentives for managers to spend their entire budget, otherwise the following years
budgets will be reduced by the amount of the under spending.
Provide tighter control on managers
The opportunity cost is less efficient operations
Reduces managers flexibility to adjust to changing operating conditions

4. Static vs. flexible budgets

Static budgets do not vary with volumes

Flexible budgets are stated as a function of some volume measure and are adjusted for changes
in volume.
Static budgets force managers to be responsible for volume fluctuations. If the manager has
control over volume, then static budgets should be used. If she doesnt, the use flexible
budgets, as they reduce the risk of volume changes borne by managers.
Flexible budgets more widely used in manufacturing departments than in distribution,
marketing or administration, because volume measures are readily available.

5. Incremental vs. Zero-based budgeting (ZBB)

Since most budgeting processes are bottom-up, where the detailed specialized knowledge
resides, lower-level managers submit a budget for next year by making incremental changes in
each line-item.
Under ZBB, each line item in total must be justified and reviewed annually. This causes
managers to maximize firm value by identifying and eliminating the expenditures whose total
cost exceeds total benefits.
ZBB is infrequently used. It would be most useful in organizations in which considerable
turnover exists in middle and senior level ranks, as management turnover destroys specialized
knowledge.
ZBB is also useful in cases where there has been substantial strategic change or high uncertainty.

Problem with ZBB: it is much more costly to implement than incremental budgeting.