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CHAPTER 24 STRATEGIC PLANNING AND BUDGETING

Changes from Eleventh Edition All changes to Chapter 24 were minor. Approach The text has very little on the mechanics of budget preparation. Such a description is time-consuming. ther material can be used if the instructor wants to describe the mechanics. !evertheless" this can be a #ey chapter. ne of the central problems in teaching accounting is that the students learn individual pieces and topics" but fail to see how everything fits together. The budget can be used to illuminate the interrelationships. $t is desirable that the capital expenditures budget be related to the material in Chapter 2%. $n that chapter the description will focus on the analysis of individual capital investment proposals. Students should understand that these individual proposals are brought together in a pac#age" as described in Chapter 24. &e have used the terms budgetee and superior 'following (ofstede) for the participants in the budgeting process. Some people regard budgetee as an aw#ward word" but we thin# it is a useful one. &e #now of no short alternative that conveys the same idea. Cases Body Glove describes the forecasting" budgeting" and reporting processes of a small manufacturer operating in a competitive" fashion-conscious" seasonal business. $t as#s students to understand the processes and to suggest possible changes for both the short and long term. Waikerie Cooperative Producers, Ltd. describes the management accounting and control systems used by an Australian citrus growing cooperative. Patagonia Inc. describes the budgeting process of a uni*ue" but successful" clothing manufacturer. $t contains many elements of +open boo# management., This case is new in the Twelfth -dition. Borealis illustrates an alternative '+beyond budgeting,) approach to traditional budgeting. $t involves the use of #ey performance indicators" trend reporting" and rolling forecasts. Problems Problem 24-1: Western Run niversit! "otor Pool a.

#$%ER&$'( ")')R P))* +udget Report for April "onthl! April )ver, +udget Actual nder .asoline.................................................................................................................................................................... / 0"122 / 0"%22 / 2223 il" minor repairs" parts and supplies........................................................................................................................ 445 112 60 utside repairs.......................................................................................................................................................... 422 451 51 $nsurance................................................................................................................................................................... 0"422 0"422 -2Salaries and benefits.................................................................................................................................................. %"122 %"122 -27epreciation.............................................................................................................................................................. 1"64% 1"64% -2-

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Totals..................................................................................................................................................................................... /0%"884 /0%"%82 / 854 !umber of automobiles.......................................................................................................................................................... 04 04 Actual miles........................................................................................................................................................................... 80"212 81"222 Cost per mile.......................................................................................................................................................................... /2.1146 /2.12% Supporting calculations for monthly budget amounts9
80"212 miles 21 mile:gal.

.asoline9................................................................................................................................................................................ x /0.22 per gallon ; /0"122

il" et al.9............................................................................................................................................................................... 80"212 miles x /.201 per mile ; /445 /822 per auto x 04 autos utside repairs9...................................................................................................................................................................... = /422 02 months. $nsurance9............................................................................................................................................................................... Annual cost for one auto ; /06"222 01 autos ; /0"222 per auto Annual cost for 04 autos ; 04 x /0"222 ; /05"222 <onthly cost ; 05"222:02 ; /0"422 Salaries and benefits9.............................................................................................................................................................. !o change from present budget '/52"222 02 ; /%"122) 7epreciation9.......................................................................................................................................................................... Annual depreciation per auto ; /44"222:01 autos ; /4"422:auto Annual depreciation for 04 autos ; /4"422:auto x 04 ; /%2"422 ; %2"422 <onthly depreciation %2"422 = /1"64% ; 02 b. utside automobile repairs are a function of the use of the automobile over its lifetime. (owever" these repairs occur irregularly throughout the year and the life of the car. A monthly budget figure based upon a per mile charge becomes *uestionable. Therefore" the use of 0:02 of the estimated annual outside repair costs ad=usted for the number of cars in operation during a month would appear to be more reasonable. >ut even this amount must be #ept in proper perspective? i.e." annual variations will certainly be more meaningful than monthly ones.

Problem 24-2: 'err!-s E.uipment Center perating >udget

0st @uarter 2nd @uarter Sales................................................................................................................................................................................................ /042"222 /262"222 Cost of goods sold A .42 sales........................................................................................................................................................ 64"222 046"222 .ross margin................................................................................................................................................................................... 14"222 002"222

perating expenses9........................................................................................................................................................................ %4"2%1 021"4%1 perating income 'loss).................................................................................................................................................................. / '22"2%1) / 4"121

0st @uarter 2nd @uarter Bixed selling expenses..................................................................................................................................................................... / 21"222 / 21"222 Bixed administrative expenses......................................................................................................................................................... 06"112 06"112 7epreciation.................................................................................................................................................................................... 8"021 8"021 >ad debts A .22 sales..................................................................................................................................................................... 2"622 1"422 Cariable A .04 sales........................................................................................................................................................................ 05"422 85"222 A .21 sales........................................................................................................................................................................ %"222 04"222 Totals" above............................................................................................................................................................................. / %4"2%1 / 021"4%1

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Problem 24-/ a. Cash >udget

0st @uarter 2nd @uarter Collection of receivables9 .%1 x /042"222 'a)................................................................................................................................................. /021"222 .24 x 042"222....................................................................................................................................................... / 88"422 .%1 x 262"222 'b)................................................................................................................................................. EEEEEEE 202"222 Total cash receipts............................................................................................................................................ 021"222 248"422

Cash disbursements9 Furchases .42 x /045"222..................................................................................................................................... 020"422 'c) .42 x 045"222..................................................................................................................................... 4%"422 .42 x 265"222..................................................................................................................................... 0%8"422 Selling expenses 'd)

2:8 x 44"422.............................................................................................................................. 25"%88 0:8 x 44"422.............................................................................................................................. 04"64% 2:8 x 44"222.............................................................................................................................. 42"622

Administrative expenses 'e)

2:8 x /21"112................................................................................................................. 0%"222G 0:8 x 21"112................................................................................................................. 6"122G 2:8 x 82"112................................................................................................................. 20"%22

-*uipment................................................................................................................................................................. EEEEEEE 22"122 Total cash disbursements....................................................................................................................................... 046"088 810"84% -xcess disbursements over receipts........................................................................................................................... '48"088) '02%"%4%) Cash balance beginning of *uarter............................................................................................................................ 04"222 '25"088) Cash balance end of *uarter...................................................................................................................................... / '25"088) /'084"522) a. To #eep a minimum cash balance of /1"222" the company must borrow /84"088 during the first *uarter and another /02%"%4% during the second *uarter. 'a) 0st *uarter sales of /042"222 as given in Froblem 24-2. 'b) 2nd *uarter sales of /262"222 as given in Froblem 24-2. 'c)

Furchases9 0st @uarter 2nd @uarter Cost of goods sold9 .42 '/042"222)....................................................................................................................................................... /64"222 .42 '/262"222)....................................................................................................................................................... /046"222 -nding inventory at 0:8 cost of goods sold of next *uarter9 0:8 '.42 x /262"222).............................................................................................................................................. 14"222 0:8 '.42 x /821"222).............................................................................................................................................. EEEEEE /042"222 41"222 /288"222 Hess beginning inventory9 As given................................................................................................................................................................ 25"222 Brom 0st *uarter.................................................................................................................................................... EEEEEEE 14"222 Ie*uired purchases................................................................................................................................................... /000"222 /0%%"222

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'd)

Selling expenses9 0st @uarter 2nd @uarter Cariable9 .04 '/042"222)................................................................................................................................................... /05"422 .04 '/262"222).................................................................................................................................................... /85"222 Bixed9 'given)......................................................................................................................................................................... 21"222 21"222 Total selling expenses........................................................................................................................................................ /44"422 /44"222

'e)

Administrative expenses9 Cariable9 .21 '/042"222).................................................................................................................................................... / %"222 .21 '/262"222).................................................................................................................................................... /04"222 Bixed9 'given)......................................................................................................................................................................... 06"112 06"112 Total administrative expenses............................................................................................................................................ /21"112 /82"112

Cases
Case 24-1: Body Glove* #ote: T&is case is unc&anged .ro/ t&e 0levent& 0dition. Approach The >ody .love case was written to illustrate a planning and budgeting system in a small company that has a high need for planning. >ody operates in a rapidly growing" competitive industry with fashion conscious customers and significant seasonal sales fluctuations. Students en=oy studying the case both because they #now the company and its products and because the company is small enough that they can comprehend the entire entity. &uggested Assignment 0uestions Suggested assignment *uestions are contained in the case. Case Anal!sis >efore starting discussion of the specific assignment *uestions" $ find it useful to summariJe the studentsK thin#ing about the company and its industry. Start by as#ing what the companyKs critical success factors 'CSBs) are. A list will loo# li#e the following9 designs that satisfy customer needs produce styles and colors to demand 'ade*uate production capacity" production flexibility) react *uic#ly to changing trends control costs 'manufacturing" inventory)

Then $ proceed to *uestion 2 and create a diagram of the budgeting process. $ li#e to diagram budgeting processes using the format shown in T!-0 because it is then easy to compare processes across companies. The >ody .love process is highly condensed. This shows up star#ly in the T!-0 diagram. >ody .love managers do not spend a lot of time in formal budgeting processes. This simplicity is consistent with the fact that >ody .love is a small company that didnKt even have a budgeting process until the prior year. The simplicity is also consistent with >ody .loveKs informal culture" evidence of which is easily seen in the companyKs organiJation chart shown in case -xhibit 0.

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The >ody .love budgeting process is also unusual in that the board of directors is not involved. !either is the budget presented to any outsiders? it is strictly for the use of management. 7uring the year" >ody .love managers ma#e monthly comparisons of budget vs. actuals. At any of these times" the budget numbers can be revised" at the presidentKs discretion. This contingency can be indicated on the timeline" if so desired. 1igure '#-1 Time line of >ody .loveKs budgeting process

1 ; management team estimates total sales growth for following year 2 ; sales manager brea#s down total sales estimate by month and by product / ; department managers develop monthly pro=ections of #ey expenses 4 ; presentation to and approval by president 1uestion !: 2or )&at purposes does Body Glove use its budgeting syste/3 W&ic& purposes are e/p&asi4ed3 The >ody .love budget is used almost exclusively for planning purposes. $t helps ensure that the companyKs level of expenses are low enough" given their sales levels" to generate ade*uate levels of profit. The budget undoubtedly provides management with some motivation to achieve the numbers they have put together. The budget vs. actuals comparisons is used for performance evaluation purposes" but the budget numbers are not lin#ed formally with incentive compensation. The needed coordination between the functions" particularly sales" purchasing" and production" occurs in processes that lie outside the end-of-year budgeting process.

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1uestion 5: Can a co/pany .unction e..ectively )it&out a budget, as Body Glove tried to do prior to .iscal year !66!3 The answer is obviously yes. >ody .love was highly successful prior to 0550. Company managers accomplished all the purposes a budget could serve both through exchange of *uantitative" but nonfinancial information and fre*uent informal communications. &ould a budget have helped the company during the early yearsM Fossibly" but the benefits of formal budgeting grows as companies grow and become more complex. !ote in -xhibit 8 that >ody .love is no longer a simple organiJation? it has 02 profit centersN 'These are two dive shops" three services 'classes" charters" rentals O repairs)" one factory" >ody .love wetsuits" Surf P! S#i P! Surf" and Accessories.) 1uestion -: W&at c&anges to Body Glove$s budgeting and revie) processes )ould you reco//end, i. any3 Hoo# at -xhibit 8" the monthly and year-to-date figures. >ody .loveKs profits are well below budget? retail sales are essentially flat? and expenses are up. &hat actions will:should >ody .love managers ta#e as a resultM Students will propose many ideas" including the following9 0. &hy have monthly reportsM &hy not *uarterlyM r seasonalM To address this suggestion" consider what decisions might be affectedM <ight monthly reports affect the commitment of discretionary expenses 'e.g." advertising and promotion" hiring) or development of new product ideas" or cash planning 'e.g." borrowing)M 2. &hy not update the budget more fre*uentlyM <ost companies do not. They li#e the annual target to shoot for. >ut for planning purposes" they may do a *uarterly" or less fre*uent" updated annual +estimate., 8. &hy use totally sub=ective evaluations of performanceM The results are affected by many significant uncontrollable factors. Some of these are mar#et uncertainties and fluctuations. thers are caused by departmental interdependency. As Iuss Hesser says 'not in the case)9 &e have somebody responsible for each department" but it is difficult to isolate what one department does. So in doing performance evaluations" we also loo# at what the company does. Sub=ectivity is a simple" inexpensive way to eliminate these distortions from the performance evaluations. 1uestion 7: W&at i. Body Glove continues to gro) and, per&aps, diversi.ies3 >ody .love will almost inevitably grow" and >ody .love managers have considered many diversification options" such as beach apparel or a line of blue =eans that +fit li#e a glove., As the company becomes larger and more complex" coordination of all the various company elements will become more difficult" and the informal company culture will not satisfy all the communications re*uirements. The budgeting system will have to involve more people" and the process will have to become more formal and elaborate.

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Case 24-2: Waikerie Cooperative Producers, Ltd.* #ote: T&is case is unc&anged .ro/ t&e 0levent& 0dition. Approach This case was written to illustrate typical issues faced in controlling a cooperative. Cooperatives are an important form of organiJation. Bor example" until the recent round of mergers" the second largest ban# in the world was a cooperative '>an# Agricole in Brance). ver 42Q of all retail sales in the R.L. are through consumer-owned cooperatives. And in Sapan one primary citrus grower producer cooperative has over four million members. The apparent specific focus of this case is on budgeting. &ai#erie managers are having trouble getting good information from their grower-members to allow them to prepare reasonably accurate budgets. >ut this budgeting issue may not be as important as &ai#erie managers seem to thin#? other things may be more important. &uggested Assignment 0uestions 0. $n what ways is management control in a co-cooperative li#e &ai#erie different from that in a typical corporationM 2. -valuate &ai#erieKs management control system. &ai#erieKs managers" if anyM Case Anal!sis (o) is /anage/ent control in a cooperative like Waikerie di..erent .ro/ t&at in a typical corporation3 81uestion !9 The &ai#ierie cooperative has some important differences form corporations that lead to different management control approaches9 0. $n a growers cooperative" li#e &ai#erie" the owners and suppliers are one and the same. Thus the suppliers are the +bosses, of management. 2. The cooperative goals are different from those in a corporation. Frofit 'or actually net operating surplus) is a constraint" not a primary goal. The primary goals in growers cooperatives li#e &ai#erie" are to maximiJe the prices paid to the grower-owners and to minimiJe the hassle associated with pac#ing and selling the product 'in other words" provide services to growerowners). $n financial terms the cooperative is really a profit center with a goal to brea#-even 'for long-term survival). A standard corporate financial results control system aimed at <aximiJing profits or financial returns is not appropriate. 8. The cooperative must abide by the international principles of co-operation. <ost important for management control purposes" it cannot compete aggressively with most local competitors" which are also cooperatives. The private fruit pac#ers have an advantage. The cooperative also has an obligation to educate its members and others about the principles and techni*ues of co-operation. This education could re*uire the cooperative to incur some extra costs. The &ai#erie Cooperative lac#s the degree of power possessed by corporate managers" so it has
*

&hat suggestions would you ma#e to

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slightly different sources of uncertainty. Hi#e other pac#ers" it had to deal with the inherent volatility in the produce mar#ets. >ut li#e other cooperatives" for the most part it had to accept all the fruit grower members wished to send to the cooperative? it had to ma#e its mar#eting plans available to its grower members" some of whom would inevitably not #eep it confidential? and it had to cope with some of the grower membersK reluctance to share relevant information. 4. The cooperative cannot decline to pay a dividend or even delay the payment of dividends. $t is obligated to pay it and failure to pay a dividend could cause some grower-members to go out of business. Evaluate Waikerie s Co!trol "yste# $%uestio! 2& The fact that the cooperative has had a negative operating surplus for two years at the same time its members were complaining that the cooperative was not paying a competitive price for produce suggests a strong possibility of problems. Students should be as#ed to thin# about the cooperatives critical success factors or #ey recurring decisions. (ere are some areas deserving of investigation by the cooperative 'and discussion by the students)9 Pricing Faying a competitive price to growers for produce supplied is one of the +four singularly important factors, mentioned at the beginning of the case. <embers are complaining but 7uncan >eaton is not really sure whether the cooperative is failing in this area. &ai#erie should do some mar#et analysis" perhaps by enlisting friendly members to solicit and disclose bids they receive from other pac#ers in the area. &ai#erie might also be well advised to consider its pricing formula. The current mar#et conditions with significant pac#ing oversupply" has created a competitive mar#et. Charging growers the full cost of pac#ing plus a +modest profit margin, might not ma#e sense particularly given &ai#erieKs strategic error of adding highest automated e*uipment at a time when less pac#ing capacity was needed. An alternate pricing formula would have the cooperative charge suppliers for only the variable cost of production plus a profit margin. The cooperative would earn a contribution toward fixed costs on every sale. &hy should the fixed costs be charged to the suppliersM $n a prospective sense" the full costs are suspect because they are based on volume estimates with *uestionable accuracy. >ut more importantly" these costs are sun# and therefore irrelevant. There seems to be no *uestion but that &ai#erieKs full costs are not competitive in the mar#et because of high-cost e*uipment" which may be idle much of the time" and interest incurred to purchase the e*uipment. <a#ing the suppliers pay for the full costs may allow the cooperative to ta#e advantage of the loyalty of some grower-members for a while" but this pricing strategy will lead to decline in volume at the very time the cooperative needs volume increases. Cost Reductions2Accounting &ai#erie operates in a commodity mar#et. The cooperative is trying to distinguish itself through superior mar#eting programs or better service to suppliers" but until that happens &ai#erie is providing a service that can be provided e*ually well by many other pac#ers in the areas. $n a commodity mar#et" cost control is essential. <anagement should be wor#ing actively to reduce costs both variable and fixed. There is evidence in the case that they are wor#ing to this end. To do so effectively" however" management may have to improve its cost accounting system 'e.g. rethin# it with activity-based

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principles in mind) to #now where processes can be improved and where costs can be cut. Planning and +udgeting &ai#erieKs management is troubled it they cannot get good crop forecasts that would enable its managers to prepare reasonably accurate annual financial plans. To some extent" its goal for accurate forecasts will never be realiJed. Bor example" the navel orange season runs from April to September" and the cooperative is as#ing for the estimates in !ovember. .iven the inherent uncertainty the growers face" these estimates cannot be reliably accurate. >ut how important are accurate estimates and accurate annual financial plansM Flanning financial resource needs 'e.g." borrowings) is important. The case does not provide much information in this area" but if contributions are not large enough to service the cooperativeKs debt" management may have to restructure the debt" or cease operation. (aving reasonably accurate numbers that can be used to commit to prices for grower members is also important" although this probably does not vary much form year-toyear. The primary advantage of accurate volume forecasts seems to be for scheduling resources-primarily labor. The cooperative has more than enough pac#ing e*uipment to service foreseeable volumes. &ith only labor as a concern" the cooperative seems not to have a great need for an annual forecast. $f growers can give the cooperative accurate one-month supply estimates" cooperative management should have enough lead-time to schedule the needed labor. $f growers still will not cooperate" perhaps the cooperative could offer rebates to those growers who provide accurate estimates. $ncentives <any students will point to the need for formal measurements and incentives tied to the critical success factors. This cooperative is small" so 7uncan >eaton may be able to #eep all of the relevant data in this head. >ut formal incentives might provide impetus for managers at various levels to be creative and to improve performance in the areas the cooperative most needs. Students will have a number of ideas for incentives. They might usefully be based on" for example" cost reductions" mar#eting program successes" services provided to grower-members 'e.g." solving problems)" grower-member satisfaction" percent returned to grower-members" and number of new grower-members. -ach of these alternatives should be evaluated in terms of lin#s to critical success factors" coverage of critical success factors" feasibility" and cost:benefit. Students will also have to consider how to measure individual employeeKs performances or how to share the rewards among groups of employees whose =oint efforts led to the success. 7epending on their choices" they may also have to consider how to eliminate the distorting effects of uncontrollable factors 'e.g. by using flexible budgets to eliminate the uncontrollable negative effect of a drought). &ubse.uent Events The &ai#erie Cooperative suffered large losses in 0558 'approximately /0 million)" and subse*uently" all of the top-level managers were replaced. At the same time" the primary lender to all the Iiverland cooperatives" the State >an# of South Australia" was pushing:forcing a merger of cooperatives" a +rationaliJation process., &ai#erie explored merger possibilities" but pulled out. The &ai#erie board thought that the >an# was see#ing to reduce its exposure and was not addressing the significant operating problems the cooperatives were facing. Still &ai#erieKs board recogniJed that the cooperative had lost its ability to control its own destiny unless it

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was to sell assets in noncore areas. &ith the +gun to its head", new management at the cooperative had to develop an alternative. After considerable uncertainty and some delay" they were able to refinance the debt with another ban#. The refinancing re*uired both the raising of funds from members and to consider future conversion to an unlisted public company. $n 0558" a total of /462"222 was raised from members through two-year interest-bearing deposits. $n 0554" members were as#ed to support the conversion to an unlisted public company" with /0 shares in the cooperative being worth approximately /86 'The cooperativeKs largest asset was itKs e*uity in >erri (oldings Htd. which holds 14Q of >errivale rchards Htd." AustraliaKs largest fruit =uice processes and mar#eter.) Those involved expected members to support the conversion. >ut they then worried that a number of shareholders would want to +cash out, rather *uic#ly. The ma=ority of the shares value would be derived from >errivale which was paying relatively low prices to the producers of Australian citrus. Case 24-': Pata(o!ia, )!c.1 #ote: T&is case is ne) in t&e T)el.t& 0dition. Purpose o* Case This case was written to illustrate the details of a budgeting process that embodies the values of an +open boo# management, process. pen boo# management ' ><) is a process designed to involve employees in the business. The goal is to get the employees to understand the +big picture, and to see how each individualKs efforts relate to overall corporate performance. $n other words" the goal is to get the employees to thin# li#e owners and to move beyond a +wage level mentality., >< involves9 0. regular sharing of the companyKs financial information and any other information that will help the employees wor# together with management to help the organiJation succeed? 2. training" so that employees understand both what that information means and how they can contribute to company profits 'value creation)? 8. rewards lin#ed to company performance 'e.g." profit sharing plan" employee stoc# ownership plan)? 4. if necessary" a change away from a top-down culture to ensure that employee ideas are both encouraged and considered fairly. &hat Fatagonia calls its +&or#boo# Frocess, embodies all four of these >< elements. >ecause the core elements of the &or#boo# Frocess involve planning and budgeting" the case can also be used to motivate a discussion of such processes. $t can be particularly useful in illustrating a more informal" or +loose", approach to planning and budgeting" which can be contrasted with some of the highly formal and elaborate processes used in many large corporations. The case is also interesting because it illustrates the Fatagonia management system. Frimarily because of the values of its founder" Fatagonia is an unusual company. Conse*uently" the case can be used to raise issues about corporate ob=ectives 'should maximiJation of value really be the primary ob=ectiveM)"
1

This teaching note was written by Lenneth A. <erchant. Copyright D 2228 by Lenneth A. <erchant.

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management style" and organiJational culture. $t can be used as an illustration of a company that ma#es heavy use of +cultural control., $n most situations" instructors can serve both purposesTcultural control and planning and budgeting: >< in a single class. -ven if the focus is on planning and budgeting systems and:or open boo# management" students can and should study the details of the &or#boo# Frocess and draw =udgments as to whether the process is aiding or harming the companyKs cultural control system. &uggested Assignment 0uestions Bor a class focused on planning and budgeting processes and:or open boo3 management systems" the following assignment *uestions are appropriate9 0. -valuate FatagoniaKs &or#boo# Frocess. &ould you recommend to FatagoniaKs management that they continue the processM &hy or why notM 2. $f you recommend continuing the process" what changes would you suggest" if anyM 8. $f you recommend discontinuing the process" what would you substitute insteadM 4iscussion $t is useful to have the students identify some of the factors that are unusual at Fatagonia. These include9 0. mission and values. The corporate mission and values are shown in -xhibit 8 of the case. Corporate profits are a constraint or a secondary" rather than a primary goal. Uves Chouinard even sees growth above a minimal level" as an evil. 2. high *uality" long lasting products. >ut Fatagonia managers hate a term that critics sometimes used to describe their products" which are not low-priced9 +Fatagucci., 8. concern for employees 4. flat organiJation 1. low bureaucracy:informal operating style 4. open culture %. distrust of bonuses" perhaps because the company does not have a good measurement system 6. distrust of ban#ers:accounting people. nly two of the eight people on the Fatagonia top management team have a business bac#ground. 5. scars left by the 0550 crisis:layoff $f the focus is on cultural control" the instructor can pose the second *uestion in the cultural control assignment and the discussion should flow easily. $f the students are critical of Fatagonia" the instructor can point out that while Fatagonia is not committed to profits as an overriding goal" it is one of the most profitable firms in its industry.

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The first *uestion in the planning and budgeting: >< assignment as#s for an evaluation. To me" the word evaluation as#s the students to identify and discuss the pros and cons of the system. Pros: 0. The goals of an >< system are to create9 a. better communication of the corporate goals throughout the ran# and file? b. better understanding as to how each employeeKs actions affects the corporationKs financial results? c. incentives for employees to behave in the corporationKs best interest? and d. incentives and opportunities for lower-level employees to ma#e useful suggestions for improvement. At least to some extent" FatagoniaKs system seems to have achieved each of these goals. 2. The >< system provides a way to motivate employees to serve corporate interests even in the absence of good measurement systems 'which the CB admits they donKt have). 8. <any employees expressed dissatisfaction with their lac# of #nowledge of the companyKs and other departmentsK plans and their lac# of involvement in the planning processes. The >< process directly addresses those concerns. 4. The >< process is well organiJed 'steps" timing)" and it was pilot tested. 1. The >< process is consistent with important aspects of the corporate cultureTrespect for employees and concern for employeesK *uality of life. 4. <ost employees have favorable reactions to the process 'see the *uotes toward the end of the case). Cons: 0. The &or#boo# Frocess is heavily financially oriented. Ferhaps the +Frocess, does not fit well in an organiJation for which financial goals are not paramount. 2. Some employees do not participate. Sust because the company says it has a highly participative system does not mean that it is getting participation. Some employees do not yet seem to understand what the financial figures mean or how to write good ob=ectives. This could perhaps be solved through more and better training. >ut more importantly" some employees seem not to want to participate. Can you have a good >< system if 0:8 of the department heads 'and perhaps more of the lower-level employees) are indifferent or hostileM Should you exclude or ignore the non-participantsM (ow can you exclude a department headM (ow can top-management motivate their participationM 8. Significant costs in time and paperwor#. The +bureaucracy, associated with the system is inconsistent with the corporate cultureTfor example" see a *uote in the case '+The company culture favored minimum bureaucracy and maximum informality,).

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4. 7o group rewards really motivate employeesM $n the Fatagaonia system there is almost Jero lin# between a personKs efforts and the rewards s:he earns. ShouldnKt rewards be at least somewhat based on individual" or at least" wor#group achievement of ob=ectivesM 1. A lot of the enthusiasm is dampened because the actuals come out two months late. 4. The enthusiasm for the process seems to be decreasing over time. <ight it be said that the costs are linear" but the benefits are decliningM %. The *uality of the plans varies. Some departments have too many ob=ectives and most have some poorly written ob=ectives. 6. The >< process is *uite short-term oriented. Are longer-term considerations captured in this systemM 5. &here is the strategic planning at FatagoniaM They donKt seem to do much of it. $n fact" it is *uestionable as to whether Fatagonia has what one would call a well-defined business strategy. )ther 0uestions After the students evaluate the &or#boo# Frocess" $ loo# to them for a =udgment as to whether Fatagonia managers should attempt to fix the problems or dump the system. $ thin# that good students can ta#e either stance. Students should identify some alternatives and then choose one" with a persuasive" well organiJed =ustification of their choice. $f students argue in favor of #eeping the >< system" then they need to address each of the +cons, listed above. &hich ones can be fixed" and howM &hich ones should merely be tolerated in exchange for the benefits the system providesM $f the students argue in favor of discontinuing the &or#boo# Frocess" then what should the company doM (ow can the company replicate the +pros, of the >< system using a different systemM Bor example" can Fatagonia create a process or culture that leads to a natural sharing of information and some motivation to achieve good results without the structure that some find onerousM What happened subse.uentl!5 $f instructors desire" toward the end of class they can provide students with an update on Fatagonia. The update will surprise most of the students. !ot long after the time of the case" Fatagonia abandoned the &or#boo# process. The process did not ma#e its third year. Laryn >arsa 'CB ) explained9 There is no *uestion but that there was tremendous enthusiasm from a lot of people the first year. Feople were curious about the financial statements. They li#ed the +brain food, classes. >ut itKs a temporary high you get from getting involved in all this. Froblems showed up at end of the year. A lot of ob=ectives were not met. Binger pointing started" and it became very destructive.

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$n the second year Vfor BU 0556W" people gamed the system. <any units set ob=ectives that were easy to accomplish" such as +turn the compost heap., LarynKs conclusion was9 A collaborative process wor#s well when a company is small. $t is tougher when the company is complex. Shortly after the time the case was written" a new C- " 7ave lsen" was hired. 7ave was an outsider who had a business bac#ground. (e did not thin# that the &or#boo# Frocess was moving the company forward. The companyKs mar#ets were becoming more competitive. (e attributed much of FatagoniaKs early growth to its near-monopoly position. !ow the company was up against significant competition" and 7ave did not thin# that the &or#boo# Frocess was the best way to respond. Uvon Chouinard was sympathetic to 7aveKs concerns. Froblems at Apple Computer" in particular" scared Uvon. Uvon viewed Apple as a product-focused company that was in many ways similar to Fatagonia. (owever" the 2:8 of the Fatagonia employees that bought into the &or#boo# Frocess were very disappointed. 7ave had to give them something else. (e started by trying to change the culture. $n particular" he wanted to try to find a better way to ma#e the whining productive and to help employees understand that what people do really matters. To that end" he hired some +culture change, consultants. They employed a number of exercises to try to convince employees to follow two behavioral rules9 '0) Turn complaints into re*uests" and '2) Histen before you spea#. The goal was to build a more collaborative culture. Another part of the culture was a greater interest in having the company grow. 7ave tried to convince employees that growth is good because it provides Fatagonia with the means to spread the environmental message" in particular through the giving away of more money. $n the late 0552s" company growth was good. Sales in BU 0556 were approximately /062 million" up 04Q from 055%" and the company was growing to an 622-person organiJation. $n this period" 7ave lsen set up seven separate entrepreneurial product development teams 'e.g." paddle sports" alpine). These teams were as#ing *uestions li#e +7o we need tights for every purposeM, >ut management of these teams was *uite complex. -ach must carry the Fatagonia message. Coordinating the efforts of these teams re*uires more leadership. $n 0555" Fatagonia still did not have an incentive system. As Laryn >arsa explained" +<oney is still a bit dirty at Fatagonia. Feople want more money" but in salary. They donKt want to earn higher bonuses than their co-wor#ers., Laryn predicted that Fatagonia would not go public or sell stoc# through an -S F until" perhaps" the ChouinardKs estate has to be settled. The strong Fatagonia culture lives on. -mployee turnover within Fatagonia is still less than 4Q per year. <ost employees have been with the company more than 02 years. Fatagonia management still prefers to hire +dirtbags., Their philosophy is that +Uou can teach a dirtbag about business" but you canKt teach a +greaseball, Va business personW about the environment., The strong culture spits deviants out.

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C&apter "-

Pedagog! The structuring and timing of the discussion of this case depends on the instructorKs purpose's) for the class" the position of the case in the course syllabus" and the studentsK bac#grounds. <any useful contrasts can be drawn between other companiesK practices and FatagoniaKs. The discussion of this case flows easily because most students have heard of Fatagonia. -ven if they had not previously #nown of the companyKs management philosophies and practices" they find them interesting. Bor example" it is easy to stimulate a heated debate about FatagoniaKs ob=ectives between some +conservative" hardcore capitalists, and some +liberal environmentalists., Case 24-4: Borealis1 #ote: T&is case is unc&anged .ro/ t&e 0levent& 0dition. Purpose of Case Companies have traditionally used budgets for planning" monitoring" and evaluation. Some companies" however" believe that budgets are inade*uate in todayKs competitive environments" that budget processes re*uire too much time and resources" and that the budgets themselves are inflexible and get *uic#ly out of date. A movement that encompasses these ideas has been populariJed under the rubric +>eyond >udgeting., A >eyond >udgeting Ioundtable is a discussion group that meets with CA<-$. ne or more of the >eyond >udgeting articles can usefully be assigned for students to read in con=unction with the >orealis case.2 >orealis" which is a >eyond >udgeting company" abandoned its budgeting system and replaced it with four targeted management tools. The main *uestion to be discussed is9 &ill these tools accomplish managerial ob=ectives more effectively and efficiently than the budget they replacedM 'eaching Approach 0. &hy do companies use budgetsM Students can be as#ed to assemble a list of purposes" which include the following9 to ma#e strategy operational to control spending 'permission to spend) to provide point estimates of spending by department 'by what : by whom) to facilitate better evaluation of decentraliJed managers by senior management to communicate important information within the organiJation" both bottom-up and top-down to enhance motivation and accountability

2. &hat is >orealisK business strategyM


1 2

(igh *uality provider. <ore flexible plastic based on proprietary formula. Hicenses >orstar technology in recent years. Iesearch and development is important. !ote that >orealis was *uite profitable 'refer to the income statement).

This teaching note was written by Lenneth A. <erchant based partly on notes provided by Iobert S. Laplan. Bor example" S.(ope and I. Braser" +>eyond >udgeting", :trategic 2inance 62" no. 4 ' ctober 2222)" p. 88 or S. (ope and I. Braser" +>eyond >udgeting9 Fathways to the -merging <odel", Balanced :corecard ;eport '<ay 01" 2222).

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8. &hat was wrong with >orealisK budgeting processM $ts budgets served too many different purposes? e.g." both forecasting and target setting. @uote in case9 +Borecasts should be realistic" targets should be challenging, 'stretch). >orealis used budgets to control spending" but >orealis did not flex the budget. >orealis had a bro#en <CS. @uote in case9 +>udgets not only set a ceiling on costs" but also a floor., The floor means that managers will spend all they are allotted. The budget constraints hindered decentraliJed decision-ma#ing. nce established" the budget *uic#ly became out-of-date because so many planning assumption variables changed *uic#ly. They were also out of managementKs control" so the variances were meaningless. 'See *uotes in the +>udgeting Frocess, part of the case) $t was a lot of wor#.

4. &hy was >orealis having trouble with its budget" while other companies donKtM Froblem in the way that management used the system. 7esign of system9 fixed vs. flexed in highly volatile mar#et where >orealis" despite its siJe was probably a +price-ta#er., 6What if 7e didn-t do budgets at all58 T&e 0/peror$s <e) Clot&es X individually" each manager expressed frustration and disli#e of budgets and the budgeting process" but collectively they felt a need for budgets. >udgets provided a 'false) sense of control since >orealis faced uncontrollable volatility in its feedstoc# costs and product prices. The board of directors gave approval as long as management could design a faster" simpler process. 1. &hat modifications would have made the existing system more usefulM Blex the budget to ma#e it more useful and dynamic. >eyond the need to flex for volume" >orealis needed to flex for changing input prices and changing product prices" which were uncontrollable by management. !ote how >orealis does a variance analysis to explain its UTU profitability '-xhibit 2C) 7evelop new standards 'e.g." compare actual to actuals to achieve continuous improvements or use external benchmar#ing" +best in class,).

4. &hat changes were institutedM And how did management expect the new measurement and control systems to helpM >orealis managers set ob=ectives to be achieved by the new measurement and control systems9 $mprove financial management and performance measurement 7ecentraliJe authority and decisions Simplify the budgeting process Ieduce the resources used in the process

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Several new tools were needed to replace the budgeting process and its two primary functions9 financial planning and performance measurement 'see -x. 4)9 Iolling Binancial Borecasts >alanced Scorecard Ley performance indicators Ielative Binancial Ferformance Activity >ased Costing -xternal >enchmar#ing Trend reporting 7ecentraliJed $nvestment <anagement

%. &hat are the strengths and wea#nesses of each of the new measurement and control systemM A9 Rolling 1orecasts goal was to achieve a simple and accurate picture of expected financial performance. similar to a flexible budget permits incorporation of dynamic states of the world. used the most ob=ective data available. spent less time explaining deviations from budget. This system could also be gamed" but >orealis did not tie compensation to achieving the forecasts" so there was little incentive to game. $f some resources are variable 'flexible) with respect to volume and mix" when the company has updated and more accurate forecasts" it can do better short-term resource budgeting 'authoriJe spending on direct" capacity" and support resources based on anticipated volume and mix of products and customers). This re*uires activity-based budgeting and would tie bac# to capacity planning 'investment management). +9 +alanced &corecardXcommunicate strategic ob=ectives and measures to employees and encourage them to set personal ob=ectives that would be lin#ed to corporate strategy.

C9 Relative 1inancial Performance :R1P; X to further distinguish between forecasting and performance measurement. The IBF was the correct flexible budget for >orealis. ne that flexed for input prices and product prices as well as volume. >orealisK financial performance was much more affected by external margin changes 'changes in the spread between input and product prices) than by actual internal process performance. important to achieve a balance and a focus on #ey performance indicators 'LF$) without overwhelming managers with metrics galore. $ntroduced small incentive plan between 8"222 and 6"222 Lronor '/122 to /0"222) based on 02 LF$s from the >SC. 49 A+C X to trac# and record costs by activities which create them" to develop cost information that was much more intuitive and understandable to plant employees. E9 E<ternal +enchmar3ing X used to set performance targets for CC" BC and operating margins by benchmar#ing against competitors 'see -x. 1). These targets were
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considered tougher" but the absence of budgets gave managers increased freedom for spending // to reach the targets. Trends9 measure and graph activity and process costs over time. Iemoved gaming? !obody wanted to be a Plaggard.K Spent less time negotiating targets. Iates were determined using /a i/al usage o. capacity. Cariances arose because not all fixed costs were allocated to products. The cost of unused capacity was assigned to profit centers based on differences between capacity planned and used.

19 4ecentrali=ed $nvestment "anagement > to put decision-ma#ing and control with plant managers and employees who were closest to the mar#etplace and customers collection of decision rights and specific #nowledge needed for the best decision ma#ing" proximity to customer and mar#ets. 6. Should compensation be tied to LF$s presented on the >SCM (ow will this affect validity of data reported or aggressiveness of target settingM &hat other processes can management use to offset the information distortion when targets are established for performance measuresM The LF$s are not about strategic uncertainties. The LF$s are about measurement of outcomes from a well-defined process X the production of little plastic pellets. $f so" then it seems L to tie compensation to LF$s. $n fact" without this reinforcement" the targets may have little motivational impact. 5. $s the >orealis new system for everyoneM &hy would it not be +universal medicine,M -mpirical evidence suggests that >orealisK system is not for every company" as most companies continue to use budgets. -very company has tension in the design and use of <CS. These systems are used both to inform and to motivate. Rsing one system to do both is li#ely to result in the introduction of manipulation. There is no one way to address this tension. Some companies" for example" set top-down budgets or use tight supervision or truth-inducing incentive systems. ne problem with the >eyond >udgeting approach is feasibility. -very company must have performance standards. >orealis replaced its internally negotiated 'budget) standards with benchmar#ed standards. This is not feasible for every business" as many companies guard their internal data on costs and margins very carefully. &hy do we observe the innovations suggested by the >eyond >udgeting Iound Table '>>IT) being implemented primarily in -urope" and not in the RSM $n Scandinavia there are multiple examples of companies that have followed this strategy. <ost notable is Svens#a (andelsban#en" which has consistently been the most profitable Scandinavian ban# over the last 22 years. -mployeesK views seem to be different in different cultures. So what wor#s for >orealis may not wor# in the RS X as suggested by the *uote by >ogsnes in the case. $n >orealis" decentraliJation seems to be a substitute for budgeting. This decentraliJation is motivated by the unpredictable price variability in >orealisK environment 'prices" costs).

06