Budgets:

Planning and Control

Managerial Accounting
IE Business School – Spring 2023
Anisa Shyti, PhD

1-1
 Objectives

➻ Budget definition and framework

➻ Purpose of budgeting: Why

➻ The budgeting process: How

➻ Types of budgets: Approaches

➻ Master budget components

1-2
 Terminology

➻ Responsibility centers

➻ Sales budgets, production budgets, etc.

➻ Master budget

➻ Human aspect of budgeting

1-3
 Cases

➻ Planning and budgeting

➻ To start or not to start? McAdam – session 10

➻ Budgeting and variance analysis

➻ Apple Contractor in China - Danshui – session 11

1-4
 The Basic Framework of Budgeting

A budget is a detailed quantitative plan for acquiring and using

financial and other resources over a specified forthcoming time
period.

1. A company’s budget ordinarily cover a one-year period

corresponding to its fiscal year.

2. Some companies also use a perpetual budget, which is

a 12-month budget that continuously rolls forward.

1-5
 Choosing the Budget Period

Operating Budget

2020 2021 2022 2023

Operating budgets ordinarily

cover a one-year period A continuous budget is a
12-month budget that rolls
corresponding to a company’s
fiscal year. Many companies divide forward one month (or quarter)
their annual budget as the current month (or quarter)
is completed.
into four quarters.

1-6
 Budget Defined

➻ The quantitative expression of a proposed plan of

action by management for a specified period

➻ An aid to coordinating what needs to be done to

implement that plan

➻ May include both financial and nonfinancial data

1-7
 Budgets are Used for Two Key Purposes:

Planning – Control –

involves developing involves the steps taken by

objectives and management to increase the
preparing various likelihood that the
budgets to achieve objectives set down while
those objectives. planning are attained and
that all parts of the
organization are working
together toward that goal.

1-8
 Why Do Organizations Create Budgets? (Planning)

Define goals
and objectives
Communicate Think about and
plans plan for the future

Benefits
Coordinate Means of allocating
activities resources

Uncover potential
bottlenecks

1-9
 Why Do Organizations Create Budgets? (Control)

From a control standpoint, organizations compare their

budgets to actual results to:

Improve the Evaluate and

efficiency and reward employees.
effectiveness of
operations.

1-10
 Purpose of Budgeting

➻ Planning:
➻ Define goals
➻ Facilitating communication and coordination
➻ Allocating resources

➻ Controlling
➻ Controlling profit and operations, providing feedback
➻ Discover, address, adjust issues
➻ Evaluating performance and providing incentives

1-11
 Planning

➻ Should provide a common framework for discussion of

objectives and strategies

➻ Documents the operational plan to achieve strategic

and operative goals

➻ Provides an appropriate allocation of resources

1-12
 Communication

Should be collaborative, with free flow of information

➻ Strategic goals come from above

➻ Top-down communication flow
➻ Upper management has better understanding of strategy

➻ Resource requirements come from lower levels

➻ Bottom-up communication flow, based on assigned objectives
➻ Operating managers have better understanding of resource
needs

1-13
 Resource Allocation

➻ Focus on resources needed, not cost

➻ Operating managers should identify the quantities of

resources needed

➻ Accounting should translate into dollar amounts

➻ Managers may not know the cost of the resources requested

1-14
 Goal Setting

➻ Goals should be reasonable, attainable

➻ Overly ambitious goals are detrimental

➻ System can only produce to its capabilities

➻ Negative impact on employees

➻ “Stretch goals” are fine if attainable, and resources are

provided
1-15
 Rewards

➻ Budgets should not be a reward/penalty system

➻ Achievement of organization-wide goals must take

precedence over empire-building

➻ Appropriate funding of activities is more important than

rewarding past success

1-16
 Budgets and Feedback

➻ Budgets offer feedback in the form of variances:

➻ Actual results deviate from budgeted targets

➻ Variances provide managers with:

➻ Early warning of problems
➻ A basis for performance evaluation
➻ A basis for strategy analysis

➻ Variances are subject to interpretations… next class

1-17
 Linking Operations to Strategy

1-18
 Planning and Performance Evaluation

Planning and evaluation are different, they use different

tools, and require different interpretations

➻ Original budget is a plan for operations

➻ Actual operations may deviate from plan, intentionally or

unintentionally

1-19
 How Do Organizations Create Budgets?

Companies usually create budgets by relying

on some combination of top-down budgeting
and self-imposed budgeting. A self-imposed
budget or participative budget is a budget
that is prepared with the full cooperation and
participation of managers at all levels.

1-20
 Types of Budget

➻ Based on time
➻ Less than a year (Forecast)
➻ Year
➻ Multi-year

➻ Based on elaboration
➻ Imposed
➻ Pseudo-participative
➻ Participative

➻ Based on the review

➻ Fixed
➻ Reviewable
➻ Rolling

➻ Based on its variability

➻ Master
➻ Flexible
1-21
 Some Budget Terminology

➻ Participatory vs. imposed budgeting: participatory

includes more bottom-up involvement

➻ Imposed budgeting is necessary in certain situations,

i.e., fiscal crisis

➻ Flexible budget—shifts budgeted revenues and costs up

and down based on actual operating results (activities)

1-22
 Some Budget Terminology – cont’d

➻ Budget lapsing: cannot carryover unspent amounts to

subsequent year

➻ Zero-based budgeting: must justify total amounts for each

line item each year

➻ Incremental budget: previous year adjusted for expected

changes in volume, prices

1-23
 Self-Imposed Budgets
Top Management

Middle Middle
Management Management

Supervisor Supervisor Supervisor Supervisor

When managers throughout the organization work collaboratively to

prepare a budget they often strive to establish challenging targets that are
also highly achievable. These goals are likely to build a lower-level
manager’s confidence and commitment to the budget
1-24
 Advantages of Self-Imposed Budgets

1. It shows respect for opinions of lower-level managers involved in

the budgeting process.

2. Budget estimates prepared by front-line managers are more

accurate than estimates prepared by top managers.

3. Motivation is generally higher when individuals participate in

setting their own goals than when the goals are imposed.

4. It empowers them to take ownership of the budget and to be

accountable for deviations from it.
1-25
 Self-Imposed Budgets – Management Review

Self-imposed budgets should be reviewed by higher levels of

management to prevent “budgetary slack”.

Most companies issue broad guidelines in terms of overall

profits or sales. Lower level managers are directed to prepare
budgets that meet those targets.

1-26
 Master Budget Components

1-27
 Seeing the Big Picture

1. How much sales revenue will we earn?

2. How much cash will we collect from customers?
3. How much raw material will we need to purchase?
4. How much manufacturing costs will we incur?
5. How much cash will we pay to our suppliers and our direct laborers, and how
much cash will we pay for manufacturing overhead resources?
6. What is the total cost that will be transferred from finished goods inventory
to cost of goods sold?
7. How much selling and administrative expense will we incur and how much
cash will we pay related to those expenses?
8. How much money will we borrow from or repay to lenders – including
interest?
9. How much operating income will we earn?
10.What will our balance sheet look like at the end of the budget period?
1-28
 Exercise

➻ Budgeting material purchases. The Mahoney Company has

prepared a sales budget of 45,000 finished units for a three-
month period. The company has an inventory of 16,000
units of finished goods on hand at December 31 and has a
target finished goods inventory of 18,000 units at the end of
the succeeding quarter

➻ It takes three gallons of direct materials to make one unit of

finished product. The company has an inventory of 60,000
gallons of direct materials at December 31 and has a target
ending inventory of 50,000 gallons at the end of the
succeeding quarter. How many gallons of direct materials
should be purchased during the three months ending March
31?
1-29
 Components of Master Budgets

➻ Operating budgets
➻ building blocks leading to the creation of the budgeted
income statement

➻ Financial budget
➻ building blocks based on the operating budget that lead to
the creation of the budgeted balance sheet and the
budgeted statement of cash flows

1-30
 Master Budget, Illustrated
Operating Budget Financial Budget

Revenues
Budget

Ending Capital
Production
Inventory Expenditures
Budget
Budget Budget

Direct
Direct Manufacturing
Manufacturing
Materials Overhead
Labor Costs Cash Budget
Costs Budget Costs Budget
Budget

Cost of Goods
Sold Budget
Budgeted
Balance Sheet

Operating
Expense
Budget Budgeted
Statement of
Cash Flows
Budgeted
Income
Statement

1-31
 Performance Evaluation – cont’d

Evaluations must be done carefully:

➻ Budgets
• are based on estimates, guesses, assumptions
• ….and lies
➻ Actual results are based on reality

1-32
 Budgeting and Human Behavior

➻ The budgeting process may be abused both by

superiors and subordinates, leading to negative
outcomes

➻ Superiors may dominate the budget process or hold

subordinates accountable for events they have no
control over

➻ Subordinates may build“budgetary slack” into their

budgets

1-33
 Budgeting Games?

➻Counterproductive behaviors:
➻ Padding or slacking the budget
➻ “Big Bath Theory”
➻ Overestimation of resource needs (overspending)
➻ Results in misallocation of resources
➻ Setting easily achievable goals

➻How to minimize game playing?

1-34
 An Example: Budgetary Slack

The practice of underestimating budgeted revenues, or

overestimating budgeted expenses, in an effort to make
the resulting budgeted goals (profits) more easily
attainable.

1-35
 An Illustration: Budgetary Slack

1-36
 Budgeting and the Organization:
Responsibility Accounting

➻Responsibility center:
➻ A part, segment, or subunit of an organization whose
manager is accountable for a specified set of
activities

➻Responsibility accounting:
➻ A system that measures the plans, budgets, actions,
and actual results of each responsibility center

1-37
 Types of Responsibility Centers

➻ Cost Center: accountable for costs only

➻ Revenue Center: accountable for revenues only

➻ Profit center: accountable for revenues and costs

➻ Investment Center: accountable for investments,

revenues, and costs

1-38
 Controllability

➻ Controllability is the degree of influence that a

manager has over costs, revenues, or related items
for which he is being held responsible

➻ Responsibility accounting focuses on information

sharing, not in laying blame on a particular manager

1-39