7 Budgeting for Operations Management
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Learning Objectives
After studying Chapter 7, you will be able to:
• Identify the major elements of a financial planning and control system.
• Define responsibility accounting, including cost, profit, and investment centers.
• Explain the major purposes of budgeting.
• Identify the major human behavior factors that affect budgets and the budgeting process.
• Understand the master budget components and their relationships.
• Identify independent and dependent budget variables, and understand the basic format and calculation
sequences necessary for preparation of budgets and supporting schedules.
• Understand the role of flexible budgeting, project budgeting, and probabilistic budgeting in planning and
control.
• Prepare and format schedules for all elements of the master budget.
• Explain the impact on budgeting of JIT systems, activity-based costing, and flexible manufacturing.
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Chapter Outline
7.1 Budgeting: A Planning and Control System
7.2 Responsibility Accounting
Responsibility Centers
Identifying Cost Centers
Control Reports and Roll-Up Reporting
7.3 Why Budget?
7.4 Behavioral Side of Budgeting
Top-Management Support
Budget Slack
Human Factors and Budget Stress
Ethics of Budgeting
7.5 Master Budget—An Overview
Master Budget Components
Master Budget for Nonmanufacturing Organizations
7.6 The Starting Point and Beyond
Finding the Controlling Constraint
Sales Forecasting
Using Activity-Based Costing Relationships
Independent and Dependent Variables
Preparing and Formatting Budget Schedules
7.7 Other Budgeting Techniques
Flexible Budgeting
Project Budgeting
Probabilistic Budgeting
7.8 A Master Budget Example
Annual Goals and Planning Assumptions
Sales Forecast
Production Plan
Supporting Schedules
Cost of Goods Manufactured and Sold Schedule
Selling and Administrative Expense Budgets
Project Budgets
Cash-Flow Forecasts
The Completed Example: Forecast Financial Statements
Master Budget Summary
7.9 Impacts of Contemporary Manufacturing Approaches
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Section 7.1 Budgeting: A Planning and Control System
Budgeting: The Negatives and the Positives!
If you mention the words plans or budgets to Ann Davis, President of Internet Pathways, you
get a reaction ranging from disdain to outright hostility. She has been heard to say:
“How can I plan? Things always change so fast!”
“My business isn’t suited to anything so formal. My managers and I need to be flexible,
fast on our feet, and ready to change direction overnight, if we have to do so.”
“The budget always says we can’t do it. I just say, ‘Do it!’”
“The budget reports tell me where I’ve been, never where I’m going.”
“That’s the accountant’s budget; it doesn’t tell me what my problems are and what to do
about them!”
“We can’t wait for approvals and reports. Budgets hold us back!”
Ann even has a coffee cup with “Budgets Are For Wimps!” printed on it. She believes that
intuition and drive, not reports, got the company to where it is today.
“The easiest way to lose our edge is to start acting like paper shufflers!” she exclaims. Each
of her comments has some truth in it; however, the comments together reflect serious
deficiencies in the firm’s management process—little or no planning, and little ability to
measure performance.
A close friend says plans and budgets strike te
or in Ann because her “style” is threatened.
She likes to operate quickly, often keeping others in the dark. The friend says that she’s afraid
to admit that she has little idea where the company is going.
Recently, a situation arose in which Ann thought employees were making too many “bad
calls” on key decisions. She was surprised by the responses she got when she asked several
department managers what was wrong. Each complained about lack of direction at the
top, how management kept changing its mind, that there was no plan of action, and how
employees felt they could not judge how each of them, and the company as a whole, was
progressing.
A simple concept is a key to budgeting: Planning is not deciding what to do in the future;
it is deciding what to do now to assure a future. This chapter discusses concepts, tools,
and processes used in a planning and control system and illustrates an integrated master
udget.
7.1 Budgeting: A Planning and Control System
Planning and control comprise an overall management system. Planning can be viewed
as a framework for formulating short-term and long-term goals and objectives, predicting
potential results under alternative ways of achieving them, and deciding how to attain
the desired results. Control is the process of using feedback on actual operating results
to compare to the plan, to evaluate performance in achieving the plans and goals, and to
make changes. A budget is a plan showing what and how resources are to be used over a
specified time period.
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Section 7.1 Budgeting: A Planning and Control System
A plan, act, control, and evaluate cycle is shown in Figure 7.1. The master plan is prepared,
transactions are recorded, reports are prepared and analyzed, and the plan is reviewed and
updated.
A mission statement sets the purpose of the organization. Goals and objectives are state-
ments about the organization’s future position and its long-term direction. They describe
specific performance targets within certain timeframes. A profit goal might be, for example,
to earn an annual 15% aftertax return on shareholders’ equity or to generate sales of $1 bil-
lion by 2021. Once goals (direction and motivations) and objectives (quantified performance
targets) are set, action plans can be defined. The budgeting process determines the inputs
needed to achieve the forecast outputs.
A planning and control system includes tools, methods, and attitudes. The following set of
common elements appears:
• Strategic planning process. This long-range planning effort defines the firm’s
mission (why the firm exists), the long-range goals (what level of achievement it
expects), and a strategic plan (what markets, price policies, resource needs, and
production capabilities the firm will have).
• Business plan and personal goal setting. Creating the annual business plan is
the task of evaluating the firm’s strengths, weaknesses, opportunities, and tactics
to build firm-wide priorities for the coming year. Also, each manager develops a
personal set of goals and a plan of achievements that are consistent with the firm’s
usiness plan.
• Planning process and timetable. A budgeting schedule includes when to start the
process, submit budgets, and review and approve budgets at various management
levels—who does what and when.
Prepare the
Master Plan
Record
Transactions
Report on
Actual vs. Plan
Review and
Update Plan
Plan
Act
Control
Evaluate
Figure 7.1: The planning and control cycle
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Section 7.2 Responsibility Accounting
• Responsibility accounting system. This is a planning and control system that com-
ines responsibility centers, control reports, and cost drivers.
• Reward or incentive system. Rewards can provide incentives for managers who
achieve their unit’s budget goals and/or MBO (management by objectives) targets.
Tying performance to compensation appears to be an increasingly common practice.
• Financial modeling. Ability to evaluate alternative or “what if” scenarios is now an
expected part of any financial planning system. Simulation can test a plan to assess
goal achievement and evaluate alternative actions.
• Participatory budgeting. It is assumed that every manager in the firm is involved
in planning and control. Often, budget objectives are set at the executive level,
ut budgets are constructed from the bottom up—sometimes called “grass roots”
udgeting.
A budget period may be a week, month, quarter, year, or longer. But normally, a master budget
is for a year’s activities and is divided into months or quarters. Long-term budgets may be for
five or more years.
7.2 Responsibility Accounting
Responsibility accounting has no universal definition but does link authority and control.
A key aspect of responsibility accounting is that managers prepare plans for their areas of
esponsibility and exert control over those activities by making decisions and evaluating
esults. A responsibility accounting system
ings discipline to planning and control tasks.
The same basic elements remain visible in the accounting systems of small firms as in the
sophisticated planning systems of large, complex organizations. The basic elements of respon-
sibility accounting are:
• Responsibility center designations—to segment the organization into small sets
of similar activities.
• Control reports—to compare actual versus plan for expenses, revenues, and other
financial and activity measures, such as cost drivers.
• Roll-up reporting capability—to summarize lower-level activities at higher levels
along responsibility channels.
Strictly speaking, managers put more effort towards managing people who incur costs rather
than actually controlling costs themselves. Controllable costs are tied to organizational struc-
ture, activities management, and performance assessment.
Responsibility Centers
From a firm’s perspective, planning and control focus on responsibility centers. A respon-
sibility center is an organizational unit that has a specific manager with authority and
control over spending, earning, or investing. Responsibility centers can be subdivided into
three groups: investment centers, profit centers, and cost centers. Figure 7.2 illustrates these
esponsibility centers.
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Section 7.2 Responsibility Accounting
An investment center is a responsibility center where control exists over costs, revenues,
and investments in assets used or managed. Managers must have the authority to acquire or
dispose of assets. Typically, divisions of large firms are considered to be investment centers
and are viewed by top management essentially as separate business entities.
A profit center is a responsibility center where control exists over generating revenue and
incu
ing its related costs. Often, sales organizations are profit centers—with product reve-
nues, cost of sales, and marketing expenses. Managers with product-line responsibility might
include both manufacturing and marketing departments. Branch or regional managers often
have sales and expense control. The term revenue center can be used where a manager has
evenue responsibility but controls few expenses, such as in a regional sales office.
A cost center, or activity center as discussed in Chapter 4, is a responsibility center where con-
trol exists over incu
ing costs. Often, cost centers are defined by an organization chart and
may be further subdivided into