Chapter 9 Profit Planning Cornerstones of Managerial Accounting

Chapter 9: Profit Planning Cornerstones of Managerial Accounting, 4 e © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Learning Objectives 1. Define budgeting and discuss its role in planning, control, and decision making. 2. Define and prepare the operating budget, identify its major components, and explain the interrelationships of its various components. 3. Define and prepare the financial budget, identify its major components, and explain the interrelationships of its various components. 4. Describe the behavioral dimension of budgeting. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Description of Budgeting ►All businesses should prepare budgets. ►Budgets help business owners and managers to plan ahead, and later, exercise control by comparing what actually happened to what was expected in the budget. ►Budgets formalize managers’ expectations regarding sales, prices, and costs. ►Even small businesses and nonprofit entities can benefit from the planning and control provided by budgets. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Budgeting and Planning and Control ► Planning and control are linked. ► Planning is looking ahead to see what actions should be taken to realize particular goals. ► Control is looking backward, determining what actually happened and comparing it with the previously planned outcomes. ► Budgets are financial plans for the future and are a key component of planning. They identify objectives and the actions needed to achieve them. ► Before preparing a budget, an organization should develop a strategic plan. ► The strategic plan plots a direction for an organization’s future activities and operations; it generally covers at least five years. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Planning, Control, and Budgets © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Advantages of Budgeting A budgetary system gives an organization several advantages. Planning Information for Decision Making Standards for Performance Evaluation Improved Communication & Coordination © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 The Master Budget ►The master budget is the comprehensive financial plan for the organization as a whole. ►Typically, the master budget is for a one-year period, corresponding to the fiscal year of the company. ►Yearly budgets are broken down into quarterly and monthly budgets. ►The use of smaller time periods allows managers to compare actual data with budgeted data more frequently, so problems may be noticed and resolved sooner. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 The Master Budget (continued) ►Some organizations have developed a continuous budgeting philosophy. ►A continuous budget is a moving 12 -month budget. ►As a month expires in the budget, an additional month in the future is added so that the company always has a 12 -month plan on hand. ►Proponents of continuous budgeting maintain that it forces managers to plan ahead constantly. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Master Budget: Directing and Coordinating ►Most organizations prepare the master budget for the coming year during the last four or five months of the current year. ►The budget committee reviews the budget, provides policy guidelines and budgetary goals, resolves differences that arise as the budget is prepared, approves the final budget, and monitors the actual performance of the organization as the year unfolds. ►The controller usually serves as the budget director, the person responsible for directing and coordinating the organization’s overall budgeting process. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Master Budget: Major Components ►A master budget can be divided into operating and financial budgets: ►Operating budgets describe the income-generating activities of a firm: sales, production, and finished goods inventories. The ultimate outcome of the operating budgets is a pro forma or budgeted income statement. ►Financial budgets detail the inflows and outflows of cash and the overall financial position. Planned cash inflows and outflows appear in the cash budget. The expected financial position at the end of the budget period is shown in a budgeted, or pro forma, balance sheet. ►Since many of the financing activities are not known until the operating budgets are known, the operating budget is prepared first. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 The Master Budget and Its Interrelationships © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Preparing the Operating Budget ►The operating budget consists of a budgeted income statement accompanied by the following supporting schedules: ►sales budget ►production budget ►direct materials purchases budget ►direct labor budget ►overhead budget ►selling and administrative expenses budget ►ending finished goods inventory budget ►cost of goods sold budget © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Sales Budget ►The sales budget is approved by the budget committee and describes expected sales in units and dollars. ►Because the sales budget is the basis for all of the other operating budgets and most of the financial budgets, it is important that it be as accurate as possible. ►The first step in creating a sales budget is to develop the sales forecast. ►The sales forecast is just the initial estimate, and it is often adjusted by the budget committee. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 9 -1 Preparing a Sales Budget © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 You Decide Budgeting in a Service Industry You are the controller for a large, regional medical center. The chief of cardiology has been pushing to have a free-standing heart hospital built on the medical center campus. However, you are concerned that taking the heart cases away from the main hospital will hurt its bottom line. While the medical center is nonprofit, it does need to cover all of its costs to stay in business. You also wonder whether the heart hospital will break even. What information do you need to forecast revenues and costs of the heart hospital? This is a two part problem. The first question, what impact will the heart hospital have on the main hospital’s revenues, requires knowledge of the number and types of heart cases seen at the main hospital each year. This information could come from the sales revenue budget from the previous year, assuming that the total number of patient days and procedures are broken out by type of case and procedure. Since so many of the costs of a hospital are fixed, there will probably be little decrease in costs as those heart patients leave for the freestanding heart hospital. The second question requires a forecast of the number of patients and probably reimbursement rates expected for procedures to be performed by the heart hospital. This information can be compared with budgeted operating costs to see if the heart hospital’s revenues can cover its costs. Forecasts of sales revenues and costs are dependent on detailed information provided by sources like the marketing or sales department and past accounting information and need to be revised and updates as new information or circumstances dictate. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Production Budget ►The production budget tells how many units must be produced to meet sales needs and to satisfy ending inventory requirements. ►To compute the units to be produced, both unit sales and units of beginning and ending finished goods inventory are needed: Units to be produced = Expected unit sales + Units in desired ending inventory (EI) – Units in beginning inventory (BI) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 9 -2 Preparing a Production Budget © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 9 -2 Preparing a Production Budget (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Direct Materials Purchases Budget ►After the production budget is completed, the budgets for direct materials, direct labor, and overhead can be prepared. ►The direct materials purchases budget tells the amount and cost of raw materials to be purchased in each time period. ►The formula used for calculating purchases is as follows: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 9 -3 Preparing a Direct Materials Purchases Budget © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 9 -3 Preparing a Direct Materials Purchases Budget (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 9 -3 Preparing a Direct Materials Purchases Budget (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Direct Labor Budget ►The direct labor budget shows the total direct labor hours and the direct labor cost needed for the number of units in the production budget. ►As with direct materials, the budgeted hours of direct labor are determined by the relationship between labor and output. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 9 -4 Preparing a Direct Labor Budget © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Overhead Budget ►The overhead budget shows the expected cost of all production costs other than direct materials and direct labor. ►Many companies use direct labor hours as the driver for overhead. ►Then costs that vary with direct labor hours are pooled and called variable overhead. ►The remaining overhead items are pooled into fixed overhead. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 9 -5 Preparing an Overhead Budget Information: Refer to the direct labor budget below. The variable overhead rate is $5 per direct labor hour. Fixed overhead is budgeted at $1, 645 per quarter (this amount includes $540 per quarter for depreciation). Required: Prepare an overhead budget. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 9 -5 Preparing an Overhead Budget (continued) Solution: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Ending Finished Goods Inventory Budget ►The ending finished goods inventory budget supplies information needed for the balance sheet and also serves as an important input for the preparation of the cost of goods sold budget. ►To prepare this budget, the unit cost of producing finished goods must be calculated by using information from the direct materials, direct labor, and overhead budgets. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 9 -6 Preparing an Ending Finished Goods Inventory Budget Information: Refer to the direct materials, direct labor, and overhead budgets prepared previously and shown here. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cornerstone 9 -6 2 Preparing an Ending Finished Goods Inventory Budget (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cost of Goods Sold Budget ►Assuming that the beginning finished goods inventory is valued at $1, 251, the budgeted cost of goods sold schedule can be prepared using information from Cornerstones 9 -3 to 9 -6. ►The cost of goods sold budget reveals the expected cost of the goods to be sold. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 9 -7 Preparing a Cost of Goods Sold Budget © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Selling and Administrative Expenses Budget ►The selling and administrative expenses budget outlines planned expenditures for nonmanufacturing activities. ►As with overhead, selling and administrative expenses can be broken down into fixed and variable components. ►Such items as sales commissions, freight, and supplies vary with sales activity. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 9 -8 Preparing a Selling and Administrative Expenses Budget Information: Refer to the sales budget below. Variable expenses are $0. 10 per unit sold. Salaries average $1, 420 per quarter; utilities, $50 per quarter; and depreciation, $150 per quarter. Advertising for Quarters 1 through 4 is $100, $200, $800, and $500, respectively. Required: Prepare a selling and administrative expenses budget. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 9 -8 Preparing a Selling and Administrative Expenses Budget (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Budgeted Income Statement ►With the completion of the budgeted cost of goods sold schedule and the budgeted selling and administrative expenses budget, a company has all the operating budgets needed to prepare an estimate of operating income. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 9 -9 Preparing a Budgeted Income Statement Information: Refer to Cornerstones 9 -1, 9 -7, 9 -8, and 9 -12 for the sales budget, the cost of goods sold budget, the selling and administrative expenses budget, and the cash budget. Assume that the tax rate is 40 percent. Required: Prepare a budgeted income statement. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Preparing the Financial Budget ►The remaining budgets found in the master budget are the financial budgets. ►The usual financial budgets prepared are: ►cash budget ►budgeted balance sheet ►budget for capital expenditures © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Cash Budget ► Understanding cash flows is critical in managing a business. ► Often, a business successfully produces and sells products but fails because of timing problems associated with cash inflows and outflows. ► Because cash flow is the lifeblood of an organization, the cash budget is one of the most important budgets in the master budget. ► The basic structure of a cash budget includes cash receipts, disbursements, any excess or deficiency of cash, and financing as shown below: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Cash Budget: Cash Available ► Cash available consists of the beginning cash balance and the expected cash receipts. Expected cash receipts include all sources of cash for the period being considered. ► The principal source of cash is from sales. ► Since a large proportion of sales is usually on account, a major task of an organization is to determine the pattern of collection for its accounts receivable. ► If a company has been in business for a while, it can use past experience to determine what percentage of credit sales are paid in the month of and months following sales. ► This is used to create a schedule of cash collections on accounts receivable. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cornerstone 9 -10 Preparing a Schedule for Cash Collections on Accounts Receivable Information: 3 From past experience, Texas Rex expects that, on average, 25 percent of total sales are cash and 75 percent of total sales are on credit. Of the credit sales, Texas Rex expects that 90 percent will be paid in cash during the quarter of sale, and the remaining 10 percent will be paid in the following quarter. Recall from Cornerstone 9 -1 that Texas Rex expects the following total sales: Quarter 1 2 3 4 $10, 000 $12, 000 $15, 000 $20, 000 The balance in accounts receivable as of the last quarter of 2011 was $1, 350. This will be collected in cash during the first quarter of 2012. Required: 1. Calculate cash sales expected in each quarter of 2012. 2. Prepare a schedule showing cash receipts from sales expected in each quarter of 2012. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cornerstone 9 -10 3 Preparing a Schedule for Cash Collections on Accounts Receivable (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Cash Budget: Cash Disbursements ► The cash disbursements section lists all planned cash outlays for the period. ► All expenses that do not require a cash outlay are excluded from the list (e. g. , depreciation is never included in the disbursements section). ► Just as sources of cash may require a schedule of cash collections on accounts receivable to calculate cash expected from credit sales, the disbursements section may require care in handling payments on account. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Cornerstone 9 -11 Determining Cash Payments on Accounts Payable © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Cornerstone 9 -11 Determining Cash Payments on Accounts Payable (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Cash Budget: Cash Excess or Deficiency ► Some companies expand the basic cash budget format by adding lines to show any borrowing or repayment necessary to achieve a minimum desired cash amount. ► When this is done, the preliminary ending cash balance is called cash excess or deficiency. ► The cash excess or deficiency line is compared to the minimum cash balance (or lowest amount of cash acceptable as noted by company policy). ► If a cash deficiency exists with less cash on hand than is needed, the company usually obtains a short-term loan. ► A cash excess is usually used to repay loans or used to make temporary investments. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Cash Budget: Borrowings and Repayments, Ending Cash Balance ► Borrowings and Repayments: If a company converts its preliminary cash balance line to a cash excess (deficiency) line, it may be borrowing or repaying money. If there is a deficiency, this section shows the necessary amount to be borrowed. When excess cash is available, this section shows planned repayments, including interest expense. ► Ending Cash Balance: The last line of the cash budget is the ending cash balance. This is the planned amount of cash to be on hand at the end of the period after all receipts and disbursements, as well as borrowings and repayments, are considered. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Cornerstone 9 -12 Preparing a Cash Budget © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Cornerstone 9 -12 Preparing a Cash Budget (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 You Decide Cash Budgeting for a Small Painting Company You are the accountant for a number of small businesses in your town, one of which is Ramon’s Paint and Plaster. Ramon has been through a tough year as construction in the town has been down. However, new home construction is picking up and Ramon has been asked to bid on twice as many jobs in the past month as he was last year at this time. Ramon needs to know what his cash flow will be for the coming year. You are starting to amass information to help you forecast monthly cash inflows and outflows for the next six months. What information do you need to forecast cash inflows and outflows for the paint and plaster business for the next six months? © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 You Decide Cash Budgeting for a Small Painting Company (continued) This is a two part problem. The first question, what inflows of cash are expected, depends on the number and size of the jobs Ramon can successfully bid on. Ramon’s business has been primarily residential, so you’ll need to know the number of housing starts (or the number of building permits applied for) and the number of remodeling jobs expected. You will also need to consider the price Ramon charges as well as the probability of prompt payment. Some builders have a good reputation for paying promptly in the first ten days of the month following work by Ramon’s crew. Others lag behind. While you can encourage Ramon to work primarily with the better builders, he may be forced to accept some jobs with contractors who frequently pay later. The second question requires a forecast of the potential cash outflows. Ramon has a crew of six workers and the hourly rate is known. He also can figure out the cost of the paint and plaster materials fairly accurately, once the size of the job is known. It will be difficult to forecast the cash inflows and outflows too far in advance. As a result, you will probably want to set up the cash budget for one to three months in advance and then update the forecasted numbers as the year progresses. Forecasts of cash inflows and outflows depend on the economic conditions, the reputation of the payment patterns of the customers, and the prices charged both for the jobs obtained as well as for the supplies used. Information from the past year can be used as a baseline, however, changing economic conditions will affect future amounts. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Budgeted Balance Sheet ►The budgeted balance sheet depends on information contained in the current balance sheet and in the other budgets in the master budget. ►Explanations for the budgeted figures are typically provided in the footnotes. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Using Budgets for Performance Evaluation ► Budgets are often used to judge the performance of managers. ► Bonuses, salary increases, and promotions are all affected by a manager’s ability to achieve or beat budgeted goals. ► Positive behavior occurs when the goals of each manager are aligned with the goals of the organization and each manager has the drive to achieve them. ► The alignment of managerial and organizational goals is often referred to as goal congruence. ► If the budget is improperly administered, subordinate managers may subvert the organization’s goals. ► Dysfunctional behavior is individual behavior that is in basic conflict with the goals of the organization. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Positive Behavior ►Key features that promote a reasonable degree of positive behavior include: ►frequent feedback on performance ►monetary and nonmonetary incentives ►participative budgeting ►realistic standards ►controllability of costs ►multiple measures of performance © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Frequent Feedback on Performance ►Managers need to know how they are doing as the year progresses. ►Frequent, timely performance reports allow managers to know how successful their efforts have been, to take corrective actions, and to change plans as necessary. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Monetary and Nonmonetary Incentives ► Incentives are the means an organization uses to influence a manager to exert effort to achieve an organization’ s goal. ► Traditional organizational theory assumes that employees are primarily motivated by monetary rewards, they resist work, and they are inefficient and wasteful. ► Thus, monetary incentives are used to control a manager’s tendency to shirk and waste resources by relating budgetary performance to salary increases, bonuses, and promotions. ► Nonmonetary incentives, including job enrichment, increased responsibility and autonomy, and recognition programs can be used to enhance a budgetary control system. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Participative Budgeting ► Rather than imposing budgets on subordinate managers, participative budgeting allows subordinate managers considerable say in how the budgets are established. ► The increased responsibility and challenge inherent in the process provide nonmonetary incentives that lead to a higher level of performance. ► However, participative budgeting has three potential problems: ► setting standards that are either too high or too low ► building slack into the budget (often referred to as padding the budget) ► pseudoparticipation © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Standard Setting ► Some managers may tend to set the budget either too loose or too tight. ► Since budgeted goals tend to become the manager’s goals when participation is allowed, making this mistake in setting the budget can result in decreased performance levels. ► The trick is to get managers in a participative setting to set high but achievable goals. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Budgetary Slack ► The second problem with participative budgeting is the opportunity for managers to build slack into the budget. ► Budgetary slack (or padding the budget) exists when a manager deliberately underestimates revenues or overestimates costs in an effort to make the future period appear less attractive in the budget than they think it will be in reality. ► Either approach increases the likelihood that the manager will achieve the budget and consequently reduces the risk that the manager faces. ► The act of padding the budget is questionable when considering what is viewed as ethical professional practice. It is certainly not communicating information fairly and objectively and constitutes a violation of the credibility standard. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Pseudoparticipation ►The third problem with participation occurs when top management assumes total control of the budgeting process, seeking only superficial participation from lower-level managers. ►This practice is termed pseudoparticipation. ►Top management is simply obtaining formal acceptance of the budget from subordinate managers, not seeking real input. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Realistic Standards ► Budgets should reflect operating realities, including the following: ► Actual Levels of Activity: Flexible budgets are used to ensure that budgeted costs can be realistically compared with costs for actual levels of activity. ► Seasonal Variations: Interim budgets should reflect seasonal effects. Toys ‘‘R’’ Us, for example, would expect much higher sales in the quarter that includes Christmas than in other quarters. ► Efficiencies: Budgetary cuts should be based on planned increases in efficiency and not simply arbitrary across-the-board reductions. Across -the-board cuts without any formal evaluation may impair the ability of some units to carry out their missions. ► General Economic Trends: General economic conditions also need to be considered. Budgeting for a significant increase in sales when a recession is projected is not only foolish but also potentially dangerous. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Controllability of Costs ►Ideally, managers are held accountable only for costs that they can control. ►Controllable costs are costs whose level a manager can influence. ►If noncontrollable costs are put in the budgets of subordinate managers to help them understand that these costs also need to be covered, then they should be separated from controllable costs and labeled as noncontrollable. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Multiple Measures of Performance ►Often, organizations make the mistake of using budgets as their only measure of managerial performance. ►While financial measures of performance are important, overemphasis can lead to a form of dysfunctional behavior called milking the firm or myopia. ►Myopic behavior occurs when a manager takes actions that improve budgetary performance in the short run but bring long-run harm to the firm. ►Budgetary measures alone cannot prevent myopic behavior. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.