403MSBABudgeting.p pt 1 Budgeting Budgets are used to coordinate activities (decision management) and to hold managers accountable (decision control). Most organizations use a mix of participative and top-down budgeting. –For better coordination, it is useful to have managers participate in setting the budget. –For better accountability, top-down budgeting is useful to set managers challenging goals. On their own, managers may set goals too low.

403MSBABudgeting.p pt 2 Budgeting & the “ratchet effect” A common problem with using budgets is that with time, budgets tend to become “tighter”: sales targets creep up, cost targets creep down -- in other words, performance expectations get ratcheted up and employees have to work harder. To counteract the ratchet effect, employees may deliberately under-perform because if they do any better, next period’s budget will become “tighter.”

403MSBABudgeting.p pt 3 Budget types Organizations use many different types of budgets –Short- and Long-run budgets short run budgets used for compensation contracts long-run budgets used for strategic planning –Line-item budgets used to set spending limits. –Budget lapsing used to prevent managers from carrying surpluses from one year to the next. Leads to waste (“use it or lose it”) (bad). Managers can’t coast on past performance (good).

403MSBABudgeting.p pt 4 Budget types Static and flexible budgets. –static budgets are based on planned or single level of activity. –flexible budgets are based on actual level of activity in flex budget, Fixed Costs are the same as the static budget (by definition these costs do not vary with volume), but variable costs are re-scaled to reflect the actual volume produced.

403MSBABudgeting.p pt 5 Budget types static budgets do not adjust for volume changes whereas flexible budgets do. if manager does not control volume decisions, the flexible budget is more useful to evaluate managerial performance. If manager controls volume both flexible budget as well as shortfall/overproduction i.e. volume must be considered.

403MSBABudgeting.p pt 6 Budget types Incremental and zero-based budgets (ZBB) are yet another type of dichotomy: –in incremental budgeting, only changes from the previous year’s budget are submitted for approval/discussion/review. easy to forget why things were added in the first place. over time many assumptions are never questioned and organization may get inefficient. –ZBB questions everything -- all budget items must be justified afresh each year. hugely time consuming and wasteful in many cases.