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I'm Larry Walter,
this is principlesofaccounting.com Chapter 21 on Budgeting.
The next module is going to look deeply at the mechanics and
the spreadsheets and mathematics of budgeting.
But before we do that I want us to think for
a few minutes about some of the human aspects of budgeting.
To begin, consider that budgeting is likely spearheaded by a budget committee.
This is a group of senior level personnel from various departments.
They're in an excellent position to provide the best information about
the units within the organization.
Their goal, their objective, is to prepare, approve, and monitor the budget.
There are two basic models or approaches to budgeting.
One is a Top-Down, Mandated Budget.
The other is a bottom up participated budget.
They both have relative strengths and weaknesses.
The Top-Down,
Mandated Budget begins will upper level management establishing parameters.
These parameters cover sales goals, expenditure levels,
anticipated profitability.
Basically, here is what we want to achieve with our organization.
Pushing that information down through and into the organization.
Lower-level personnel have little impact in overall goal strategy.
Mid-level executives may refine directives as the budget information is passed down.
In other words, they may report back to upper level management that some
aspect is not anticipated to be achieved.
Some negotiation occurs about what's realistic for the organization.
Let's look at this graphically.
So the President or Chief Executive Officer of the company pushes down to
the Vice President of Sales, sales goals, targeted levels of anticipated outcomes.
The Vice President of Finance gets directives as well as does
the Vice President of Production.
They each then work with persons under them or departments under them,
such as the Marketing Manager and Sales Manager and so forth to communicate
the nature of the budget, the expected outcomes for the organization.
This is in direct contrast to a Bottom-Up, Participative Budget
where lower level units drive the development of budgets for their units.
Individual budgets are grouped and
regrouped to form divisional budgets and the mid-level executives again
add input along the way as information passes up through the organization.
Top management finally reviews the overall plan for consistency and coordination,
and really, determining whether it is an acceptable plan for the organization.
So, here we would start with information flowing up
from the individual unit managers to the mid-level managers and vice presidents,
and finally, back up to the President and CEO.
The advantages of a Bottom-Up, Participative Budget process
is that it may improve morale among employees and job satisfaction.
It's viewed as more team-based.
And the information may be prepared and
initiated by those who have the best knowledge of specific areas of operation.
There are disadvantages, however, it's a more time consuming process,
it's more expensive to develop and
administer, generally speaking, a Bottom-Up, Participative approach.
And, certainly, managers may try to pad their budgets giving them room for
mistakes and inefficiency.
If I anticipate doing a million and a half in sales, I might say, well,
we think we can do a million four in sales, so
when we come out at the million five, we'll look good compared to our budget.
So, that's always a problem in the budgeting process,
is people trying to leave them room to look good against expected performance as
it relates to both sales and expenses.
Now recognize, as budget information is transferred up and down an organization,
whether it's Top-Down or
Bottom-Up, information was passing through mid-level managers.
This is the old telephone game problem,
information changes as it's communicated from one party to the next.
That can happen in the budgeting process, as well.
Top management can lose touch with information originating on the front line
and front line employees may not get a clear picture of the organization's
goals and objectives.
The higher the hierarchy within the organization,
the more likely this is to occur.
As a result, some companies have been very specific and
conscious to develop an organizational structure that is flat.
It's a short distance or span or nexus of control from the top of the organization
to the lower level personnel that is, certainly aids the communication
process and understanding and cooperative working together.
We had also sometimes contributes sometimes to a far more efficient
operation and organization.
Any time you have budgeting,
it's based on anticipated or forward-looking information.
We don't want to simply shoot from the hip or make up the information.
Errors in budgets are inevitable.
But we can certainly try to reduce those errors.
So we need to give careful consideration to all of the estimates incorporated in
that budget, and this should not just be ad hoc,
we should be basing this on study and statistical evaluation.
I'd referred earlier to padding a budget, this term is often called budget slack.
Budget slack occurs when individuals attempt to create an environment
where budgeted goals are met or exceeded.
With budget slack, however, employees may lose incentives to be proactive and
pushing ahead and trying to optimize efficiency.
Workers may become concerned that beating goals will create a higher benchmark
in the future.
And managers may overspend in fear of losing money in subsequent periods.
That's a common problem with budgets.
Be sure and spend your budget so it won't be reduced next year.
So there are problems in the budgeting process.
One needs to be very thoughtful about the human aspects of budgeting.
Sometimes, particularly in governmental organizations,
there's a debate about the best way to do a budget.
The incremental budget uses last year's budget as the starting point and
simply increments that for additional expenditures, reduced expenditures, and so
forth based on the new information, anticipated changes in the environment.
However that can also cause certain expenditures to become
simply a legacy type expenditures, without really giving full thought and
consideration to whether those expenditures continue to be necessary.
And so some organizations have implemented zero based budgeting concepts.
This requires each period a careful and thoughtful reconsideration of
each expenditure that needs to be justified for the budget period.
No expenditure is presumed to be acceptable simply because it's reflective
of the status quo.
Can be time-consuming and expensive to implement a zero-based budget.
Sometimes, you might just take categories or
specific line items for re-examination each year.
Also, recognize there is an idea of an Impossible Budget.
One can set a budget that's so rigid it's seen as unattainable.
This can cause employees to become very frustrated and actually finally result in
a giving up type mentality, where employee performance suffers, morale goes down.
It's sort of like the football team that's so
far behind they can't catch up any longer and they sort of give up, so
the same element is possible with budgeting considerations.
Also recognize that budgeting can introduce some interesting ethical
dimensions.
An overly optimistic budget, one that personnel are having trouble achieving.
If there's a lot of pressure nevertheless to achieve that budget,
another way to do that rather than having true performance is actually just to lie
in the numbers that are communicated up the channel.
And so we want to be very careful about cooking the books to reach
unrealistic goals.
This usually starts out small.
This month, we didn't make our sales target, so let's fudge on the numbers and
we'll make up next month.
Next month we fall further behind and further behind, and suddenly
the information can become so distorted that the organization is out of control,
and it's an ever escalating pattern that is quite problematic for the organization.
And so be aware of that ethical challenge when you're expecting employees to
report performance according to the budgeted results.
So management should be thoughtful about realism in their budget and
lower level managers should be truthful when reporting even when there's bad news.
The upper division management is entitled to and
wants to know what's going on within the organization even when it's not good news.
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