Strategic Planning and Budgeting Strategic Planning The planning of management control is to implement an organization strategies.

The processz of identifying, evaluating and deciding on these strategis is called strategy formulation. Although the strategy formulation process is referred to as a system, it is not in fact systematic. It is important to consider strategies whenever,there is a need to do so such as the oppurtunity to capitalize on new technology, a change in consumer preferences, a threat from new competitor. Because the occurence of such events is unpredictable, strategy formulation cannot be systematic process carried out to a predetermined schedule. Strategic planning is referred or sometimes called programming and long range planning. It is the process of deciding on the programs the organizaion will undertake to implement its strategie and on the approximate amount of resources to be allocated to each program. There are three main parts to the strategic planning process: 1. Review of the on-going programs. Most activities the typical organization will undertake in the next few years are similar to those already in progress. However, it is dangerous to complaces about these on-going programs. Thus there must a systematic throrough way of reviewing each existing activity to anticipate new conditions and decide upon appropriate actions. Zero-Based Budgeting. A systematic way of making an analysis of an on-going programs is called a zero based review. In deciding on the cost that are appropriate for a program, the cost estimates are built up from scratch or from zero. This review is useful for major programs to overcome the natural tendency toward complancency and inertia and is also useful for expense cenrers having a high proportion of discretionary costs. Because a zero base review is time consuming and upsetting the normal functioning of the responsibility center, it cannot be effectively conducted every year for every program and every expense center. An effective zero base review involves thoroughly reviewing each part of the whole organization every to three to five years. Making a zero base review of an expense center involves asking basic questions about each significant activity of the center, such as

Should this activity continue to be performed at all? Is too much being done? Too little? Should it be done internally or should it be contracted to an outside firm? Is there a more efficient way of obtaining the desired results? How much should it cost?

In the last few year, this activity has been popularized under new names including process analysis, process reingeneering and activity-based management. Activity-Based Costing. This involves more accurate allocation of joint (indirect costs) to cost objects than usually result when broad based overhead rates are used. Although that description related to manufacturing overhead, the same approach can be used in assigning any direct cost to the various cost objects that jointly cause the cost to be incurred. In particular, ABC concepts can be used in arriving at the full cost of a product line or other program of interest. Examining the costs (resource consumption) of the various activities required to implement the program and then applying these based costs to the demands a program places on each of these activities yields full cost figures. The approach may be used either in performing zero based review of on-going programs or in evaluating new program proposals. 2. Proposed new programs. Within the boundaries of the agreed upon strategies, management should be alert to the need for proposed new programs, either to counter a threat to existing operations or to take advantage of new oppurtunities. Management analyses these proposals whenever the need or the oppurtunity comes to its attention. In business such proposals usually involve new capital investments and the appropriate analytical techniques . Whether a new capital investment is involved, special attention must be given whether a new program will increase step-function costs in the various departments that will play role in implementing the program. Such costs are mistakenly labelled as fixed costs, resulting in an understatement of the impact of a new program will have on the organizations total costs. Benefit/Cost analysis. Revenue is a measure of the output of a profit oriented organization. Non profit organizations have also outputs, but many cannot be measured in monetary terms. Similarly, the outputs of many units within a

profit oriented company cannot be expressed in terms of revenues. In these situations, analysis of new program proposal based on its estimated profit or return of investment is not possible. Sometimes, it is possible to use a similar approach by comparing the costs of a programs with some measure of the benefits that are expected as a consequence of incurring costs. This approach s called benefit/cost analysis. Benefits/costs analysis is widely used for analyzing programs in non profit organization. Profit oriented companies also use this analysis in evaluating programs proposals that are spending more money to improve safety conditions, to reduce pollution, or to provide information to management. Zero based review also requires extensive used of this approach. The cost estimates in the benefit/cost analysis are usually straight forward. The difficult part of the analysis is estimating the value of the benefits. In the many situations, in which no meaningful estimate of the quantitative amount of benefits can be made, the anticipated profits are carefully described in words. Then, the decision must answer this question: Are the perceived benefits worth at least the estimated cost? The answer to this question is necessarily judgemental, but the judgement can be aided by a careful estimate of the programs costs and a careful assessment of the likely benefits. 3. Formal strategic planning systems. Every organizations should review its ongoing programs and make decisions on proposed new programs. Although many do these informally, most large companies have a formal system in which the financial and other consequences of these programs are projected for a number of years in the future. Such projection is called the long range plan. It shows revenues, costs and other information for individual programs for a number of years ahead-usually 5 years as few as 2 or 3 years. Usually the strategic planning begins several months prior to the start of the annual budgeting process. Formal strategic planning begins after senior management has analyzed the need for changes in basic goals and strategies. These are dessiminated to the operating managers, who then prepare tentative programs, following the guidelines set forth by senior management. Next, these proposed programs are discussed at lenght with senior management and out of these discussions emerges a set of programs for the whole company. These approved programs provide the guidelines for preparing the annual budget.

Budgeting A budget is a plan expressed in quantitative, usually monetary, terms covering a specified period of time, usually one year. Practically all companies, except some of the smallest, prepare budgets. Many companies refer to their annual budget as a profit plan, since it shows the planned activities that the company expects to undertake in its responsibility centers in order to obtain its profit goal. Almost all nonprofit organizations also prepare budget. The budget serves as: 1. 2. 3. 4. 5. 6. An aid in making and coordinating short-range plans. A device for communicating these plans to the various responsibility center managers. A way of motivating managers responsibility centers goals. to achieve their

A benchmark for controlling ongoing activities A basis for evaluating the performance of responsibility centers and their managers. A means of educating managers.

Planning. Major planning decisions are usually made in the strategic planning activity, and the process of developing the budget is essentially a refinement of these plans. Managers must consider how conditions in the future may change and what steps they should take to get ready for these changed conditions. Furthermore, each responsibility center affects and is affected by the work of other responsibility centers. The budgetary process helps coordinate these separate activities to ensure that all parts of the organization are in balance with one another. Most important, production plans must be coordinated with marketing plans to ensure that the production processes are geared up to produce the planned sales volume. Similarity, cash management plans (e.g., plans for short-term borrowing or for short-term investment of excess fund) must be based on projected inflows from sales and outflows for operating costs. Communication. Managements plans will not be carried out ( except by coincidence) unless the organization understands what the plans are. These plans include such specific things as how many goods and services are to be produced; what method, people, and

equipment are to be used; how much material is to be purchased; and what selling prices are to be. The organization also needs to be aware of policies and constraints to which it is excepted to adhere. Examples of these kinds of information include the maximum amounts that may be spent for advertising, maintenance, and administrative costs; wage rates and hours of work; and desired quality levels. The approved budget is the most useful device for communicating quantitative information concerning these plans and limitations. Motivation. If the atmosphere is right, the budgeting process can also be a powerful force in motivating managers to work toward the objectives of their responsibility centers and, hence, the goals of the overall organization. Such an atmosphere cannot exist unless responsibility center managers have been told what is expected of their responsibility centers. Motivation will be greatest when these managers have played an active role in the development of their budgets, as described later in this chapter. Controlling. As described in chapter 22, management controls purpose is to attain desired results. A budget is a statement of the results desired as of the time the budget was prepared. A carefully prepared budget is the best possible standard against which to compare actual performance. This is because it incorporates the estimated effect of all variables that were foreseen when the budget was being prepared. Until fairly recently, the general practice was to compare current results with results for last month or for the same period a year ago; this is still the basic means of comparison in some organizations. But such a historical standard has the underlying forces at work or in the planned programs for the current year. A comparison of actual performance with budgeted performance provides a red flag; it directs attention to areas where action may be needed. An analysis of the variance between actual and budgeted results may (1) help identify a problem area that needs attention, (2) reveal an exploitable opportunity not predicted in the budgeting process, or (3) reveal that the original budget was unrealistic in some way. Evaluation. Monthly variances from budgets are used for control purposes during the years. The comparison of actual and budgeted results for the entire year is frequently a major factor in the yearend evaluation of each responsibility center and its manager. Some companies calculate a managers bonus as a predetermined percentage of the net favorable variance in his or her responsibility center. Education. Although many companies do not explicitly recognize it as such, budget preparation is an educational tool. Budgets serve to

educate managers about the detailed working of their responsibility centers and the interrelationships of their centers with other centers in the organization. This is particularly true for a person who has been newly appointed to the position of responsibility center manager. Any person who has attempted preparation of an annual budget for personal financial affairs can appreciate the educational nature of this process. Multiple-Use Complications. Because the budget serves multiple purpose, budget preparations can be a complicated process. One problem is that manager may introduce bias when preparing their portion of the budget. This raises difficult questions: Should there be, in effect two sets of budget numbers? Should a company evaluate manager based on the realistic amount or the inflated amount? Rather than accepting the bias by having two sets of numbers, most companies try to design checks and balances into the budget preparation process that are intended to eliminate or at least substantially reduce the amount of bias in the budget numbers which is observed through budget negotiation. The Master Budget. Although we have referred to the budget, the complete budget package in an organization includes several items, each of which is also referred to as a master budget. There are three principal parts of the master budget as follows: 1. An operating budget showing the planned operations for the coming year that includes revenues, expenses and changes in inventory and other working capital items. 2. A cash budget showing the anticipated sources and uses of cash in that year. 3. A capital expenditure budget showing planned changes in property, plant and equipment. The Operating Budget. This sets forth the first year slice of the long range plans in terms of the responsibility centers obligated for implementing the plan. The long-range plan is structured in terms of programs, whereas a given responsibility centers activities cut across a number of programs. As a statement of the performance expected for each responsibility center manager, the operating budget is an excellent control device because comparing it with actual performance can provide a basis for assessment. Each manager is responsible for preparing these parts of the operating budger that correspond to sphere of responsibility. Responsibility budgets are broken down into cost elements. Such breakdown is useful both as a guide to spending and basis for identifying the areas of inadequate performance of actual spending differs from the budgeted amounts.

Project Budgets. Some organizations work on defined projects. The manager of the project may use other personnel and other resources from various functional departments in the organization. Hence, the project budget contains amounts that are also reported in the budgets for the responsibility centers. If personnel from functional departments are assigned temporarily to a project, they have two bosses, the project manager and the manager of their functional department. Such a practice results in matrix organization. Becuase of the dual lines of authority and responsibility, the control of a matrix organization is complicated. In budget preparation it is important that the project budgets be consistent with the budgets of the functional departments that will be supplying resources to the projects. Flexible (Variable)Budgets. If the total costs in a responsibility center are expected to vary with changes in volume, as is the case with most standard cost centers, the responsibility budget may be in the form of a flexible budget or variable budget. Such a budget shows the planned behavior of costs at various volume levels. It is appropriately used in responsibility centers with a high proportion of engineered costs, because additional volume causes additional costs in such centers. The flexible budget is usually expressed in terms of a cost-volume relationship- that is, a fixed amount for a specified time period plus a variable amount of unit per volume. In structuring such budget, care must be taken that the time period is clear, the volume is correctly defined, and that step-function costs have been treated appropriately. When there is a flexible budget, the costs of one volume level are used as part of the master budget. The volume level is the planned level of operations for the budget period; for an annual budget, this is usually the same as the standard (normal) volume used for setting predetermined overhead rates. Budgeted costs at other volume levels are used in the evaluation phase of the management control cycle, at which time actual costs are compared with the budgeted costs corresponding to the actual volume level that was experienced. Management by objectives. The system that supplements the monetary accounting information with other information about the results of the managers action is called the Management by Objectives (MBO). It gets its name because the system states specific objectives that the responsibility center manager is expected to achieve during the period covered by the budget. These objectives are analogous to revenues, expenses and profit amounts in financial budgets. This approach is especially useful in expense centers for which comparisons of actual costs versus budgeted costs are of limited usefulness in evaluating performance.

Experiences with MBO in businesses shown that it improves results in those responsibility centers where monetary measures are not felt to be useful indicators of performance. Without MBO, there is a tendency in such areas not to measure results at all. For MBO to be successful, however, it must be actively supported by senior management and carefully integrated with other aspects of the management control system. In some companies MBO has proven ineffective because it was implemented by the human resource management department and was not integrated with the management control system adminstered by the controllers department. MBO should be an integral part of the management control system, not a separate system. At the profit or investment center level, MBO seems more appropriate for new endeavors than for mature one. If a division is formed to enter a business that is new to the company, non financial objectives such as developing channels of distribution and building market share are dominant in the divisions early years. But as the division matures, financial objectives such as return on investment or net cash flow generated become more important.