Master Budget Components and Performance Evaluation

Major Components of a Master Budget

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.

Behavioral Dimension of Budgeting

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 align with the organization's goals, driving them to achieve those goals.
• 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.

Positive Behavior

Key features that promote a reasonable degree of positive behavior include:

• Frequent feedback on performance: Managers need to know how they are doing as the year progresses.
• 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.

Monetary Incentives

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

Nonmonetary incentives, such as increased responsibility and autonomy, and recognition programs, can be used to enhance a budgetary control system.

Participative Budgeting

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, it has three potential problems:

1. Setting standards that are either too high or too low.
2. Building slack into the budget.
3. Pseudo-participation.

Controllability of Costs

Controllable costs are costs whose level a manager can influence.

Multiple Measures of 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.

Zero-Base Budgeting

In zero-base budgeting, managers are required to justify all budgeted expenditures, not just changes in the budget from the previous year. The baseline is zero rather than last year's budget.

International Aspects of Budgeting

Multinational companies face special problems when preparing a budget.

Service Department Allocations

• Operating Departments: Carry out the central purpose of the organization.
• Service Departments: Do not directly engage in operating activities. The costs of the service department become overhead costs to the operating department.

Allocation Approaches

1. Direct Method
2. Step-Down Method
3. Reciprocal Method

The direct and step-down methods do not fully account for reciprocal services because service departments provide services to each other.

Flexible Budgets and Performance Analysis

Characteristics of Flexible Budgets

• Planning budgets are prepared for a single, planned level of activity.
• Performance evaluation is difficult when actual activity differs from the planned level of activity.
• May be prepared for any activity level in the relevant range.
• Show costs that should have been incurred at the actual level of activity.
• Help managers control costs.

How a Flexible Budget Works

To "flex" a budget, we need to know that:

• Total variable costs change in direct proportion to changes in activity.
• Total fixed costs remain unchanged within the relevant range.

Planning budget revenues and expenses and flexible budget revenues and expenses.

Activity variances are the differences between the budget amounts.