Topic 3

Budgeting and
Management Control
Systems
(Part 2)

Management Control
Systems

A major role for control systems is to

motivate behavior congruent with
the desires of the organization since
human interests and motivation can
vary significantly

Major Behavioral
Considerations

Embedding the organizations ethical code

of conduct into MCS design
Using a mix of short and long-term
qualitative and quantitative performance
measures
Empowering employees to be involved in
decision making and MCS design
Developing an appropriate incentive system
to reward performance

Impact of MCS on Behavior

Many managers try to implement

new systems without considering the
behavioral implications and
consequences of a MCS
Negative consequences:
Goal congruence may not occur
Motivation could be low
Employees may be encouraged to
engage in dysfunctional behavior
Eg:

data manipulation, gaming,

budget slack etc

Ethical Code of Conduct

in MCS Design

A set of ethical principles is at the

center of many boundary systems
MCS should incorporate the principles
of an organizations code of ethical
conduct
MCS that incorporates ethical
principles can provide decision makers
with guidance as they face ethical
dilemmas

Pressures Affecting a MCS

Managers are often subject to intense

pressures from their job circumstances
and from other influential organizational
members to suspend their ethical
judgment in certain situations
These pressures include the following
requests:

to tailor information to favor particular

individuals or groups
to falsify reports or test results
for confidential information
to ignore questionable or unethical
practices

Ethics and Management

Accountants

Management accountants are

guided by the organizations code of
ethical conduct and the ethical
standards of their professional
associations
Management accountants often
play a significant role in MCS
design, which should reflect their
professional standards

Motivation

In addition to fostering ethical behavior,

a central issue in MCS design is how to
motivate appropriate behavior at work
When designing jobs and specific tasks,
system designers should consider the
following three dimensions of
motivation:
Direction
Intensity
Persistence

GoalCongruence

Goal congruence - the organization and

its employees align their respective goals
The alignment of goals occurs as
employees:
Perform their jobs well and are helping
to achieve organizational objectives,
and
Are attaining their individual goals at
the same time

Diagnostic Control Systems

Even if goals are aligned, different

types of tasks require different levels
of skill, precision, responsibility,
initiative, and uncertainty
In most situations, managers try to
establish systems that they do not
have to personally monitor on a
regular basis
These are called diagnostic control
systems

Interactive Control
Systems
If there is a large degree of strategic

uncertainty, managers spend much

more time monitoring the decisions
and actions of their subordinates
These are called interactive control
systems
At the core of both systems are two
common methods of control: task and
results control

Using Budgets to Achieve

Organizational Objectives
The Budgeting Process

A budget is a quantitative
expression of the money inflows and
outflows that reveal whether a
financial plan will meet
organizational objectives
Budgeting is the process of
preparing budgets
Budgets provide a way to
communicate the organizations

The Budgeting Process

The process that determines the planned

level of most flexible costs
Budgets serve as a control for managers
within the business units of an organization
Budgets play a central role in the
relationship between planning and control
Budgets reflect in quantitative terms how
to allocate financial resources to each part
of an organization, based on the planned
activities and short-run objectives of that
part of the organization

The Budgeting Process

Budgeting the activities of each unit can

Reflect how well unit managers
understand the organizations goals
Provide an opportunity for the
organizations senior planners to
correct misperceptions about the
organizations goals

Budgeting also serves to coordinate the

many activities of an organization

The Budgeting Process

Budgets help to anticipate potential

problems
Budgeting reflects the cash cycle and
provides information anticipate
borrowing needed to finance the
inventory buildup early in the cash cycle
If budget planning indicates that the
organizations sales potential exceeds
its manufacturing potential, then the
organization can develop a plan to put
more capacity in place or to reduce
planned sales

Type of budgets

Factors relevant to determine the type

or style of budgets:

The type of organization

The leadership style
Personalities of people affected by the
budget
The method of preparation
The desired results of the budgeting process

Type of budgets

Two major types of budgets

Operating budgets - summarize the
level of normal activities of the firm
E.g.

sales, purchasing, and production budget

Financial budgets - identify the

expected financial consequences of the
activities summarized in the operating
budgets
E.g.

cash budget, capital expenditure budget,

pro-forma balance sheet and Income
statement

Budgets as planning and

control tools

A tool with which top management

cascades strategy goals to operating
levels
Planning one of the important
element of budgeting work
Is the process of developing objectives and
selecting a future action to accomplish them
Top and middle management responsible
Budgetary planning system

Control measure performance against

expectation
Achieved through continuous reporting of actual
progress and expenditure relatives to plan
Budgetary control system

Aims to provide a formal basis for monitoring the

progress towards achieving objectives
Usually functions in a closed loop
Closed loop starts with planning, then record
actual transaction and lastly, reports against the
plan and generates management response

Examples of budgetary control system

Standard costing variance analysis

MBE

MBE managers concentrate on the

exceptional items have time to take
corrective action

Special budget called flexible budget

Feedback and feed forward

process

Feedback monitor past results to detect and

correct disturbances to the plan (monitor)
Feed forward reacts to immediate of
forthcoming dangers by making adjustment
to the system in advance in order to cope
with the problem on time (warn)
Should function within single budgeting
system

because feedback control is too slow and feed

forward control is too risky

What If Analysis

Explore the effects of alternative marketing,

production, and selling strategies

Alternative proposals like these can be

evaluated in a what-if analysis

The structure and information required to

prepare the master budget can be used
easily to provide the basis for what-if
analyses

What-if analysis is only as good as the

model used to represent what is
being evaluated
Planners test planning models by
varying the model estimates
If small changes in an estimate used
in the production plan have a
dramatic effect on the plan, the
model is said to be sensitive to that
estimate i.e: sensitivity analysis

Sensitivity Analysis

Sensitivity analysis is the process

of selectively varying a plans or a
budgets key estimates for the
purpose of identifying over what
range a decision option is preferred
Sensitivity analysis enables planners
to identify the estimates that are
critical for the decision under
consideration

Managing the Budgeting Process

Many organizations use a budget team, headed

by the organizations budget director or the
controller, to coordinate the budgeting process
The budget team usually reports to a budget
committee, which generally includes the chief
executive officer, the chief operating officer, and
the senior executive vice presidents
The composition of the budget committee reflects
the role of the budget as the planning document
that reflects and relates to the organizations
strategy and objectives

Managing the Budgeting

Process

Using a budget committee may signal to

other employees that budgeting is something
that is relevant only for senior management
Senior management must take steps to
ensure that the organization members
affected by the budget do not perceive the
budget and the budgeting process as
something beyond their control or
responsibility

Behavioral Aspects of
Budgeting

Because of the human factor

involved in the process, budgets
often do not develop smoothly
Two related areas are of particular
importance with respect to the
behavioral issues:

Designing the budget process

Influencing the budget process

Designing the Budget

How should budgets be determined and

who should be involved in the budgeting
process?
Three common methods of setting
budgets:

Authoritarian - superior simply tells

subordinates what their budget will be
Participation - all parties agree about
setting the budget targets, using a joint
decision-making process
Consultation - managers ask subordinates

Designing the Budget (2 of 2)

Research shows that the most motivating types of

budgets are those that are tight

With targets that are perceived as ambitious but

attainable

Recently, some companies have implemented what

are known as stretch targets

Stretch targets exceed previous targets by a significant

amount and usually require an enormous increase in a goal
over the next budgeting period
The theory is that only in this manner will companies
completely reevaluate the ways in which they develop and
produce products and services

InfluencingTheBudgetProc
ess

When incentives and compensation are

tied to the budget, some managers have
been known to play budgeting games in
which they attempt to manipulate
information and targets to achieve as high
a bonus as possible (or the best
evaluation)
Participation provides employees the
opportunity to affect their budgets in ways
that may not always be in the best
interests of the organization

Budget Slack

Budget slack is created by requiring excess

resources or distorting performance information
If subordinates succeed in creating budget
slack, they will find it easy to meet or exceed
their budgeted objectives
Budgeting games can never be eliminated,
although some organizations have devised
methods to decrease the amount of budget
slack

Benefit and problems associated

with traditional budgeting

Benefits:
1)

2)
3)

4)
5)
6)
7)

Major formal way to translate objectives into specific

plan and task
Important medium for communication
Help achieve coordination between various
departments and functions
Involvement of all level of management
Save management time
Performance systematically reported and monitored
Systematic monitoring of result compared to the plan

Problems:
1)

Competitive strategy

Rarely strategic focused and often

contradictory
Concentrate on cost reduction and not
value creation
Constrain responsiveness and flexibility
Add little value tend to be bureaucratic
and discourage creative thinking

Business process
1) time consuming and costly
2) developed and updated too infrequently,
usually annually
3) based on unsupported assumption
4) encourage gaming and dysfunctional
behaviour

Organizational capacity
Strengthen vertical command and control
Do not reflect the emerging network
structures that organizations are adopting
Reinforce departmental barriers rather than
encourage knowledge sharing
Make people feel undervalued

END OF CHAPTER