Question

Read at least 2 academically reviewed articles and Write an annotated bibliography paper on Master Budgeting

Answer 1

Master Budgets

The fourth type of budget is referred to as the master budget or financial plan. The master budget is the primary financial planning mechanism for an organization and also provides the foundation for a traditional financial control system. More specifically, it is a comprehensive integrated financial plan developed for a specific period of time, e.g., for a month, quarter, or year. This is a much broader concept than the first three types of budgeting. The master budget includes many appropriation budgets (typically in the administrative and service areas) as well as flexible budgets, a capital budget and much more. A diagram illustrating the various parts of a master budget is presented in Exhibit 9-4.

The master budget has two major parts including the operating budget and the financial budget (See Exhibit 9-4). The operating budget begins with the sales budget and ends with the budgeted income statement. The financial budget includes the capital budget as well as a cash budget, and a budgeted balance sheet. The main focus of this chapter is on the various parts of the operating budget and the cash budget. The budgeted balance sheet is covered briefly, but not emphasized. A detailed discussion of capital budgeting and investment management is provided in Chapter 18 after some other prerequisite concepts are introduced. In the next section, we consider the purposes, benefits, limitations and assumptions of the master budget.

THE PURPOSES AND BENEFITS OF THE MASTER BUDGET

There are a variety of purposes and benefits obtained from budgeting. Consider the following:

Integrates and Coordinates

The master budget is the major planning device for an organization. Thus, it is used to integrate and coordinate the activities of the various functional areas within the organization. For example, a comprehensive plan helps ensure that all the needed inputs (equipment, materials, labor, supplies, etc.) will be at the right place at the right time when needed, just-in-time if possible. It also helps insure that manufacturing is planning to produce the same mix of products that marketing is planning to sell. The idea is that the products should be pulled through the system on the basis of the sales budget, rather than produced speculatively and pushed on the sales force. As discussed in Chapter 8, excess inventory and other resources hide problems and add unnecessary costs. The integrative nature of the budget provides a way to implement the lean enterprise concepts of just-in-time and the theory of constraints where the emphasis is placed on the performance of the total system (organization) rather than the various subsystems or functional areas.

Communicates and Motivates

Another purpose and benefit of the master budget is to provide a communication device through which the company’s employees in each functional area can see how their efforts contribute to the overall goals of the organization. This communication tends to be good for morale and enhance jobs satisfaction. People need to know how their efforts add value to the organization and its' products and services. The behavioral aspects of budgeting are extremely important.

Promotes Continuous Improvement

The planning process encourages management to consider alternatives that might improve customer value and reduce costs. Recall that "Plan" is the first step in the Shewhart-Deming plan- do-check-action continuous improvement cycle discussed in Chapter 8. The PDCA cycle supports specific improvements in the company’s processes. The financial plan and subsequent financial performance measurements reflect the financial expectations and consequences of those efforts.

Guides Performance

The master budget also provides a guide for accomplishing the objectives included in the plan. The budget becomes the basis for the acquisition and utilization of the various resources needed to implement the plan. Perfection of the guidance aspect of budgeting can significantly reduce the amount of uncertainty and variability in the company’s operations. In a JIT environment, the budget can also serve as a guide to vendors. For example, suppliers to General Motors Saturn plant in Tennessee have access to Saturn’s production schedule through an on-line database. This information allows Saturn’s vendors to deliver the required parts in the order needed to precise locations just-in-time without a purchase order or delivery schedule.3

Facilitates Evaluation and Control

The master budget provides a method for evaluating and subsequently controlling performance. We will develop this idea in considerable detail in the following chapter. Performance evaluation and control is a very powerful and very controversial aspect of budgeting. (For example, see the discussion of Johnson's ABM Model in Chapter 8).

LIMITATIONS AND PROBLEMS

There are several limitations and problems associated with the master budget that need to be considered by management. These problems involve uncertainty, behavioral bias and costs.

Uncertainty

Budgeting includes a considerable amount of forecasting and this activity involves a considerable amount of uncertainty. Uncertainty affects both sides of the financial performance dichotomy, (see Exhibit 9-1) but uncertainty on the revenue side presents a more serious limitation for planning. The sales budget is frequently based on a forecast supported by a variety of assumptions about the economy, the actions of the federal reserve board and congress in implementing monetary and fiscal policy, and the actions of competitors, suppliers, and customers. The uncertainty associated with sales forecasting creates a greater problem than uncertainty on the cost side because the other parts of the budget (see Exhibit 9-4) are derived from the sales forecast. This forces management to constantly monitor and analyze changes in the economic environment. From the planning perspective, the inability to accurately forecast the future reduces the usefulness of the original budget estimates for materials requirements planning (MRP) and planning for other resource needs. Uncertainty on the cost side tends to be less of a problem because management has more influence over the quantities of resources consumed than over the quantities of their own products purchased by customers. From a performance evaluation and control perspective, uncertainty on both sides of the financial performance dichotomy is not as much of a problem because flexible budgets are used to fine tune the original budget to reflect expectations at the current level of activity. The manner in which flexible budgets are used for performance evaluation is given considerable attention in Chapter 10 and Chapter 13.

Behavioral Bias

A second problem involves a variety of behavioral conflicts that are created when the budget is used as a control device. To be effective, the budget must be used by the managers it is designed to help. Thus, it must be acceptable to all levels of management. The behavioral literature on budgeting supports the view that the budget should reflect what is most likely to occur under efficient operating conditions. If a budget is to be used as an effective planning and monitoring device, it should encourage a high level of performance and efficiency, but at the same time, it should be fair and obtainable. If the budget is viewed by managers as unfair, (too optimistic) it may intimidate rather than motivate. One way to gain acceptance is referred to as participative (rather than imposed) budgeting. The idea is to include all levels of management in the budget preparation process. Of course this process must be coordinated by a budget director to ensure that a fair budget is obtained that will help achieve the goals of the total organization.

Another way to reduce the behavioral bias against budgeting is to recognize the concepts of variation and interdependence when using the budget to evaluate performance. Recall from our discussion of the statistical control concept in Chapter 3 that there is variation in all performance and most of this variation is caused by the system , (i.e., common causes) not the people working in the system. The concept of interdependence refers to the fact that the various segments of a company are part of a system. Inevitably, these segments, or subsystems influence each other. Failure to adequately recognize the interdependencies within an organization tends to cause behavioral conflicts and motivate participants to optimize the performance of the various segments (subsystems) rather than to optimize the performance of the overall system.

Finally, the behavioral conflicts associated with budgeting are reduced by using flexible budgets when evaluating performance. We will return to these ideas below and again in Chapter 10.

Costs

A third problem or limitation is that budgeting requires a considerable amount of time and effort. Many companies maintain a twelve month budget on a continuous basis by adding a future month as the current month expires.4 While this does not create a major expenditure for large or medium sized organizations, smaller companies may find it difficult to justify the costs involved. Many small, potentially profitable firms, do not plan effectively and eventually fail as a result. Cash flow problems are common, e.g., not having enough cash available (or accessible through a line of credit with a bank) to pay for merchandise or raw materials or to meet the payroll. Many of these problems can be avoided by preparing a cash budget on a regular basis.