Question

Dave Ludwig is the chief financial officer (CFO) of a major sporting goods manufacturer, Playco. Playco manufactures four major product lines: golf equipment, hockey equipment, baseball equipment, and sporting apparel. All products are sold through an extensive network of independent retailers, some of which are major sporting goods outlets. Each product line is considered to be a separate division, headed up by a senior product manager who is responsible for all major day-to-day operating decisions, including pricing, product mix, production, and managing and expanding dealer relationships. All of Playco's senior product managers have been with the company for at least 6 years, with experience ranging from 6 to 15 years.

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In the past, Playco has always used a top-down approach to developing the master budget, whereby a senior management team, including the CEO, the CFO, and the vice-presidents of manufacturing and marketing, set the revenue and expense budgets each year for the four major product lines. These budgets have been based on the company's strategic plans; the team's analysis of the operating environment (including the key competitors); and other factors that could affect demand for sporting goods, such as expected inflation rates, interest rates, and changing demographics. Some input was sought from the senior product manager of each of the major product lines when developing the budget. However, this was limited to a one-on-one meeting between the manager and the CFO at the beginning of the budgeting process each year. These meetings typically lasted about an hour, during which the product managers were invited to provide input on the competitive environment, anticipated pricing issues, production plans (including any ­design changes), and so on. After these meetings had been completed, the senior management team typically met several times over a one-month period and finalized the budget. Each product manager was then assigned a detailed budget for all revenue and expense items under his or her control. The budget assignment was done during a meeting attended by all of the senior product managers and the senior management team. Each product manager's budget was presented by the CFO using a Microsoft PowerPoint presentation, so all managers were aware of each other's budgets. The product managers were free to comment on or react to their assigned budget at the meeting, but no negotiations took place. Typically, the managers said little other than to acknowledge their assigned budgets and perhaps discuss the challenges they presented.

Ludwig and the other members of the senior management team had always believed that their top-down approach was appropriate for several reasons. First, it was efficient since it didn’t require extensive input from the senior product managers, other than the one-hour meetings with the CFO. Typically, the entire process took about a month. Second, it resulted in what Ludwig believed were consistently challenging and fair budgets across the four product lines. With some small variations, the revenue growth budgets and unit cost reduction targets were very consistent across the product lines each year. Ludwig believed this was important because the product managers' bonuses were influenced by how well they did compared to budget, and the top-down approach eliminated the problem of budget slack. Finally, since all of the members of the senior management team had been with the company for at least 10 years, and some input was solicited from the senior product managers, Ludwig felt that the budget was based on good information and thus was reasonably accurate.

Despite the perceived benefits of the top-down approach, Ludwig is beginning to hear some grumblings from the senior product managers that the process isn’t fair and isn’t resulting in accurate budgets. Ludwig isn’t convinced that the process is unfair but acknowledges that there appear to be accuracy problems. Over the past five years, it has been common to see the revenues and expenses of the different product lines coming in considerably better or worse than budget. Some product lines did well in a given year and beat their budgets while others failed to meet their budgets. Moreover, some product lines did well one year and then poorly the next year compared to budget. There doesn’t seem to be a predictable pattern to these results. Given this, Ludwig decides to attend an executive seminar on the use of participative budgeting to see if Playco might benefit from the approach.

After completing the seminar, Ludwig is convinced that the potential benefits arising from participative budgets, including more accurate budget estimates and greater commitment to the budgets by the senior product managers, justify trying the approach. He persuades the other members of the senior management team that Playco should try the participative ­approach in developing budgets for 2016. The process they agree on is as follows:

Senior management will communicate the key strategic goals to the senior product managers (e.g., overall profit targets for the company) as well as key planning assumptions about inflation rates, unemployment rates, interest rates, etc.

Based on the strategic goals and planning assumptions, the senior product managers will develop their own detailed revenue and expense budgets for 2016, providing written justification for any major assumptions and other key factors influencing their budgets (e.g., anticipated actions such as price cuts or new product introductions by key competitors).

Senior management will review the budgets submitted by the senior managers and meet with them individually to discuss and negotiate the final amounts.

Richard Wood, senior product manager for the golf equipment line, is the first to have his budget review meeting with the senior management team. The attendees are Ludwig (CFO), Lois Davis (CEO), Bill Stevens (VP Marketing), and Marita Delano (VP Production). Below are excerpts from the discussion at the meeting:

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Wood: I just want to start off by saying how much I appreciate being given the chance to participate in setting my own budgets this year. My team has worked very hard in putting these estimates together. We have done extensive market research, talked to our distributors at length, and identified opportunities for improvements over last year. Overall I think that our revenue budget, which shows a 10% increase over last year, and our gross margin percentage, which is budgeted to improve by 3% despite higher costs on some raw materials, represent aggressive but attainable targets.

Ludwig: Well, Richard, we’re glad to hear that you appreciate being permitted more involvement with the budget this year. We also think this is the right approach to use for many reasons and value your input in developing the budgets.

Davis: I echo Dave's sentiments about your participation but I must say, Richard, that overall we think your budget estimates for both revenues and expenses are a bit soft. We think you can do better.

Wood: I don’t understand. As I stated earlier, my budget represents solid growth in revenues and effective cost management. If I achieve my budgets, the performance of the golf equipment product line in 2016 will be the best it's been in five years.

Stevens: There is no doubt that 10% revenue growth is a good starting point, but my sense of the golf equipment market for 2016 is that 15% growth is achievable. People are more health conscious than ever, and with longer golf seasons across the country because of climate change, we should see a nice spike in sales next year.

Delano: As for your expense budget, I commend you for budgeting a 3% improvement in gross margin percentage, but I think more can be done. I’ve crunched the numbers and talked to some of your production people, and I don’t see why you can’t budget a 5% improvement. You need to lean harder on suppliers for price reductions, use less overtime on the production line, and find other ways to cut costs next year.

Wood: This doesn’t make any sense. If you guys think you know better than me what my budget should be, why did you ask me to participate in the first place? I’ve pushed my suppliers to the limit and I’m not willing to sacrifice quality to get lower unit costs. Overtime is unavoidable given scheduled shutdowns in the plant and the rush orders that inevitably occur. And, we’re already running as lean as we can in production, so there isn’t room to reduce costs more than I’ve budgeted without severely cutting corners.

Dave: Now hold on Richard; don’t get defensive. Remember, as part of our new participative approach, we are here to negotiate the final budget with you to arrive at figures we’re all comfortable with.

Wood: But this doesn’t feel like a negotiation; it feels like I’m being told what my budget should be, despite the fact that I’ve assured you my numbers are solid. I’ve been with Playco 10 years-surely that gives me some credibility when it comes to developing a budget!

Davis: We didn’t say the negotiations would be easy or that we don’t trust you, Richard. But, you have to understand that from a companywide perspective, your budgets aren’t good enough. We need more from you. And don’t forget, because annual bonuses are linked to actual performance against budget, it's fair for us to demand that your budgets be very challenging.

Wood: I’m at a loss here; this isn’t at all what I expected the process would be like. In some ways, I liked our old top-down approach better.

Ludwig: I think we’ve thrashed this out as much as we can. Richard; your mandate is clear. Do some fine-tuning of your estimates to come in with a revenue budget that is up 15% from 2015 and a gross margin budget that shows 5% improvement over last year. Because of our new participative approach, you are free to do whatever you need to make that happen in your budget.

Davis: Dave's right, take your time with these changes, Richard, and send us each a copy of your new budget within the next couple of weeks. I don’t think we need to meet again since we all know what needs to be done. Thanks everyone; this has been a very efficient process.

The budget review meetings with the other senior product managers follow a similar pattern.

Required:

1. Why might the top-down approach have led to inaccurate budgets in prior years?

2. Identify the problems with the participative budgeting approach being used at Playco. What consequences may result from their approach?

3. What changes would you recommend be made to the participative budgeting approach at Playco?

Answer 1

Solution- 1: Why might the top-down approach have led to inaccurate budgets in prior years?

• Under the Top-down approach, Playco has given the responsibility of setting up the revenue and expenses budget to CEO, CFO and Senior management members.
• Few Inputs were taken from Senior Product Managers to finalize the budget. While the meeting took place between only CFO and Manager. There was no involvement of CEO and Senior Management members.
• Budgets were given to Product Managers after few rounds of discussion between senior tema members.
• No negotiation took place in budget assignment discussions as well.

Possible reasons for inaccurate budget:

• Since there was no interaction between Senior Management members & CEO and Product Managers it may be that Products targets set were realistically high.
• Since a predictable pattern is missing for Product Managers, the assumption used in preparing budget should be analyzed thoroughly.
• A commentary needs to be prepared on every year budget and actual variance and should be taken into consideration while preparing next year budget which seems is missing.
• Senior Product managers were not much participative in budget preparation as per the top-down approach followed by Management.

Solution-2: Identify the problems with the participative budgeting approach being used at Playco. What consequences may result from their approach?

• Though the approach involves the higher participation of Product Managers now and leaves the room with Managers to set their own budget but the discussion doesn’t sound like working.
• The Problem with the current approach is :

1. Missing Production Manager: The data taken for Expenses is being challenged by VP- Production. The Person who has given the production expense data to Wood should also participate in.
2. In the discussion, Incentive for Product Manager should not be linked since this is always implied in Industry.
3. The conversation doesn’t sound like a negotiation instead it sounds like order being passed on by Management to Product Manager which is not correct. Product Manager should be asked to investigate further in revenue growth and cost improvement and should be asked to validate the assumptions rather than declaring a straight away growth number

Solution-3: What changes would you recommend be made to the participative budgeting approach at Playco?

• Instead of passing on comments on just one Product Manager’s budget presentation, it should gather all the product Mangers’ target first. Then Playco should consolidate the whole budget and look at the item by item where exactly cost can be pushed down or revenue can be pushed up.
• After analyzing the problem in consolidated budget, another round of discussion should happen with Product Managers informing them the potential problems with Managers and negotiate further based on realistic numbers.