Chap 024

Chapter 24 - Strategic Planning and Budgeting
CHAPTER 24
STRATEGIC PLANNING AND BUDGETING
Changes from Twelfth Edition
All changes to Chapter 24 were minor.
Approach
The text has very little on the mechanics o !udget preparation. Such a description is time-consuming.
"ther material can !e used i the instructor wants to descri!e the mechanics. #evertheless$ this can !e a
%ey chapter. "ne o the central pro!lems in teaching accounting is that the students learn individual
pieces and topics$ !ut ail to see how everything its together. The !udget can !e used to illuminate the
interrelationships.
&t is desira!le that the capital expenditures !udget !e related to the material in Chapter 2'. &n that chapter
the description will ocus on the analysis o individual capital investment proposals. Students should
understand that these individual proposals are !rought together in a pac%age$ as descri!ed in Chapter 24.
(e have used the terms budgetee and superior )ollowing *ostede+ or the participants in the !udgeting
process. Some people regard !udgetee as an aw%ward word$ !ut we thin% it is a useul one. (e %now o
no short alternative that conveys the same idea.
Cases
Body Glove descri!es the orecasting$ !udgeting$ and reporting processes o a small manuacturer
operating in a competitive$ ashion-conscious$ seasonal !usiness. &t as%s students to understand the
processes and to suggest possi!le changes or !oth the short and long term.
Waikerie Cooperative Producers, Ltd. descri!es the management accounting and control systems used !y
an Australian citrus growing cooperative.
Patagonia Inc. descri!es the !udgeting process o a uni,ue$ !ut successul$ clothing manuacturer. &t
contains many elements o -open !oo% management.. This case is new in the Twelth /dition.
Borealis illustrates an alternative )-!eyond !udgeting.+ approach to traditional !udgeting. &t involves the
use o %ey perormance indicators$ trend reporting$ and rolling orecasts.
24-0
Problems
Problem 24-1: Western Rn !ni"ersit# $otor Pool
a. !%&'ER(&T) $*T*R P**+
,dget Report for April
$onthl#
,dget
April
Actal
*"er-
!nder
1asoline............................................................................................................................................................................................... 2 0$344 2 0$'24 2 2245
"il$ minor repairs$ parts and supplies................................................................................................................................................... 467 334 80
"utside repairs..................................................................................................................................................................................... 444 473 73
&nsurance.............................................................................................................................................................................................. 0$644 0$644 -4-
Salaries and !eneits............................................................................................................................................................................. '$344 '$344 -4-
9epreciation......................................................................................................................................................................................... 3$86' 3$86' -4-
Totals................................................................................................................................................................................................... 20'$::6 20'$':2 2 :76
#um!er o automo!iles........................................................................................................................................................................ 06 06
Actual miles......................................................................................................................................................................................... :0$234 :3$444
Cost per mile........................................................................................................................................................................................ 24.3348 24.34'
Supporting calculations or monthly !udget amounts;
1asoline;..............................................................................................................................................................................................
mile<gal. 23
miles :0$234
x 20.24 per gallon = 20$344
"il$ et al.;.............................................................................................................................................................................................. :0$234 miles x 2.403 per mile = 2467
"utside repairs;.................................................................................................................................................................................... 444 2
months. 02
autos 06 x auto per 2:44
=
&nsurance;............................................................................................................................................................................................. Annual cost or one auto = 208$444 03 autos
= 20$244 per auto
Annual cost or 06 autos = 06 x 20$244 = 207$244
>onthly cost = 07$244<02 = 20$644
Salaries and !eneits;............................................................................................................................................................................ #o change rom present !udget )274$444 02 = 2'$344+
9epreciation;........................................................................................................................................................................................ Annual depreciation per auto = 266$444<03 autos
= 24$444<auto
Annual depreciation or 06 autos = 24$444<auto x 06 = 2'4$444
= '4$444
>onthly depreciation
= 86' $ 3 2
02
'4$444
=
!. "utside automo!ile repairs are a unction o the use o the automo!ile over its lietime. *owever$
these repairs occur irregularly throughout the year and the lie o the car. A monthly !udget igure
!ased upon a per mile charge !ecomes ,uestiona!le. Thereore$ the use o 0<02 o the estimated
annual outside repair costs ad?usted or the num!er o cars in operation during a month would appear
to !e more reasona!le. But even this amount must !e %ept in proper perspective@ i.e.$ annual
variations will certainly !e more meaningul than monthly ones.
24-2
c.
Problem 24-2: Terr#.s E/ipment Center
"perating Budget
0st Auarter 2nd Auarter
Sales..................................................................................................................................................................................................... 2044$444 2284$444
Cost o goods sold B .64 sales............................................................................................................................................................. 84$444 068$444
1ross margin........................................................................................................................................................................................ 36$444 002$444
"perating expenses;............................................................................................................................................................................. '6$4'3 043$4'3
"perating income )loss+....................................................................................................................................................................... 2 )24$4'3+ 2 6$323
Cixed selling expenses.......................................................................................................................................................................... 2 23$444 2 23$444
Cixed administrative expenses.............................................................................................................................................................. 08$334 08$334
9epreciation......................................................................................................................................................................................... :$023 :$023
Bad de!ts B .42 sales........................................................................................................................................................................... 2$844 3$644
Daria!le B .04 sales............................................................................................................................................................................. 07$644 :7$244
B .43 sales............................................................................................................................................................................. '$444 04$444
Totals$ a!ove.................................................................................................................................................................................. 2 '6$4'3 2 043$4'3
Problem 24-0
a. Cash Budget
Collection o receiva!les;
.'3 x 2044$444 )a+............................................................................................................................................................................ 2043$444
.24 x 044$444.................................................................................................................................................................................. 2 ::$644
.'3 x 284$444 )!+............................................................................................................................................................................ EEEEEEE 204$444
Total cash receipts....................................................................................................................................................................... 043$444 24:$644
Cash dis!ursements;
Purchases .64 x 2067$444...................................................................................................................................................................................... 040$444
)c+ .44 x 067$444...................................................................................................................................................................................... 6'$644
.64 x 287$444...................................................................................................................................................................................... 0':$444
Selling expenses 2<: x 44$644......................................................................................................................................................................................... 27$'::
)d+ 0<: x 44$644......................................................................................................................................................................................... 04$86'
2<: x 64$244......................................................................................................................................................................................... 42$844
Administrative expenses 2<: x 223$334........................................................................................................................................................................................ 0'$444F
)e+ 0<: x 23$334........................................................................................................................................................................................ 8$344F
2<: x :2$334........................................................................................................................................................................................ 20$'44
/,uipment............................................................................................................................................................................................ EEEEEEE 22$344
Total cash dis!ursements.................................................................................................................................................................. 048$0:: :30$:6'
/xcess dis!ursements over receipts...................................................................................................................................................... )4:$0::+ )04'$'6'+
Cash !alance !eginning o ,uarter....................................................................................................................................................... 04$444 )27$0::+
Cash !alance end o ,uarter................................................................................................................................................................. 2 )27$0::+ 2)0:6$744+
24-:
a. To %eep a minimum cash !alance o 23$444$ the company must !orrow 2:4$0:: during the irst
,uarter and another 204'$'6' during the second ,uarter.
)a+ 0st ,uarter sales o 2044$444 as given in Pro!lem 24-2.
)!+ 2nd ,uarter sales o 2284$444 as given in Pro!lem 24-2.
)c+ Purchases; 0st Auarter 2nd Auarter
Cost o goods sold;
.64 )2044$444+.................................................................................................................................................................................. 284$444
.64 )2284$444+.................................................................................................................................................................................. 2068$444
/nding inventory at 0<: cost o
goods sold o next ,uarter;
0<: ).64 x 2284$444+......................................................................................................................................................................... 36$444
0<: ).64 x 2:23$444+......................................................................................................................................................................... EEEEEE 2044$444 63$444 22::$444
Gess !eginning inventory;
As given........................................................................................................................................................................................... 27$444
Crom 0st ,uarter............................................................................................................................................................................... EEEEEEE 36$444
He,uired purchases.............................................................................................................................................................................. 2000$444 20''$444
)d+ Selling expenses; 0st Auarter 2nd Auarter
Daria!le; .04 )2044$444+...................................................................................................................................................................................... 207$644
.04 )2284$444+...................................................................................................................................................................................... 2:7$244
Cixed; )given+....................................................................................................................................................................................... 23$444 23$444
Total selling expenses...................................................................................................................................................................... 244$644 264$244
)e+ Administrative expenses;
Daria!le; .43 )2044$444+...................................................................................................................................................................................... 2 '$444
.43 )2284$444+...................................................................................................................................................................................... 204$444
Cixed; )given+....................................................................................................................................................................................... 08$334 08$334
Total administrative expenses.......................................................................................................................................................... 223$334 2:2$334
Cases
Case 24-1: Body Glove
*

%ote: This case is unchanged fro the T!elfth "dition.
Approach
The Body 1love case was written to illustrate a planning and !udgeting system in a small company that
has a high need or planning. Body operates in a rapidly growing$ competitive industry with ashion
conscious customers and signiicant seasonal sales luctuations. Students en?oy studying the case !oth
!ecause they %now the company and its products and !ecause the company is small enough that they can
comprehend the entire entity.
*
This teaching note was prepared !y Proessor Ienneth A. >erchant. Copyright J !y Ienneth A. >erchant.
24-4
(ggested Assignment 1estions
Suggested assignment ,uestions are contained in the case.
Case Anal#sis
Beore starting discussion o the speciic assignment ,uestions$ & ind it useul to summariKe the studentsL
thin%ing a!out the company and its industry. Start !y as%ing what the companyLs critical success actors
)CSCs+ are. A list will loo% li%e the ollowing;
designs that satisy customer needs
produce styles and colors to demand )ade,uate production capacity$ production lexi!ility+
react ,uic%ly to changing trends
control costs )manuacturing$ inventory+
Then & proceed to ,uestion 2 and create a diagram o the !udgeting process. & li%e to diagram !udgeting
processes using the ormat shown in T#-0 !ecause it is then easy to compare processes across companies.
The Body 1love process is highly condensed. This shows up star%ly in the T#-0 diagram. Body 1love
managers do not spend a lot o time in ormal !udgeting processes. This simplicity is consistent with the
act that Body 1love is a small company that didnLt even have a !udgeting process until the prior year.
The simplicity is also consistent with Body 1loveLs inormal culture$ evidence o which is easily seen in
the companyLs organiKation chart shown in case /xhi!it 0.
The Body 1love !udgeting process is also unusual in that the !oard o directors is not involved. #either is
the !udget presented to any outsiders@ it is strictly or the use o management.
9uring the year$ Body 1love managers ma%e monthly comparisons o !udget vs. actuals. At any o these
times$ the !udget num!ers can !e revised$ at the presidentLs discretion. This contingency can !e indicated
on the timeline$ i so desired.
24-3
2igre T%-1
Time line o Body 1loveLs !udgeting process
1 = management team estimates total sales growth or ollowing year
2 = sales manager !rea%s down total sales estimate !y month and !y product
0 = department managers develop monthly pro?ections o %ey expenses
4 = presentation to and approval !y president
#uestion $% &or !hat purposes does Body Glove use its budgeting syste' Which purposes are
ephasi(ed'
The Body 1love !udget is used almost exclusively or planning purposes. &t helps ensure that the
companyLs level o expenses are low enough$ given their sales levels$ to generate ade,uate levels o
proit. The !udget undou!tedly provides management with some motivation to achieve the num!ers they
have put together. The !udget vs. actuals comparisons is used or perormance evaluation purposes$ !ut
the !udget num!ers are not lin%ed ormally with incentive compensation. The needed coordination
!etween the unctions$ particularly sales$ purchasing$ and production$ occurs in processes that lie outside
the end-o-year !udgeting process.
#uestion )% Can a copany function effectively !ithout a budget, as Body Glove tried to do prior to
fiscal year $**$'
24-6
The answer is o!viously yes. Body 1love was highly successul prior to 0770. Company managers
accomplished all the purposes a !udget could serve !oth through exchange o ,uantitative$ !ut
noninancial inormation and re,uent inormal communications.
(ould a !udget have helped the company during the early yearsM Possi!ly$ !ut the !eneits o ormal
!udgeting grows as companies grow and !ecome more complex. #ote in /xhi!it : that Body 1love is no
longer a simple organiKation@ it has 04 proit centersN )These are two dive shops$ three services )classes$
charters$ rentals O repairs+$ one actory$ Body 1love wetsuits$ Sur P# S%i P# Sur$ and Accessories.+
#uestion +% What changes to Body Glove,s budgeting and revie! processes !ould you recoend, if
any'
Goo% at /xhi!it :$ the monthly and year-to-date igures. Body 1loveLs proits are well !elow !udget@
retail sales are essentially lat@ and expenses are up. (hat actions will<should Body 1love managers ta%e
as a resultM
Students will propose many ideas$ including the ollowing;
0. (hy have monthly reportsM (hy not ,uarterlyM "r seasonalM To address this suggestion$ consider
what decisions might !e aectedM >ight monthly reports aect the commitment o discretionary
expenses )e.g.$ advertising and promotion$ hiring+ or development o new product ideas$ or cash
planning )e.g.$ !orrowing+M
2. (hy not update the !udget more re,uentlyM >ost companies do not. They li%e the annual target to
shoot or. But or planning purposes$ they may do a ,uarterly$ or less re,uent$ updated annual
-estimate..
:. (hy use totally su!?ective evaluations o perormanceM The results are aected !y many signiicant
uncontrolla!le actors. Some o these are mar%et uncertainties and luctuations. "thers are caused !y
departmental interdependency. As Huss Gesser says )not in the case+;
(e have some!ody responsi!le or each department$ !ut it is diicult to isolate what one department
does. So in doing perormance evaluations$ we also loo% at what the company does.
Su!?ectivity is a simple$ inexpensive way to eliminate these distortions rom the perormance evaluations.
#uestion -% What if Body Glove continues to gro! and, perhaps, diversifies'
Body 1love will almost inevita!ly grow$ and Body 1love managers have considered many diversiication
options$ such as !each apparel or a line o !lue ?eans that -it li%e a glove.. As the company !ecomes
larger and more complex$ coordination o all the various company elements will !ecome more diicult$
and the inormal company culture will not satisy all the communications re,uirements. The !udgeting
system will have to involve more people$ and the process will have to !ecome more ormal and ela!orate.
24-'
Case 24-2: Waikerie Cooperative Producers, Ltd.
*

Approach
This case was written to illustrate typical issues aced in controlling a cooperative. Cooperatives are an
important orm o organiKation. Cor example$ until the recent round o mergers$ the second largest !an%
in the world was a cooperative )Ban% Agricole in Crance+. "ver 44Q o all retail sales in the R.I. are
through consumer-owned cooperatives. And in Sapan one primary citrus grower producer cooperative
has over our million mem!ers.
The apparent speciic ocus o this case is on !udgeting. (ai%erie managers are having trou!le getting
good inormation rom their grower-mem!ers to allow them to prepare reasona!ly accurate !udgets. But
this !udgeting issue may not !e as important as (ai%erie managers seem to thin%@ other things may !e
more important.
0. &n what ways is management control in a co-cooperative li%e (ai%erie dierent rom that in a
typical corporationM
2. /valuate (ai%erieLs management control system. (hat suggestions would you ma%e to
(ai%erieLs managers$ i anyM
Case Anal#sis
.o! is anageent control in a cooperative like Waikerie different fro that in a typical corporation'
/#uestion $0
The (ai%ierie cooperative has some important dierences orm corporations that lead to dierent
management control approaches;
0. &n a growers cooperative$ li%e (ai%erie$ the owners and suppliers are one and the same. Thus the
suppliers are the -!osses. o management.
2. The cooperative goals are dierent rom those in a corporation. Proit )or actually net operating
surplus+ is a constraint$ not a primary goal. The primary goals in growers cooperatives li%e
(ai%erie$ are to maximiKe the prices paid to the grower-owners and to minimiKe the hassle
associated with pac%ing and selling the product )in other words$ provide services to grower-
owners+. &n inancial terms the cooperative is really a proit center with a goal to !rea%-even )or
long-term survival+. A standard corporate inancial results control system aimed at >aximiKing
proits or inancial returns is not appropriate.
*
This teaching note was prepared !y Ienneth A. >erchant. Copyright J !y Ienneth A. >erchant.
24-8
:.
4. The cooperative must a!ide !y the international principles o co-operation. >ost important or
management control purposes$ it cannot compete aggressively with most local competitors$ which
are also cooperatives. The private ruit pac%ers have an advantage. The cooperative also has an
o!ligation to educate its mem!ers and others a!out the principles and techni,ues o co-operation.
This education could re,uire the cooperative to incur some extra costs.
The (ai%erie Cooperative lac%s the degree o power possessed !y corporate managers$ so it has
slightly dierent sources o uncertainty. Gi%e other pac%ers$ it had to deal with the inherent
volatility in the produce mar%ets. But li%e other cooperatives$ or the most part it had to accept
all the ruit grower mem!ers wished to send to the cooperative@ it had to ma%e its mar%eting plans
availa!le to its grower mem!ers$ some o whom would inevita!ly not %eep it conidential@ and it
had to cope with some o the grower mem!ersL reluctance to share relevant inormation.
3. The cooperative cannot decline to pay a dividend or even delay the payment o dividends. &t is
o!ligated to pay it and ailure to pay a dividend could cause some grower-mem!ers to go out o
!usiness.
Evaluate Waikeries Co!trol "yste# $%uestio! 2&
The act that the cooperative has had a negative operating surplus or two years at the same time its
mem!ers were complaining that the cooperative was not paying a competitive price or produce suggests
a strong possi!ility o pro!lems. Students should !e as%ed to thin% a!out the cooperatives critical success
actors or %ey recurring decisions. *ere are some areas deserving o investigation !y the cooperative )and
discussion !y the students+;
Pricing
Paying a competitive price to growers or produce supplied is one o the -our singularly important
actors. mentioned at the !eginning o the case. >em!ers are complaining !ut 9uncan Beaton is not
really sure whether the cooperative is ailing in this area. (ai%erie should do some mar%et analysis$
perhaps !y enlisting riendly mem!ers to solicit and disclose !ids they receive rom other pac%ers in the
area.
(ai%erie might also !e well advised to consider its pricing ormula. The current mar%et conditions with
signiicant pac%ing oversupply$ has created a competitive mar%et. Charging growers the ull cost o
pac%ing plus a -modest proit margin. might not ma%e sense particularly given (ai%erieLs strategic
error o adding highest automated e,uipment at a time when less pac%ing capacity was needed.
An alternate pricing ormula would have the cooperative charge suppliers or only the varia!le cost o
production plus a proit margin. The cooperative would earn a contri!ution toward ixed costs on every
sale.
24-7
(hy should the ixed costs !e charged to the suppliersM &n a prospective sense$ the ull costs are suspect
!ecause they are !ased on volume estimates with ,uestiona!le accuracy. But more importantly$ these
costs are sun% and thereore irrelevant. There seems to !e no ,uestion !ut that (ai%erieLs ull costs are
not competitive in the mar%et !ecause o high-cost e,uipment$ which may !e idle much o the time$ and
interest incurred to purchase the e,uipment. >a%ing the suppliers pay or the ull costs may allow the
cooperative to ta%e advantage o the loyalty o some grower-mem!ers or a while$ !ut this pricing
strategy will lead to decline in volume at the very time the cooperative needs volume increases.
Cost Redctions3Acconting
(ai%erie operates in a commodity mar%et. The cooperative is trying to distinguish itsel through
superior mar%eting programs or !etter service to suppliers$ !ut until that happens (ai%erie is providing a
service that can !e provided e,ually well !y many other pac%ers in the areas. &n a commodity mar%et$
cost control is essential. >anagement should !e wor%ing actively to reduce costs !oth varia!le and ixed.
There is evidence in the case that they are wor%ing to this end. To do so eectively$ however$
management may have to improve its cost accounting system )e.g. rethin% it with activity-!ased
principles in mind+ to %now where processes can !e improved and where costs can !e cut.
Planning and ,dgeting
(ai%erieLs management is trou!led it they cannot get good crop orecasts that would ena!le its managers
to prepare reasona!ly accurate annual inancial plans. To some extent$ its goal or accurate orecasts will
never !e realiKed. Cor example$ the navel orange season runs rom April to Septem!er$ and the
cooperative is as%ing or the estimates in #ovem!er. 1iven the inherent uncertainty the growers ace$
these estimates cannot !e relia!ly accurate.
But how important are accurate estimates and accurate annual inancial plansM Planning inancial
resource needs )e.g.$ !orrowings+ is important. The case does not provide much inormation in this area$
!ut i contri!utions are not large enough to service the cooperativeLs de!t$ management may have to
restructure the de!t$ or cease operation. *aving reasona!ly accurate num!ers that can !e used to commit
to prices or grower mem!ers is also important$ although this pro!a!ly does not vary much orm year-to-
year.
The primary advantage o accurate volume orecasts seems to !e or scheduling resources-primarily
la!or. The cooperative has more than enough pac%ing e,uipment to service oreseea!le volumes. (ith
only la!or as a concern$ the cooperative seems not to have a great need or an annual orecast. & growers
can give the cooperative accurate one-month supply estimates$ cooperative management should have
enough lead-time to schedule the needed la!or. & growers still will not cooperate$ perhaps the
cooperative could oer re!ates to those growers who provide accurate estimates.
&ncenti"es
>any students will point to the need or ormal measurements and incentives tied to the critical success
actors. This cooperative is small$ so 9uncan Beaton may !e a!le to %eep all o the relevant data in this
head. But ormal incentives might provide impetus or managers at various levels to !e creative and to
improve perormance in the areas the cooperative most needs.
24-04
Students will have a num!er o ideas or incentives. They might useully !e !ased on$ or example$ cost
reductions$ mar%eting program successes$ services provided to grower-mem!ers )e.g.$ solving pro!lems+$
grower-mem!er satisaction$ percent returned to grower-mem!ers$ and num!er o new grower-mem!ers.
/ach o these alternatives should !e evaluated in terms o lin%s to critical success actors$ coverage o
critical success actors$ easi!ility$ and cost<!eneit. Students will also have to consider how to measure
individual employeeLs perormances or how to share the rewards among groups o employees whose ?oint
eorts led to the success. 9epending on their choices$ they may also have to consider how to eliminate
the distorting eects o uncontrolla!le actors )e.g. !y using lexi!le !udgets to eliminate the
uncontrolla!le negative eect o a drought+.
(bse/ent E"ents
The (ai%erie Cooperative suered large losses in 077: )approximately 20 million+$ and su!se,uently$ all
o the top-level managers were replaced.
At the same time$ the primary lender to all the Hiverland cooperatives$ the State Ban% o South Australia$
was pushing<orcing a merger o cooperatives$ a -rationaliKation process.. (ai%erie explored merger
possi!ilities$ !ut pulled out. The (ai%erie !oard thought that the Ban% was see%ing to reduce its
exposure and was not addressing the signiicant operating pro!lems the cooperatives were acing. Still
(ai%erieLs !oard recogniKed that the cooperative had lost its a!ility to control its own destiny unless it
was to sell assets in noncore areas.
(ith the -gun to its head$. new management at the cooperative had to develop an alternative. Ater
considera!le uncertainty and some delay$ they were a!le to reinance the de!t with another !an%. The
reinancing re,uired !oth the raising o unds rom mem!ers and to consider uture conversion to an
unlisted pu!lic company. &n 077:$ a total o 2684$444 was raised rom mem!ers through two-year
interest-!earing deposits. &n 0774$ mem!ers were as%ed to support the conversion to an unlisted pu!lic
company$ with 20 shares in the cooperative !eing worth approximately 2:8 )The cooperativeLs largest
asset was itLs e,uity in Berri *oldings Gtd. which holds 34Q o Berrivale "rchards Gtd.$ AustraliaLs
largest ruit ?uice processes and mar%eter.+ Those involved expected mem!ers to support the conversion.
But they then worried that a num!er o shareholders would want to -cash out. rather ,uic%ly. The
ma?ority o the shares value would !e derived rom Berrivale which was paying relatively low prices to
the producers o Australian citrus.
Case 24-': Pata(o!ia, )!c.
1

%ote: This case unchanged fro the T!elfth "dition.
Purpose o* Case
This case was written to illustrate the details o a !udgeting process that em!odies the values o an -open
!oo% management. process. "pen !oo% management )"B>+ is a process designed to involve employees
in the !usiness. The goal is to get the employees to understand the -!ig picture. and to see how each
individualLs eorts relate to overall corporate perormance. &n other words$ the goal is to get the
employees to thin% li%e owners and to move !eyond a -wage level mentality..
"B> involves;
1
This teaching note was written !y Ienneth A. >erchant. Copyright J 244: !y Ienneth A. >erchant.
24-00
0. regular sharing o the companyLs inancial inormation and any other inormation that will
help the employees wor% together with management to help the organiKation succeed@
2. training$ so that employees understand !oth what that inormation means and how they can
contri!ute to company proits )value creation+@
:. rewards lin%ed to company perormance )e.g.$ proit sharing plan$ employee stoc% ownership
plan+@
4. i necessary$ a change away rom a top-down culture to ensure that employee ideas are !oth
encouraged and considered airly.
(hat Patagonia calls its -(or%!oo% Process. em!odies all our o these "B> elements.
Because the core elements o the (or%!oo% Process involve planning and !udgeting$ the case can also !e
used to motivate a discussion o such processes. &t can !e particularly useul in illustrating a more
inormal$ or -loose$. approach to planning and !udgeting$ which can !e contrasted with some o the
highly ormal and ela!orate processes used in many large corporations.
The case is also interesting !ecause it illustrates the Patagonia management system. Primarily !ecause o
the values o its ounder$ Patagonia is an unusual company. Conse,uently$ the case can !e used to raise
issues a!out corporate o!?ectives )should maximiKation o value really !e the primary o!?ectiveM+$
management style$ and organiKational culture. &t can !e used as an illustration o a company that ma%es
heavy use o -cultural control..
&n most situations$ instructors can serve !oth purposesTcultural control and planning and
!udgeting<"B> in a single class. /ven i the ocus is on planning and !udgeting systems and<or open
!oo% management$ students can and should study the details o the (or%!oo% Process and draw
?udgments as to whether the process is aiding or harming the companyLs cultural control system.
Cor a class ocused on planning and bdgeting processes and<or open boo4 management systems$ the
ollowing assignment ,uestions are appropriate;
0. /valuate PatagoniaLs (or%!oo% Process. (ould you recommend to PatagoniaLs management that
they continue the processM (hy or why notM
2. & you recommend continuing the process$ what changes would you suggest$ i anyM
:. & you recommend discontinuing the process$ what would you su!stitute insteadM
5iscssion
&t is useul to have the students identiy some o the actors that are unusual at Patagonia. These include;
0. mission and values. The corporate mission and values are shown in /xhi!it : o the case.
Corporate proits are a constraint or a secondary$ rather than a primary goal. Uves Chouinard
even sees growth a!ove a minimal level$ as an evil.
24-02
2.
:. high ,uality$ long lasting products. But Patagonia managers hate a term that critics sometimes
used to descri!e their products$ which are not low-priced; -Patagucci..
4. concern or employees
3. lat organiKation
6. low !ureaucracy<inormal operating style
'. open culture
8. distrust o !onuses$ perhaps !ecause the company does not have a good measurement system
7. distrust o !an%ers<accounting people. "nly two o the eight people on the Patagonia top
management team have a !usiness !ac%ground.
04. scars let !y the 0770 crisis<layo
& the ocus is on cultural control$ the instructor can pose the second ,uestion in the cultural control
assignment and the discussion should low easily. & the students are critical o Patagonia$ the instructor
can point out that while Patagonia is not committed to proits as an overriding goal$ it is one o the most
proita!le irms in its industry.
The irst ,uestion in the planning and !udgeting<"B> assignment as%s or an evaluation. To me$ the
word evaluation as%s the students to identiy and discuss the pros and cons o the system.
Pros:
0. The goals o an "B> system are to create;
a. !etter communication o the corporate goals throughout the ran% and ile@
!. !etter understanding as to how each employeeLs actions aects the corporationLs inancial
results@
c. incentives or employees to !ehave in the corporationLs !est interest@ and
d. incentives and opportunities or lower-level employees to ma%e useul suggestions or
improvement.
At least to some extent$ PatagoniaLs system seems to have achieved each o these goals.
2. The "B> system provides a way to motivate employees to serve corporate interests even in the
a!sence o good measurement systems )which the CC" admits they donLt have+.
:. >any employees expressed dissatisaction with their lac% o %nowledge o the companyLs and
other departmentsL plans and their lac% o involvement in the planning processes. The "B>
process directly addresses those concerns.
4. The "B> process is well organiKed )steps$ timing+$ and it was pilot tested.
3. The "B> process is consistent with important aspects o the corporate cultureTrespect or
employees and concern or employeesL ,uality o lie.
24-0:
6.
'. >ost employees have avora!le reactions to the process )see the ,uotes toward the end o the
case+.
Cons:
0. The (or%!oo% Process is heavily inancially oriented. Perhaps the -Process. does not it well in
an organiKation or which inancial goals are not paramount.
2. Some employees do not participate. Sust !ecause the company says it has a highly participative
system does not mean that it is getting participation. Some employees do not yet seem to
understand what the inancial igures mean or how to write good o!?ectives. This could perhaps
!e solved through more and !etter training. But more importantly$ some employees seem not to
want to participate. Can you have a good "B> system i 0<: o the department heads )and
perhaps more o the lower-level employees+ are indierent or hostileM Should you exclude or
ignore the non-participantsM *ow can you exclude a department headM *ow can top-management
motivate their participationM
:. Signiicant costs in time and paperwor%. The -!ureaucracy. associated with the system is
inconsistent with the corporate cultureTor example$ see a ,uote in the case )-The company
culture avored minimum !ureaucracy and maximum inormality.+.
4. 9o group rewards really motivate employeesM &n the Patagaonia system there is almost Kero lin%
!etween a personLs eorts and the rewards s<he earns. ShouldnLt rewards !e at least somewhat
!ased on individual$ or at least$ wor%group achievement o o!?ectivesM
3. A lot o the enthusiasm is dampened !ecause the actuals come out two months late.
6. The enthusiasm or the process seems to !e decreasing over time. >ight it !e said that the costs
are linear$ !ut the !eneits are decliningM
'. The ,uality o the plans varies. Some departments have too many o!?ectives and most have some
poorly written o!?ectives.
8. The "B> process is ,uite short-term oriented. Are longer-term considerations captured in this
systemM
7. (here is the strategic planning at PatagoniaM They donLt seem to do much o it. &n act$ it is
,uestiona!le as to whether Patagonia has what one would call a well-deined !usiness strategy.
*ther 1estions
Ater the students evaluate the (or%!oo% Process$ & loo% to them or a ?udgment as to whether Patagonia
managers should attempt to ix the pro!lems or dump the system. & thin% that good students can ta%e
either stance. Students should identiy some alternatives and then choose one$ with a persuasive$ well
organiKed ?ustiication o their choice.
24-04
& students argue in avor o %eeping the "B> system$ then they need to address each o the -cons. listed
a!ove. (hich ones can !e ixed$ and howM (hich ones should merely !e tolerated in exchange or the
!eneits the system providesM
& the students argue in avor o discontinuing the (or%!oo% Process$ then what should the company doM
*ow can the company replicate the -pros. o the "B> system using a dierent systemM Cor example$
can Patagonia create a process or culture that leads to a natural sharing o inormation and some
motivation to achieve good results without the structure that some ind onerousM
What happened sbse/entl#6
& instructors desire$ toward the end o class they can provide students with an update on Patagonia. The
update will surprise most o the students.
#ot long ater the time o the case$ Patagonia a!andoned the (or%!oo% process. The process did not
ma%e its third year.
Iaryn Barsa )CC"+ explained;
There is no ,uestion !ut that there was tremendous enthusiasm rom a lot o people the
irst year. People were curious a!out the inancial statements. They li%ed the -!rain ood.
classes. But itLs a temporary high you get rom getting involved in all this. Pro!lems
showed up at end o the year. A lot o o!?ectives were not met. Cinger pointing started$
and it !ecame very destructive.
&n the second year Vor CU 0778W$ people gamed the system. >any units set o!?ectives
that were easy to accomplish$ such as -turn the compost heap..
IarynLs conclusion was;
A colla!orative process wor%s well when a company is small. &t is tougher when the
company is complex.
Shortly ater the time the case was written$ a new C/"$ 9ave "lsen$ was hired. 9ave was an outsider
who had a !usiness !ac%ground. *e did not thin% that the (or%!oo% Process was moving the company
orward. The companyLs mar%ets were !ecoming more competitive. *e attri!uted much o PatagoniaLs
early growth to its near-monopoly position. #ow the company was up against signiicant competition$
and 9ave did not thin% that the (or%!oo% Process was the !est way to respond.
Uvon Chouinard was sympathetic to 9aveLs concerns. Pro!lems at Apple Computer$ in particular$ scared
Uvon. Uvon viewed Apple as a product-ocused company that was in many ways similar to Patagonia.
*owever$ the 2<: o the Patagonia employees that !ought into the (or%!oo% Process were very
disappointed. 9ave had to give them something else. *e started !y trying to change the culture. &n
particular$ he wanted to try to ind a !etter way to ma%e the whining productive and to help employees
understand that what people do really matters. To that end$ he hired some -culture change. consultants.
They employed a num!er o exercises to try to convince employees to ollow two !ehavioral rules; )0+
Turn complaints into re,uests$ and )2+ Gisten !eore you spea%. The goal was to !uild a more
colla!orative culture.
24-03
Another part o the culture was a greater interest in having the company grow. 9ave tried to convince
employees that growth is good !ecause it provides Patagonia with the means to spread the environmental
message$ in particular through the giving away o more money. &n the late 0774s$ company growth was
good. Sales in CU 0778 were approximately 2084 million$ up 04Q rom 077'$ and the company was
growing to an 844-person organiKation.
&n this period$ 9ave "lsen set up seven separate entrepreneurial product development teams )e.g.$ paddle
sports$ alpine+. These teams were as%ing ,uestions li%e -9o we need tights or every purposeM. But
management o these teams was ,uite complex. /ach must carry the Patagonia message. Coordinating the
eorts o these teams re,uires more leadership.
&n 0777$ Patagonia still did not have an incentive system. As Iaryn Barsa explained$ ->oney is still a !it
dirty at Patagonia. People want more money$ !ut in salary. They donLt want to earn higher !onuses than
their co-wor%ers..
Iaryn predicted that Patagonia would not go pu!lic or sell stoc% through an /S"P until$ perhaps$ the
ChouinardLs estate has to !e settled.
The strong Patagonia culture lives on. /mployee turnover within Patagonia is still less than 4Q per year.
>ost employees have !een with the company more than 04 years. Patagonia management still preers to
hire -dirt!ags.. Their philosophy is that -Uou can teach a dirt!ag a!out !usiness$ !ut you canLt teach a
-grease!all. Va !usiness personW a!out the environment.. The strong culture spits deviants out.
Pedagog#
The structuring and timing o the discussion o this case depends on the instructorLs purpose)s+ or the
class$ the position o the case in the course sylla!us$ and the studentsL !ac%grounds. >any useul contrasts
can !e drawn !etween other companiesL practices and PatagoniaLs.
The discussion o this case lows easily !ecause most students have heard o Patagonia. /ven i they had
not previously %nown o the companyLs management philosophies and practices$ they ind them
interesting. Cor example$ it is easy to stimulate a heated de!ate a!out PatagoniaLs o!?ectives !etween
some -conservative$ hardcore capitalists. and some -li!eral environmentalists..
Case 24-4: Borealis
1

Prpose of Case
1
This teaching note was written !y Ienneth A. >erchant !ased partly on notes provided !y Ho!ert S. Iaplan.
24-06
Companies have traditionally used !udgets or planning$ monitoring$ and evaluation. Some companies$
however$ !elieve that !udgets are inade,uate in todayLs competitive environments$ that !udget processes
re,uire too much time and resources$ and that the !udgets themselves are inlexi!le and get ,uic%ly out o
date. A movement that encompasses these ideas has !een populariKed under the ru!ric -Beyond
Budgeting.. A Beyond Budgeting Houndta!le is a discussion group that meets with CA>-&. "ne or more
o the Beyond Budgeting articles can useully !e assigned or students to read in con?unction with the
Borealis case.
2
Borealis$ which is a Beyond Budgeting company$ a!andoned its !udgeting system and replaced it with
our targeted management tools. The main ,uestion to !e discussed is; (ill these tools accomplish
managerial o!?ectives more eectively and eiciently than the !udget they replacedM
Teaching Approach
0. (hy do companies use !udgetsM
Students can !e as%ed to assem!le a list o purposes$ which include the ollowing;
to ma%e strategy operational
to control spending )permission to spend+
to provide point estimates o spending !y department )!y what < !y whom+
to acilitate !etter evaluation o decentraliKed managers !y senior management
to communicate important inormation within the organiKation$ !oth !ottom-up and top-down
to enhance motivation and accounta!ility
2. (hat is BorealisL !usiness strategyM
*igh ,uality provider.
>ore lexi!le plastic !ased on proprietary ormula. Gicenses Borstar technology in recent years.
Hesearch and development is important.
#ote that Borealis was ,uite proita!le )reer to the income statement+.
:. (hat was wrong with BorealisL !udgeting processM
&ts !udgets served too many dierent purposes@ e.g.$ !oth orecasting and target setting. Auote in
case; -Corecasts should !e realistic$ targets should !e challenging. )stretch+.
Borealis used !udgets to control spending$ !ut Borealis did not lex the !udget. Borealis had a
!ro%en >CS.
Auote in case; -Budgets not only set a ceiling on costs$ !ut also a loor.. The loor means that
managers will spend all they are allotted.
The !udget constraints hindered decentraliKed decision-ma%ing.
"nce esta!lished$ the !udget ,uic%ly !ecame out-o-date !ecause so many planning assumption
varia!les changed ,uic%ly. They were also out o managementLs control$ so the variances were
meaningless. )See ,uotes in the -Budgeting Process. part o the case+
2
Cor example$ S.*ope and H. Craser$ -Beyond Budgeting$. 1trategic &inance 82$ no. 4 )"cto!er 2444+$ p. :: or S. *ope and H.
Craser$ -Beyond Budgeting; Pathways to the /merging >odel$. Balanced 1corecard 2eport )>ay 03$ 2444+.
24-0'
&t was a lot o wor%.
24-08
4. (hy was Borealis having trou!le with its !udget$ while other companies donLtM
Pro!lem in the way that management used the system.
9esign o system; ixed vs. lexed in highly volatile mar%et where Borealis$ despite its siKe was
pro!a!ly a -price-ta%er..
7What if we didn.t do bdgets at all68
The "peror,s 3e! Clothes X individually$ each manager expressed rustration and disli%e o
!udgets and the !udgeting process$ !ut collectively they elt a need or !udgets. Budgets
provided a )alse+ sense o control since Borealis aced uncontrolla!le volatility in its eedstoc%
costs and product prices. The !oard o directors gave approval as long as management could
design a aster$ simpler process.
3. (hat modiications would have made the existing system more useulM
Clex the !udget to ma%e it more useul and dynamic.
Beyond the need to lex or volume$ Borealis needed to lex or changing input prices and
changing product prices$ which were uncontrolla!le !y management.
#ote how Borealis does a variance analysis to explain its UTU proita!ility )/xhi!it 2C+
9evelop new standards )e.g.$ compare actual to actuals to achieve continuous improvements or
use external !enchmar%ing$ -!est in class.+.
6. (hat changes were instituted M And how did management expect the new measurement and
control systems to helpM
Borealis managers set o!?ectives to !e achieved !y the new measurement and control systems;
&mprove inancial management and perormance measurement
9ecentraliKe authority and decisions
Simpliy the !udgeting process
Heduce the resources used in the process
24-07
Several new tools were needed to replace the !udgeting process and its two primary unctions;
inancial planning and perormance measurement )see /x. 4+;
Holling Cinancial Corecasts
Balanced Scorecard
Iey perormance indicators
Helative Cinancial Perormance
Activity Based Costing
/xternal Benchmar%ing
Trend reporting
9ecentraliKed &nvestment >anagement
'. (hat are the strengths and wea%nesses o each o the new measurement and control systemM
A9 Rolling 2orecasts
goal was to achieve a simple and accurate picture o
expected inancial perormance.
similar to a lexi!le !udget permits incorporation o
dynamic states o the world.
used the most o!?ective data availa!le.
spent less time explaining deviations rom !udget.
This system could also !e gamed$ !ut Borealis did not
tie compensation to achieving the orecasts$ so there was little incentive to game.
& some resources are varia!le )lexi!le+ with respect to volume and mix$ when the company has
updated and more accurate orecasts$ it can do !etter short-term resource !udgeting )authoriKe
spending on direct$ capacity$ and support resources !ased on anticipated volume and mix o
products and customers+. This re,uires activity-!ased !udgeting and would tie !ac% to capacity
planning )investment management+.
,9 ,alanced (corecardXcommunicate strategic o!?ectives and
measures to employees and encourage them to set personal o!?ectives that would !e
lin%ed to corporate strategy.
C9 Relati"e 2inancial Performance :R2P; X to urther distinguish !etween orecasting and
perormance measurement. The HCP was the correct lexi!le !udget or Borealis. "ne
that lexed or input prices and product prices as well as volume. BorealisL inancial
perormance was much more aected !y external margin changes )changes in the spread
!etween input and product prices+ than !y actual internal process perormance.
important to achieve a !alance and a ocus on %ey perormance indicators )IP&+
without overwhelming managers with metrics galore.
&ntroduced small incentive plan !etween :$444 and 8$444 Ironor )2344 to 20$444+
!ased on 02 IP&s rom the BSC.
59 A,C X to trac% and record costs !y activities which create them$ to develop cost
inormation that was much more intuitive and understanda!le to plant employees.
E9 E<ternal ,enchmar4ing X used to set perormance targets or DC$ CC and operating
margins !y !enchmar%ing against competitors )see /x. 3+. These targets were
24-24
considered tougher$ !ut the a!sence o !udgets gave managers increased reedom or
spending 22 to reach the targets.
Trends; measure and graph activity and process costs over time.
Hemoved gaming@ #o!ody wanted to !e a Plaggard.L
24-20
Spent less time negotiating targets.

Hates were determined using a4ial usage of capacity. Dariances arose !ecause not
all ixed costs were allocated to products. The cost o unused capacity was assigned
to proit centers !ased on dierences !etween capacity planned and used.
29 5ecentrali=ed &n"estment $anagement > to put decision-ma%ing and control with
plant managers and employees who were closest to the mar%etplace and customers -
collection o decision rights and speciic %nowledge needed or the !est decision
ma%ing$ proximity to customer and mar%ets.
8. Should compensation !e tied to IP&s presented on the BSCM
*ow will this aect validity o data reported or aggressiveness o target settingM (hat other
processes can management use to oset the inormation distortion when targets are esta!lished
or perormance measuresM
The IP&s are not a!out strategic uncertainties. The IP&s are a!out measurement o outcomes
rom a well-deined process X the production o little plastic pellets. & so$ then it seems "I to tie
compensation to IP&s. &n act$ without this reinorcement$ the targets may have little motivational
impact.
7. &s the Borealis new system or everyoneM (hy would it not !e -universal medicine.M
/mpirical evidence suggests that BorealisL system is not or every company$ as most companies
continue to use !udgets. /very company has tension in the design and use o >CS. These
systems are used !oth to inorm and to motivate. Rsing one system to do !oth is li%ely to result in
the introduction o manipulation. There is no one way to address this tension. Some companies$
or example$ set top-down !udgets or use tight supervision or truth-inducing incentive systems.
"ne pro!lem with the Beyond Budgeting approach is easi!ility. /very company must have
perormance standards. Borealis replaced its internally negotiated )!udget+ standards with
!enchmar%ed standards. This is not easi!le or every !usiness$ as many companies guard their
internal data on costs and margins very careully.
(hy do we o!serve the innovations suggested !y the Beyond Budgeting Hound Ta!le )BBHT+
!eing implemented primarily in /urope$ and not in the RSM &n Scandinavia there are multiple
examples o companies that have ollowed this strategy. >ost nota!le is Svens%a *andels!an%en$
which has consistently !een the most proita!le Scandinavian !an% over the last 24 years.
/mployeesL views seem to !e dierent in dierent cultures. So what wor%s or Borealis may not
wor% in the RS X as suggested !y the ,uote !y Bogsnes in the case.
&n Borealis$ decentraliKation seems to !e a su!stitute or !udgeting. This decentraliKation is
motivated !y the unpredicta!le price varia!ility in BorealisL environment )prices$ costs+.
24-22

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Chapter 24 - Strategic Planning and Budgeting

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