CHAPTER 6

BUDGETING

P 6-10: Solution to Potter-Bowen (20 minutes)

[Top-down budgeting and incentives]

PB’s sales budgeting system is essentially a top-down approach. Senior

management forecasts total sales and unit prices at the firm-wide level and distributes this
plan to the divisions, and then to the regions, and finally to the individual salespeople. The
total projected sales cascades down through the sales force based on historical sales
patterns. This budgeting procedure does not provide for the assembling of knowledge from
lower levels in the firm, namely the sales force. They are not asked how many 6103s each
can sell. They are told how many they will sell. It is not a bottom-up budgeting process.
Thus, the first point to note is the budget system does not assemble knowledge from lower
levels of the organization.
While the budgeting system does not assemble specialized knowledge from lower
levels of PB, it does solve the problem of salespeople under-forecasting sales to more easily
meet their sales quotas. Budgeting systems entail trade-offs between decision management
and decision control. PB uses the budget to set sales quotas to motivate and compensate
its sales force. While PB’s system does not emphasize decision management, it reduces
many of the problems with decision control.
PB’s budgeting and compensation systems will lead to some dysfunctional
behavior. Growing regions and sales territories within a region will find it easier to meet
their targets and thus receive a greater bonus than shrinking territories. Therefore, it will
be difficult for PB to keep its best salespeople in declining territories. Salespeople will
tend to gravitate to those territories expected to have above average growth.
Salespeople have incentives to maximize dollar sales, not profits. Therefore,
individual salespeople have incentives to offer price discounts to generate sales.
Another problem with the PB systems is that it ratchets up the budget based on past
performance. Salespeople knowing this will tend to withhold sales if they are below 90
percent or above 150 percent. If sales are below 90 percent or above 150 percent, additional
sales will just increase their next year’s target without providing any current year bonus.
Thus salespeople will try to defer these sales into the next fiscal year.
Having such wide break points (ten percentage points) causes salespeople at the
end of the year to withhold sales if the sale does not put them into the next category. For
example, suppose a salesperson had achieved 134 percent of his/her target for the year and
it is December 14. The person will try to delay recording sales between the 14th and the
31st until the next budget period unless these sales push the person into the 140–150
percent category.

P 6-21: Solution to Spa Ariana (30 minutes)

[Breakeven analysis and flexible vs. static budgets]
a. The breakeven point is found by dividing fixed costs by contribution margin. Or,
339.5 treatments per month = $14,600 / ($100 – 57)

b. April’s budget based on 550 treatments is:

Flexible Budget for April

(Number of treatments = 550)

Variable cost Fixed Cost Total

Revenue $55,000
Therapist $22,000 (22,000)
Supplies/laundry 2,200 (2,200)
Management $5,500 (5,500)
Utilities 1,600 (1,600)
Rent 3,850 6,000 (9,850)
Repairs/upkeep/
cleaning 3,300 1,500 (4,800)
Total cost $31,350 $14,600 ($45,950)
Budgeted Profit $ 9,050

c. The performance report for April based on a static budget of 550 treatments:

Performance Report for April Based on 550 Treatments

Budget Actual Variance

Revenue $55,000 $53,000 ($2,000) U
Therapist (22,000) (21,280) (720) F
Supplies/laundry (2,200) (1,795) (405) F
Management (5,500) (5,125) (375) F
Utilities (1,600) (1,725) 125 U
Rent (9,850) (9,710) (140) F
Repairs/upkeep/
cleaning (4,800) (5,080) 280 U
Total cost ($45,950) ($44,715) ($1,235) F
Budgeted Profit $ 9,050 $ 8,285 ($ 765) U

d. The performance report for April based on a flexible budget of 530 treatments:
 Performance Report for April Based on 530 Treatments

Variable Fixed Flex.

Cost Cost Budget Actual Variance
Revenue $53,000 $53,000 $0
Therapist $21,200 0 ($21,200) ($21,280) 80 U
Supplies/
laundry 2,120 0 (2,120) (1,795) (325) F
Management 0 5,500 (5,500) (5,125) (375) F
Utilities 0 1,600 (1,600) (1,725) 125 U
Rent 3,710 6,000 (9,710) (9,710) 0
Repairs/
upkeep/
cleaning 3,180 1,500 (4,680) (5,080) 400 U
Total cost $30,210 $14,600 ($44,810) ($44,715) ($95) F
Budgeted Profit $8,190 $8,285 $95 F

e. It depends. For decision management purposes, the report in part (c) is better. The
owners had expected 550 treatments. At this volume the Spa should have generated
profits of $9,050. Instead, it had profits of $8,285, or $765 less than expected. The
primary cause of this unfavorable profit variance was 20 fewer treatments. Since
each treatment generates contribution margin of $43, 20 fewer treatments results in
$860 of less profit. To help the owners understand what went wrong and to help
correct the problem, the static budget, which was based on the owner’s prior
expectation, is most useful. For decision control purposes (i.e., to evaluate and
reward the manager of the Spa), the flexible budget report is better if the manager
has no control over the number of treatments. In this case, if the manager can only
control costs, the flexible budget report does not hold the manager accountable for
volume fluctuations. If the manager can affect the volume via advertising and
operating policies, then for decision control purposes, the static budget provides
better incentive alignment between the owners and the manager.

f. The cost structure of the Spa does not include any return of the owners’ initial
$450,000 investment. Suppose the Spa is in business for 10 years, or 120 months.
Then, just to return their initial investment (ignoring any interest on this
investment), the Spa must generate $450,000/120, or $3,750 per month (before
taxes and interest). This raises the breakeven point to ($14,600+3,750)/$43, or
426.7 treatments. Even though the $450,000 is a sunk cost (except to the extent
that the owners can sell the remaining term of their lease to a new owner), the
owners invested this money expecting to earn a return on their investment.
P 6–24: Solution to Madden International (35 minutes)
[Sharing of specialized knowledge via intensive budgeting and financial
reviews]

a. (i) Strengths:
• constant interaction and communication among all the managers
• generates collection of specific knowledge about markets, products,
industry
• encourages value-maximization
• stimulates sharing of specialized knowledge across managers
• forces managers to plan for short & long-run
• better decision making — helps separate the effects of
unforeseen/uncontrollable costs
• encourages local risk taking which is diversifiable at the corporate level
• uniformity of procedures for evaluation across the firm (facilitates
knowledge transfers)
• not being evaluated based on the budget reduces the incentives to
“shade” estimates

(ii) Weaknesses:
• very time consuming for senior and corporate management
• compensation is very subjective, not tied to meeting objective
performance criteria
• five-year plans have little value in rapidly changing world (except they
force managers to think ahead)
• comparability across subsidiaries difficult

b. Given the complexity of the markets in which Madden operates and the rate of
change in these markets, Madden’s success and value depend critically on the
generation, collection, and dissemination of specialized knowledge. A very formal,
structured budget system forces managers to communicate frequently. In the
setting of the budget and in financial review committees, this specialized
knowledge is communicated.
To illustrate the preceding point, consider the following analogy.
Elementary schools hold school dances for 11 and 12 year olds. Usually, the boys
would be on one side of the room and the girls on the other. To get the boys and
girls to dance, the boys would be placed in one line and the girls in a second line
and then the two lines would be paired up and dance partners assigned.
In many ways, the very formal, highly structured budget scheme is like
requiring pre-teenage children to line up at a dance. It is a way to force people in
different functional areas such as marketing, manufacturing, and R&D to share their
specialized knowledge with different parts of the subsidiary and corporate
headquarters. Normally, marketing people would only talk to marketing people,
finance people to finance people, and so forth. Because the world is changing so
rapidly, cross-functional meetings must be more frequent. Without such an
 elaborate system, meetings would be less frequent and there would be less
communication between marketing, manufacturing, and R&D people.
In order to encourage people to share knowledge, very little weight should
be placed on using budgets as a performance evaluation scheme. In Madden’s
situation, to maximize the value of the budget system for decision management
(i.e., sharing specialized knowledge), very little weight is placed on using budgets
for decision control (i.e., performance evaluation).
Also, the high uncertainty in the environment makes it difficult to attribute
the “success” of a new innovation to a given manager’s actions.

P 6-25: Solution to Brehm Vineyards (35 minutes)

[Flexible budgeting, breakeven, and performance evaluation]

a. Flexible budget at 8,000 units:

Fixed Variable Total

Cost Cost Cost
Revenue $960,000
Grape costs $240,000 $2.10 $256,800
Labor 75,000 2.15 92,200
Packaging 14.00 112,000
Selling and administrative costs 36,000 36,000
Utilities 4,000 0.75 10,000
Total cost $355,000 $19.00 (507,000)
Net income before tax $453,000

b. Breakeven volume = FC ÷ contribution margin:

BE = $355,000 ÷ ($120 - $19) = 3,515 cases

c. Volume needed to generate profits of $300,000 after taxes:

After tax profit = $300,000 = [$120 × Q -$19 x Q - $355,000] × (1-0.40)

$300,000 ÷ .0.60 + $355,000 = $101 × Q

Q = 8465.3 cases

d. Performance report based on 6,000 cases:

 Fixed Variable Budgeted
Cost Cost Cost Budget Actual Variance
Revenue $720,000 $840,000 $120,000F
Grape costs $240,000 $2.10 $252,600 260,000 7,400U
Labor 75,000 2.15 87,900 98,000 10,100U
Packaging 14.00 84,000 83,000 -1,000F
Selling & admin 36,000 36,000 39,000 3,000U
Utilities 4,000 0.75 8,500 8,800 300U
Total cost $355,000 $19.00 $469,000 488,800 19,800U
Net income $251,000 $351,200 $100,200F

e. In a normal year Brehm expects net income of $453,000. Bad weather cut actual
net income to $351,200, or about 22 percent. However, Brehm generated $100,200
more income than budgeted at 6,000 actual cases. This favorable net income
variance was due to $120,000 favorable revenue variance resulting from a $20 per
case increase in the wholesale price. All expense categories report unfavorable
variances (except $1,000 favorable packaging variance). The total cost variance
was $19,800 unfavorable with Labor ($10,100 unfavorable) and Grape Costs
($7,400 unfavorable) being the major reasons. The higher than budgeted revenues
of $120,000 were offset by about $20,000 of unfavorable cost variances.
One’s evaluation of management depends on whether you believe
management was responsible for negotiating the higher than normal price of $140
versus the price of $120 that exists during normal production of 8,000 cases.
Managers could not do anything about the weather other than to mitigate the
weather’s adverse effects. The only way to assess whether managers successfully
mitigated the effects of the bad weather is to benchmark Brehm’s juice yield against
other white pinot growers in the same region.
Bad weather drove production down to 6,000 cases. If we assume that
management is responsible primarily for budgeted costs and nature determines
quantity, and the market determines the wholesale price, then one must conclude
that management did a less than stellar job of controlling costs. On the surface,
costs exceeded budget by about $20,000, or about 4 percent.