Homework Lance
P 6-1: Solution to G. Bennett Stewart on Management Incentives (15 minutes) [Costs and benefits of budgeting]
The quote fails to recognize that budgeting systems have survived and thus in general must be yielding benefits at least as large as their costs. While Stewart’s analysis of budgeting systems offers insights into the dysfunctional aspects of budgeting, it does not address the question of the benefits such systems provide that allow these systems to survive.
Mr. Stewart’s criticism of budgets focuses on their decision control role. When used as performance measures and linked to bonuses, budgets cause gaming. There is no question that such gaming exists. The important questions are: What is the magnitude of the gaming? If budgets are not used to measure performance, what is and does it result in better or worse incentives?
P 6–2: Solution to Investment Banks (15 minutes)
[Zero-based budgeting]
a. Zero-based Budgeting (ZBB) is a form of budgeting in which each and every line item request in every budget must be justified by demonstrating that the benefits from requesting this amount of money exceed the amount requested. ZBB differs from the more typical case of incremental budgeting, in which only the increment over last year’s budget on each line item is justified. Presumably, ZBB better roots out inefficiencies in the firm by forcing each manager to demonstrate each year that each and every expenditure proposed is in the best interest of the firm. However, ZBB is more time consuming and thus more costly to operate than incremental budgeting. Moreover, ZBB tends to deteriorate into an incremental-type budgeting system whereby each year managers pull out last year’s justifications and make incremental changes to last year’s plan.
b. All budgeting systems separate decision management from decision control. Managers who propose next year’s budgets do not have the decision control rights to approve (ratify) such requests. Those with the decision monitoring rights must have the specific knowledge to exercise the ratification rights. While ZBB is more costly to operate than incremental budgeting, it is more useful in the sense that it transfers more specific knowledge about each line item comprising the budget. In organizations that experience high turnover among the people with the decision monitoring rights, the benefits of ZBB are higher than in firms with more stable management.
Managers tend to be promoted vertically within organizations. Having been in lower-level positions, they have a great deal of specific knowledge about their subordinates’ budgets. Therefore, the benefits of ZBB (the value of the specific knowledge transferred) are lower in organizations with little external turnover of senior management positions.
Given the high external turnover in Cabots, Cabots is more likely to be using ZBB than Rogers Petersen.
P 6–3: Solution to Ice Storm (15 minutes)
[Assigning responsibility and controllability of expenses]
a. The cover memo for the second statement is:
As you can see from the enclosed operating statement for this year, our operating profits excluding the ice storm exceeded budget by $107,000 thus achieving 105 percent of our budgeted profit. This better-than-projected profit results from revenues being 1 percent higher than anticipated, and occupancy costs 3 percent lower than expected. However, labor and materials exceeded budget.
Taking into account the ice storm damage costs of $653,000 our total profits were $546,000 below budget.
b. There are two issues raised by this problem: agenda setting and controllability. How financial analyses are presented affects agendas. The second statement, which separates the storm costs from normal operations, focuses the discussion on the ice storm and whether the costs of the ice storm are measured properly. That is, how were the costs of the ice storm computed? Dye’s superiors might conclude that the reason for M&P’s favorable operating performance (before the ice storm costs are considered) is because Dye charged some normal operating costs to the ice storm to improve “operating profits before the ice storm.” While the second statement tries to remove the costs of the ice storm from Dye’s performance evaluation, the second statement also exposes Dye to charges that Dye did not do enough to reduce the costs of possible storms (e.g., removing tree limbs from around the greenhouses).
The second issue involves whether the manager should be held responsible for the ice storm. While the manager cannot prevent such storms, Dye can reduce the adverse consequences of such events. The second statement, which separates out the ice storm, tries to make the case that the manager should not be held accountable for the ice storm. The extent to which this ploy works depends on whether Dye’s boss focuses on the ice storm and blames Dye for not doing enough prevention.
P 6–4: Solution to Budget Lapsing versus Line-Item Budgets (15 minutes) [Budget lapsing]
a. Budget lapsing refers to preventing the manager from carrying over to the next fiscal period any unspent budget funds from this fiscal period. Line-item budgeting refers to restricting the manager’s ability to shift unspent funds from one line item to another line item within the same fiscal period. Thus, budget lapsing restricts manager’s decision rights across time, whereas line-item budgets restrict managers’ decisions rights within a fiscal year.
b. Budget lapsing occurs in most organizations, probably to reduce the horizon problem of managers who build up large balances that are spent before they change jobs. It also is used to control manager’s risk aversion. If it is optimum to spend $X on a certain activity, it is not optimum to have the manager save a portion of $X because she is risk averse.
c. Line-item budgets restrict managers’ decision rights. You would expect to observe such restrictions where the agency costs of manager’s discretion is high or where alternative monitoring devices such as incentive schemes and competition from other firms is low. Government agencies and certain non-profit organizations face little external competition and are unable to effectively employ incentive compensation schemes. Thus, these organizations are more likely to use line-item budgets.
P 6-5: Solution to DMP Consultants (15 minutes)
[Advantages and disadvantages of participative (bottom-up) budgeting]
The memo should contain the following points:
Participative budgets help assemble specialized knowledge from lower levels of the firm. But if these budget estimates are then used for determining employees’ compensation, this creates strong incentives for employees to lie, to sandbag the numbers, and to bias their information so it makes it easier for them to meet their sales quotas.
Are our firm’s sales compensation and budgeting systems broken? Remember, “If it ain’t broke, don’t fix it.”
DMP is suggesting a “one size fits all approach.” But each firm must tailor its budgeting systems to its own unique organizational structure which best enables it to achieve its corporate strategy. Some firms will have top-down budgets and others will have bottom-up budgets.
Top-down budgets are good for decision control, but bad for decision management. Bottom-up budgets are good for decision management, but compromise decision control (compensation). Participative budgets that are also used for decision control create distorted information.
Only changing the budgeting system results in changing one leg of the three-legged stool. If participative budgeting is adopted, other parts of the firm’s organizational architecture will have to be examined and perhaps modified.
P 6-6: Solution to Federal Insurance (15 minutes)
[Zero-based budgeting]
Federal will use zero-based budgeting because its senior management team is new, from outside of Federal, and not familiar with the detailed operations of Federal. Hence, zero-based budgeting will provide them with substantially more detailed information about the various divisions and administrative departments of Federal than traditional incremental budgeting.
P 6-7: Solution to Golf World (20 minutes)
[Agency costs and flexible budgets change incentives]
a. Almost all of the difference between actual operating profits and the static budget for April is due to the reduced cart rentals from 6,000 to 4,000. When the variances are calculated based on the flexible budget, Grimes operation shows only a $1,100 unfavorable variance. Labor and gas and oil were over budget. The $200 unfavorable variance in labor is probably insignificant and the $900 gas & oil difference is likely a timing difference between when the gas and oil are purchased and when they are actually used.
b. The major advantage of the controller’s flexible budget scheme is that it separates those items Grimes can control from those he can’t control. The flexible budget (and hence the variances) are adjusted for volume effects which presumably are out of Grimes’ control. But are they? Herein lies the disadvantage of the controller’s scheme. By removing volume effects from Grimes’ variances, he has no incentive to worry about cart rentals. If in fact the only variances for which he is responsible are the operating costs, he can show favorable variances by reducing the quality of his services. The carts will not be cleaned as well, they will break down more on the course, and he will not choose the cart fleet to maximize his profit center’s profits but rather to minimize costs.
Also, Grimes has specialized knowledge of the customers’ demand curves for carts. If he is held responsible for revenues (i.e., the controller’s proposal is rejected), Grimes has more incentive to implement pricing policies that maximize profits. If volume effects are “flexed out” of Grimes’ budget, he has no incentive to offer special prices in order to price discriminate.
c. An agency problem exists between Sandy Green and Golf World under the present organizational structure. Green receives the benefits of closing the courses to golf carts (this reduces the maintenance her crews have to conduct) but she does not bear the full costs of this action (the reduced revenues from golf carts). By shutting a course because of wetness, Green keeps that course looking good and does not have to repair cart damage. In time, this translates to lower maintenance costs and higher golf course profits. But this decision imposes a negative externality on Grimes and the golf cart profit center.
One way to internalize this externality is to include as part of Green’s operating statement the difference between Grimes’ actual and static budget operating profits.
Some students are tempted to convert Golf Carts to a cost center from a profit center. This question involves who should have the decision rights to set the cart price. If Grimes can best set the price it should be a profit center, otherwise it should be a cost center. Who should set the price depends on who has the specialized knowledge and who has the comparative advantage in acquiring the knowledge. If Golf Carts becomes a cost center, Grimes will have no incentive to acquire the knowledge to set the profit-maximizing cart price.
P 6-8: Solution to Coating Department (20 minutes)
[Identifying fixed and variable costs for a flexible budget]
a. The first step in identifying the flexible budget is determining which accounts are fixed and which are variable. Given the data in the problem, one way to identify fixed and variable costs is to compute the unit cost per year (total cost ÷ coating hours) and see if the unit cost is relatively constant over the wide volume swings observed in 2014 – 2016. The following table takes the total cost data and divides them by machine hours.
2014
2015
2016
Coating materials
$4.11
$4.10
$4.12
Engineering support
$2.24
$4.08
$2.06
Maintenance
$2.87
$4.28
$2.38
Occupancy costs (square footage)
$2.20
$3.44
$1.78
Operator labor
$9.26
$9.33
$9.69
Supervision
$3.72
$5.65
$3.25
Utilities
$1.03
$1.05
$1.06
From this table, we see that coating materials, operator labor, and utilities have fairly constant unit costs indicating that these items are probably variable costs. Fixed costs include engineering support, maintenance, occupancy costs, and supervision. Based on the preceding analysis, we can now estimate fixed and variable costs for 2016 by separating costs into fixed and variable components as in the next table.
Random
2014
2015
2016
Average
Walk
Variable costs:
Coating material
$4.11
$4.10
$4.12
$ 4.11
$ 4.12
Operator labor
9.26
9.33
9.69
9.43
9.69
Utilities
1.03
1.05
1.06
1.05
1.06
Total variable cost
$14.59
$14.87
Fixed costs:
Engineering support
$27,962
$34,295
$31,300
$ 31,186
$ 31,300
Maintenance
35,850
35,930
36,200
35,993
36,200
Occupancy costs
27,502
28,904
27,105
27,837
27,105
Supervision
46,500
47,430
49,327
47,752
49,327
Total fixed cost
$142,768
$143,932
In estimating 2017’s costs, given we do not have specific data on expected relative price changes, we can either take an average of the last three years’ data for each cost category, or we can assume that 2017 will look most like 2016. This last assumption is called a random walk model: our best estimate of the future is the most recent observation of the past. Therefore, we have two flexible budgets:
Expected costs = $142,768 + $14.59 per machine hour
Expected costs = $143,932 + $14.87 per machine hour
b. The following table calculates the coating department’s cost per machine hour for 2017 using both an average of the annual costs and a random walk.
Random
Average
Walk
Variable cost per machine hour
$ 14.59
$ 14.87
Times: Expected 2017 machine hours
16,000
16,000
Total variable costs
$233,333
$237,920
Plus: Fixed cost
142,768
143,932
Budgeted costs
$376,102
$381,852
Expected 2017 machine hours
16,000
16,000
Cost per hour in coating department
$ 23.51
$ 23.87
P 6–9: Solution to Marketing Plan (20 minutes)
[Long-run versus short-run budgets]
Approve the advertising campaign, but only the first year of the plan. Approving the plan in general and specifically authorizing the one-year budget gives Jensen the flexibility to move ahead on the program. There is no compelling case for granting a three-year budget for this advertising campaign, while there are some reasons not to approve all three years now. The disadvantages of granting a three-year budget include:
a. New information will become available over the next three years regarding the company’s other products, profitability, competition, etc. By approving all three years now, senior management gives up decision monitoring rights over the next three years. This makes it more difficult to assemble and take advantage of new information when it becomes available.
b. Jensen can have the project approved for the first year. This is a tentative approval for the entire three years, but senior managers reserve the decision rights to review and monitor performance over the three years. If she is given a three-year budget, there is less monitoring of results than if three one-year budgets are approved.
c. Three one-year budgets will require Jensen to make a presentation each year of the results to date and projected benefits of continuing the program. Thus, three one-year budgets are more likely to force Jensen and senior managers to communicate more information about the ad campaign, its results, and other related aspects of the business.
d. Setting a single three-year budget that does not lapse at the end of each year sets a precedent in the firm. Other managers will request similar treatment. Annual budgets that lapse are a mechanism to control agency problems. Allowing exceptions to annual budget lapsing will reduce monitoring and likely increase agency problems.
e. Setting a single three-year budget produces different incentive effects for Jensen than three one-year budgets. Presumably, Jensen will exert more effort at the end of each of the three years preparing for the budget review than if there is just one review at the end of three years. But this of course depends on how the performance evaluation and reward systems operate in conjunction with the budget review process.
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 6–11: Solution to Feder Purchasing Department (20 minutes)
[Solving for fixed and variable cost given the flexible budget]
Actual spending $1,175,000
Unfavorable variance – 41,400
Flexible budget @ 9,300 units $1,133,600
First, write down the flexible budgets for the beginning and end of February. There are two equations in two unknowns (FC and VC). Subtract one equation from the other to get one equation in one unknown (VC). Then solve for the other unknown (FC).
$1,133,600 = FC + VC × 9,300 (End of February flexible budget)
1,076,400 = FC + VC × 8,200 (Beginning of February flexible budget)
57,200 = 1,100 VC
VC = $52
FC = $1,133,600 – $52 × 9,300
= $650,000
GIPHY App Key not set. Please check settings