activities having their own expense pools can get out of hand.
Three to five, perhaps even seven to ten separate cost drivers
for fixed-cost allocation may be understandable and feasible,
but there is a limit.
Returning to the title of this section, the fundamental
management question is whether any allocation
scheme is worth the effort. Whatâ€™s the purpose? Does allocation
help decision making? The basic management purpose should
not be to find the true or actual profit for each product or other
sales revenue source. The fundamental question is whether
management is making optimal use of the resources and poten-
tial provided by the divisionâ€™s fixed operating expenses.
The bottom line is finding which sales mix maximizes total
contribution margin. Allocation of indirect fixed expenses in
and of itself doesnâ€™t help to do this. Indirect fixed expenses
may have to be allocated for legal or contract purposes. If so,
the method(s) for such allocation should be spelled out in
advance rather than waiting until after the fact to select the
Sometimes a business may allocate fixed expenses to mini-
mize the apparent profit on a product. I was hired to be an
expert witness for the plaintiff in a patent infringement law-
suit against a well-known corporation. The defendant had
already lost in the first stage, having been found guilty of
patent infringement. For three years the defendant corpora-
tion had manufactured and sold a product on which the plain-
tiff owned the patent without compensating the plaintiff. The
second stage was to assess the amount of damages to be
awarded to the plaintiff.
The plaintiff was suing for recovery of the profit made by
the defendant corporation on sales of the product. The defen-
dant allocated every indirect fixed cost it could think of to the
productâ€”including part of the CEOâ€™s annual salaryâ€”to mini-
mize the profit that was allegedly earned from sales of the
product. The jury threw out this heavy-handed allocation and
awarded $16 million to the plaintiff.
It goes without saying that managers should plan ahead and
formulate strategy and tactics for the coming yearâ€”and
longer. The future does not take care of itself. Any manager
will tell you of the importance of forecasting major changes,
adapting the core strategy of the business to the new environ-
ment, developing and implementing initiatives, and in general
keeping ahead of the curve. One tool for planning is budget-
ing. The technical aspects and detailed procedures of a com-
prehensive budgeting system are beyond the scope of this
book. The following discussion focuses on fundamentals.
Reasons for Budgeting
Management decisions taken as a whole should constitute an
integrated and coordinated strategy and an overarching plan of
action for achieving the profit and financial objectives of a busi-
ness. Decisions are like the blueprint for a building; control
should be carried out in the context of the decision blueprint.
Budgeting is one very good means of integrating management
decision making and management control, akin to constructing
a building according to its blueprint.
Decisions are made explicit in a budget, which is the con-
crete plan of action for achieving the profit and financial
objectives of the business according to a timetable. Actual
results are then evaluated against budget, period by period,
line by line, and item by item. Variances have to be explained.
They serve as the catalyst for taking corrective action or for
revising the plan as needed.
Lack of budgeting doesnâ€™t necessarily mean that there is no
management control. Budgeting is certainly helpful but not
absolutely essential for management control. Many businesses
do little or no budgeting, yet they make a good profit and
remain solvent and financially healthy. They depend on the
management control reports to track their actual profit per-
formance, financial position, and cash flows. But they have
no formal or explicit budget against which to compare actual
results. More than likely they use the previous year as the
reference for comparison.
The master budget is made up of the separate profit and
other budgets for each organizational unitâ€”such as sales
territories, departments, product lines, branches, divisions,
or subsidiaries. Each subunitâ€™s budget is like a building stone
in a large pyramid that leads up to the master budget at the
top. Starting at the bottom end, sales and expense budgets
dovetail into larger-scale profit budgets, which in turn are
integrated with cash flow and financial condition (balance
The larger the organization, the more likely youâ€™ll find a
formal and comprehensive financial budgeting process in
place. And the more bureaucratic the organization, the more
likely that it uses a budgeting system. The budget is one pri-
mary means of communication and authorization down the
line in the organization. The budget provides the key bench-
marks for evaluating performance of managers at all levels.
Actual is compared against budget, and significant variances
are highlighted, investigated, and reported up the line. Man-
agers are rewarded for meeting or exceeding the budget, and
they are held accountable for unfavorable variances.
A complete budget plan requires a profit budget (income
statement) and cash flow budget for the coming period and a
budgeted financial condition report (balance sheet) at the end
of the period. As explained in previous chapters, the financial
condition of the business is driven mainly by the profit-making
operations of the business. Capital expenditures for replace-
ments and expansions of long-term operating assets of the
business must be included in the cash flow budget and the
budgeted year-end financial condition.
A total financial plan in which a profit budget is integrated
with the financial condition and cash flow budgets is a very
convincing package when youâ€™re applying for a loan or renew-
ing an existing line of credit. It shows that the companyâ€™s total
financial plan has been thought out.
Costs and Disadvantages of Budgeting
There are persuasive reasons for and advantages of budget-
ing. On the other side of the coin, budgeting is costly and
may lead to a lot of game playing and dysfunctional behav-
ior. Some reasons for budgeting are not highly applicable to
smaller businesses or even to midsized businesses. Smaller
businesses do not need budgets for communication and
coordination purposes, functions that are much more impor-
tant in larger organizations, where top management is dis-
tant from its far-flung, day-to-day operations.
Profit budgeting depends heavily on the ability of managers
to provide detailed and accurate forecasts of changes in the
key factors that drive profit. Nothing is more counterproduc-
tive and discouraging than an unrealistic profit budget built
on flimsy sales projections. If no one believes the sales budget
numbers, the budget process becomes a lot of wasted motion
or, worse, an exercise in hypocrisy.
The profit budget should be accepted as realistically achiev-
able by those managers responsible for meeting the objectives
and goals of the profit plan and as a realistic benchmark
against which actual performance can be compared. If budget
goals are too unrealistic, managers may engage in all sorts of
manipulations and artificial schemes to meet their budget
profit targets. There are enormous pressures in a business
organization to make budget, even if managers think the
budget is unfair and unrealistic.
Then there are always unexpected developmentsâ€”events that
simply cannot be foreseen at the time of putting together a
budget. The budget should be adjusted for such developments,
but making budget revisions is not easy; itâ€™s like changing
horses in the middle of the stream. Once adopted, budgets
tend to become carved in stone. Higher levels of management
quite naturally are suspicious that requests for budget adjust-
ments may be attempts to evade budget goals or excuses for
substandard performance. Budgeting works best in a stable
and predictable environment.
As mentioned previously, management control entails thou-
sands of details. Control deals with detail, detail, and more
detail. Day to day and month to month the manager has to
pay attention to an avalanche of details. Keeping all the
details in perspective is a challenge, to say the least. Control
reports comparing actual with budget should not let the
details take over, which can easily cause managers to lose
sight of the overall progress toward profit goals.
The whole point of budgeting, which is easy to lose sight of,
is to achieve profit and other financial objectives. Budgeting is
not an end but a means. Detailed expense and cost reporting
is required so that managers can keep close watch on the total
effect of the key expense and cost factors that were forecast in
the profit budget. Often, managers ask for reams of detailed
expense and cost reports, but they do not necessarily read all
Managers do not simply make decisions and then assume that
their decisions put into motion everything that has to be done
to achieve the goals of the business. Managers must follow
through and exercise management control throughout the
period. There is no such thing as putting a business on auto-
matic pilot. Managers have to watch everything. Management
control depends on feedback information about actual per-
formance, which managers compare against the plan.
Management control begins with a solid foundation of
internal accounting controls. These forms and procedures are
absolutely essential to ensure the reliability of the information
recorded by a businessâ€™s accounting system. Internal account-
ing controls also serve a second dutyâ€”to deter and detect
fraud and other dishonest behavior. Most fraud can be traced
to the absence or breakdown of internal accounting controls.
These controls should be enforced vigilantly. Many larger
business organizations use internal auditors to evaluate and
improve their internal accounting controls and to perform
The chapter offers guidelines for management control re-
ports. These reports should resonate with the decision-making
analysis methods and models used by managers. These reports
should provide the most relevant benchmarks against which
actual performance is compared. Control reports contain a
great amount of detail, but key factors and variances should be
highlighted and not lost in the avalanche of details. Control
reports should focus on several negative factors that adversely
affect sales prices, sales volume, and expenses.
Budgeting provides useful yardsticks and standards for
management control. But budgeting is done for more than just
control purposes. Budgeting is a broader management prac-
tice that encompasses strategic planning, communication
throughout the organization, motivation of managers, and
more. The brief overview in the chapter looks at the reasons
for budgeting, as well as its inherent disadvantages.
If youâ€™re in the manufacturing business, this chapter is an
absolute must. The chapter presents a concise explanation of
the accounting methods used by virtually all manufacturers to
determine and measure product cost. To set sales prices, to
control costs, and to plan for the future, a business must know
the costs of manufacturing its products.
But suppose youâ€™re not in the business of manufacturing the