chapter 6-8: Budgeting, cost allocation and practices

What are some of the synergies that budgets provide within large corporation?

1. A communication device involving both vertical and horizontal information transfers. 2. A negotiation and internal contracting procedure. 3. A role in the performance evaluation and reward system. 4. A role in partitioning decision rights.

What are some reasons to allocate service department costs, independent of which allocation method is chosen?

1. To tax the users with some positive price that causes them to reduce their consumption from what it would be under a zero price(no allocation). 2. By allocating the costs, senior management gets information about the total demand for the service at the allocated cost. 3. By comparing the internally allocated cost with the external market price of comparable services, senior management is able to assess the operating efficiency of the service department. 4. Taxing the internal service helps allocate a scarce resource. At a zero price, demand will almost always exceed supply. In the absence of a price mechanism to allocate department services, senior management will be confronted with complaints to increase the amount of service via larger budgets and must device a nonprice priority schemes to manage the queue waiting for service.

Possible solutions to the death spiral

1. when excess capacity exists, charge only for VC 2. Reduce the total amount of fixed costs allocated 3. Use practical capacity instead of actual utilization to calculate overhead 4. Allocation base choice is crucial

What is a bottom-up budgeting system?

A bottom-up budget means that lower levels of the organization prepare the initial budget because they have the specialized knowledge, and as the budget winds its way through the decision ratification process, higher levels of the organization review the budget review the budget and bring to bear additional knowledge.

Define "budget variance".

A budget variance occurs when actual expenses do not match budgeted expenses exactly or when budgeted revenues do not match the actual revenues exactly

What is the difference between a positive and negative externality?

A negative externality causes others to bear some costs as the result of a decision made that is beyond their control. A positive externality causes others to receive some benefit as the result of a decision made that is out of their control.

Describe how a non-insulating allocation promotes cooperation among managers and encourages mutual monitoring.

A non-insulating allocation method causes the performance measure (e.g., divisional profits) to depend on the performance of another division. If other divisions improve their performance, your division bears fewer allocation costs and hence will show better performance (after receiving allocated costs). Non-insulating allocation methods create incentives for managers to cooperate and mutually monitor each other to protect their interests.

Define static and flexible budgets. Discuss their advantages and weaknesses.

A static budget is a budget that does not change with volume. The major reason for using flexible budgets is to better measure the actual performance of a person or an entity after controlling for volume effects, assuming that the person/entity being evaluated cannot control the volume changes. However, is a manager can influence the effect of the volume change, then it is unwise to shield the manager from the volume changes.

How do cost allocations act as a tax system?

Allocating costs causes an increase in the reported costs using the resource being allocated. For example, if property taxes are allocated using square footage, then floor space becomes taxed. These cost allocations are like taxes on these resources. Like all taxes on consumption items, the tax discourages use of the item levied with the tax.

Why do some organizations practice budget lapsing? What are the disadvantages?

Budget lapsing provide tighter controls on managers than budgets that do not lapse. The primary purpose is to prevent certain agency problems from occurring. The opportunity cost of lapsing budgets is usually less efficient operations. Managers will devote time at year-end to ensure that the budget is fully spent, thereby protecting future budget levels.

Are budgets a part of the performance measurement system or the performance reward system?

Budgets are a part of both. Most managers are evaluated in part on how well they are able to meet the budgeted expectations of their department, division, and so on. Budget variances are indicators of whether managers are meeting expectations. A large unfavorable variance may cause a manager to be demoted or lose his job.

How are budgets developed?

Budgets are developed using "key planning assumptions" or "basic estimating factors".

How do budgets partition decision rights within a firm?

Budgets separate decision management from decision control. Managers have the decision management rights (i.e. budget preparations and operating decisions). The BOD has the decision control rights (i.e. budget review and approval and financial statement review).

Define externality and give an example of one

Externalities are costs or benefits imposed on other individuals without their participation in the decision-making process and without compensation for the cost or benefits imposed on them (e.g., air pollution).

Should common costs be allocated?

If common costs are not allocated, managers have less incentive to invest in the specialized knowledge necessary to to determine the optimal level of the common costs. Furthermore, if the decision rights over the level of the common costs do not reside with a manager and are not allocated back to the manager's department, the manager will always demand more common costs.

What are joint costs? How do they differ from common costs?

Joint costs are costs incurred in the production of two or more outputs from the same production process in fixed proportion. Joint products are produced in fixed proportions. Common costs arise in production settings where there can be substitution among outputs. More of one output can be produced by reducing the output of another product. Joint costs are associated with disassembly processes where a joint input is disassembled into several products. Common costs usually describe assembly processes where numerous inputs including some common resources are assembled to form the output.

How are key planning assumptions derived?

Key planning assumptions represent those factors that are to some extent beyond management control and that set a limit on the overall activities of the firm. They must be forecast based on past experience, field estimates and/or statistical analysis.

What are the advantages and disadvantages of line-item budgets?

Line-item budgets authorize a manager to spend only up to a specific amount on each line item. These budgets are an extreme form of control; decision rights to substitute resources are denied. The benefit of such control is a reduction of agency costs. The disadvantage of these budgets are that managers are disinclined to look for savings because they cannot transfer the savings to another line item, then the manager has no incentive to search for savings.

How are externalities reduced within a firm?

One way to reduce externalities is to impose a tax on the use of the resource or decision that creates the externality.

What are some of the reasons for allocating costs?

Some of the reasons for allocating costs are taxes, external financial reporting, third-party reimbursement, and solving the organizational problem.

What is step-down allocation? What are some criticisms of this allocation method?

Step-down allocation is an allocation method that recognizes that service departments use each other's services. The process begins by choosing one service department and allocating its cost to the remaining service and operating departments. The process is repeated for each of the remaining service departments. A major criticism of the step-down method is that the sequence of is arbitrary and large differences in the cost per unit of service across different sequences are possible. The step-down method also ignores the fact that departments earlier in the sequence use service departments later in the sequence.

What are the advantages and disadvantages of the net realizable method for allocating joint costs?

The advantage of the NRV method is that is does not distort the relative profitability of product-line costs and hence is better for decision making. The disadvantages NRV is that it is costly to collect selling prices and costs beyond the split-off point.

What purposes are served by the budgeting process in a large firm?

The budgeting process serves as a communication tool in a large firm. The process gives managers the incentive to share their specific knowledge and this transmitting this knowledge vertically and horizontally throughout the firm. Key planning assumptions are shared and developed in this process as well. The information-sharing process also serves as a negotiation and contracting procedure between different subunits within the firm. Review of the prior year's budget is a part of this process, and therefore budgeting is a part of the performance evaluation and reward and punishment system. These processes partition decision rights within the firm.

What is the death spiral and how is it prevented?

The death spiral can result whenever transfer prices include fixed costs and users shift away from the internal common resource. This further increases the full cost transfer price, causing further users to reduce their demand. Death spirals can be avoided by using variable cost transfer pricing and cost allocation.

How do the direct allocation and step-down methods differ?

The direct allocation method ignores service departments using each other's services in allocation costs. The step-down method allocates service department costs to other service departments later in the sequence.

How does the cost per unit of service vary over the sequence of service departments when the step-down method is used?

The first service department in the step-down sequence has a smaller cost per unit than if it is the last department in the sequence. The reason is twofold 1) there are fewer costs allocated, and 2) there are more users over which to allocate the costs.

What is the ratchet effect?

The ratchet effect refers to basing next year's budget on this year's actual performance, if this year's actual performance exceeds this year's budget. If, in this year actual performance falls short of budget, next year's budget is not reduced. Budget ratcheting causes employees to reduce outputs this year to avoid being held to a higher standard in future periods.

Why would managers bias their forecasts when preparing a budget?

This is just another example of the trade-off between decision management and control. The budgeting process transfers specific knowledge about key planning assumptions. However, if the budget is also used for decision control and provides incentives for meeting the budget, the managers will "shade" their forecasts to enhance their performance whenever performance is measured by comparing actual results with budget.

Describe some methods for allocating joint costs

Three common methods to allocate joint costs are 1) physical measures, 2) relative sales value methods, and 3) net realizable value method. The fundamental point to remember when analyzing situations involving joint costs is that any joint cost allocated to final products is meaningless for assessing product-line profitability.

Rb=MCb.

Under this condition, the cost allocation and the marginal cost is equal. In this case the cost allocation perfectly reflects the amount of tax to apply.

Rc≤MCc

Under this condition, the cost of allocation rate is less than the marginal cost of the externality. Taxing under this condition is better than no tax.

Ra≥MC

the overhead rate at volume level a, is greater than MCa, the marginal cost at a. Under this condition, the cost allocation overstates the marginal cost of the externality. Therefore, taxing might cause more harm than good