There are several ways in which a budget can be used to enhance a company’s control systems so that objectives are more easily met and it is more difficult for costs to stray from approved levels. One of the best methods for controlling costs is to link the budget for each expense within each department to the purchasing system. By doing so, the computer system will automatically accumulate the total amount of purchase orders that have been issued thus far against a specific account, and will refuse any further purchase orders when the budgeted expense total has been reached.
This approach can involve the comparison of the monthly budget to monthly costs, or compare costs with annual budgeted totals. The latter approach can cause difficulty for the inattentive manager, since actual expenses may be running well ahead of the budget for most of the year, but the system will not automatically flag the problem until the entire year’s budget has been depleted.
Alternatively, a comparison to monthly budgeted figures may result in so many warning flags on so many accounts that the purchasing staff is unable to purchase many items. One workaround for this problem is to use a “fixed coverage percentage” by which purchases are allowed to exceed the budget; another possibility is to compare cumulative expenses only with quarterly budget totals, which reduces the total number of system warning flags.
Another budgetary control system is to compare actual with budgeted results for the specific purpose of evaluating the performance of employees.
Example: The warehouse manager may be judged based on actual inventory turnover of 12x, which compares unfavorably to a budgeted turnover rate of 15x. Similarly, the manager of a cost center may receive a favorable review if the total monthly cost of her cost center averages no more than $152,000. This also works for the sales staff, who can be assigned sales quotas that match the budgeted sales levels for their sales territories. In this manner, a large number of employees can have their compensation levels directly tied to the achievement of budgeted goals. This is a highly effective way to ensure that the budget becomes a fixture in the lives of employees.
Problems With Linking Employee pay To performance Levels on Budgets
However, there is also a problem with linking employee pay to performance levels as outlined in the budget.
What is the problem?
If employees realize that they will fall short of their bonus targets, they will be more likely to hoard their resources or possible sales for the next period, when they will have a better opportunity to achieve better performance and be paid a bonus. The result is wild swings in corporate performance from period to period as employees cycle through the hoard-to-splurge circuit. Employees may also stretch or break the accounting rules in a variety of ways to achieve the target.
Definitely, the solution is to link the budget to a “sliding performance scale” that contains no ‘‘hard performance goals“.
The best example of the sliding bonus scale is what it is not—there are no specific goals at which the bonus target suddenly increases in size. Instead, the bonus is a constant percentage of the goal, such as 1 percent of sales or 5 percent of net after-tax profits. Also, there should be no upper boundary to the sliding scale, which would present employees with the disincentive to stop performing once they have reached a maximum bonus level. Similarly, there should theoretically be no lower limit to the bonus either, though it is more common to see a baseline level that is derived from the corporate breakeven point, on the grounds that employees must at least ensure that the company does not lose money.
The sliding scale approach also makes it much easier to budget for the bonus expense at various activity levels, rather than trying to budget for the more common all-or-nothing bonus payment.
Yet another budgetary control system is to use it as a feedback loop to employees. This can be done by issuing a series of reports at the end of each reporting period that are specifically designed to match the responsibilities of each employee.
Example: Below figure shows a single revenue line item that is reported to a salesperson for a single territory. The salesperson does not need to see any other detailed comparison with the budget, because he is not responsible for anything besides the specific line item that is reported to him.
This reporting approach focuses the attention of many employees on just those segments of the budget over which they have control. Though this approach can result in the creation of dozens or even hundreds of reports by the accounting department, they can be automated on most packaged accounting software systems, so that only the initial report creation will take up much accounting time.
An additional control use for the budget is to detect fraud. The budget is usually based on several years of actual operating results, so unless there are major changes in activity levels, actual expense results should be fairly close to budgeted expectations. If not, variance analysis is frequently used to find out what happened. This process is an excellent means for discovering fraud, since this activity will usually result in a sudden surge in expense levels, which the resulting variance analysis will detect. The two instances in which this control will not work is when the fraud has been in existence for a long time [and so is incorporated into the budgeted expense numbers already] or the amount of fraud is so low that it will not create a variance large enough to warrant investigation.