1 Budget Choice

Budget Choice: Planning Versus Controlby Neil C. Churchill

The term “budget” tends to conjure up in the minds of many managers images of inaccurate estimates, produced in tediousdetail, which are never exactly achieved but whose shortfalls or overruns require explanations. And that is what budgets are likefor many smaller businesses. This wasteful way of using budgets overlooks important managerial objectives that budgeting canhelp achieve.

Growing Concerns presents a view of budgeting in this issue of HBR different from that presented in the May–June issue byJerry Viscione, who argued that managers of small ventures must pay particular attention to the targets they set whenformulating budgets. While not disagreeing that targeting is important, Neil Churchill maintains that budgets should beconsidered from a broader perspective. He views them as having two primary functions: planning and control. Managers mustdecide which function is more important and then resolve a number of formulation issues. These include the initiation process,implementation, the period covered, whether the budget should be fixed or flexible, and how it should be used to evaluateperformance. He concludes that large companies concerned about operational efficiency should focus on the coordination andcontrol aspects of budgeting while small and innovative companies should be concerned with planning aspects. Whatever thefocus, budget preparation and implementation are important in carrying out company strategy and in professionalizing thesmaller company.

I start my classes on budgeting by displaying two situations on the blackboard:

Then I ask the class, “Which budget is better, assuming in both cases that the manager gets the job done in time, that theend result is the same quality of performance and customer satisfaction, and that the manager doesn’t develop ulcers in theprocess of implementation?”

A heated argument usually follows. Most class participants eventually choose Budget 2 after being assured of equal results.A minority, however, hold out for Budget 1, which seems to them the “most reasonable.”

These opposing views come together when I ask, “Which would be best for borrowing money on a one-loan-a-year basis?” Inthis case, the choice is almost always Budget 1. And when I ask, “Which would be best for motivating performance?” themajority of participants usually select Budget 2.

As this example shows, budgets can be used both for planning (Number 1) and for control (Number 2), although the samebudget is not always optimal for both purposes.

Occasionally a company uses a budget with “stretch” in it for motivating performance—sales, for instance—and a more“realistic” budget for planning—expected sales, for example. More commonly, companies use the same document for bothpurposes.1 Large companies tend to use budgets mostly for control and smaller entrepreneurial companies use themprimarily as planning tools.

But no matter whether it is used for planning or for control, a budget is more than a forecast. A forecast is a prediction of whatmay happen and sometimes contains prescriptions for dealing with future events. A budget, on the other hand, involves acommitment to a forecast to make an agreed-on outcome happen.

Budgets come in several variations. Cash budgets are especially important to new and growing businesses, whereas capitalbudgets are widely used if capital expenditures are important and recurring. Human resource or “headcount” budgets (thecapital budgets of service companies) serve as means of control in labor-intensive companies. But generally when the term

Budget Choice: Planning Versus Control - Harvard Business Review http://hbr.org/1984/07/budget-choice-planning-versus-control/ar/pr

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budget is used, it refers to an operating budget containing an organization’s detailed revenue and expense accounts groupedeither by operating units, such as divisions or departments, or by products and product lines. Such a document is a centralpart of the management control system of many companies.

In preparing a budget, a company can proceed in a number of different ways. Some companies use a top-down and others abottom-up approach in budget preparation. Some revise their budgets quarterly and others never change them. Some useflexible budgets to evaluate managerial performance while others compare results against original estimates. These and otherdifferences in budget structures and processes largely determine the effectiveness of budgeting and whether it accomplishesmanagement’s objectives.

In this article I consider eight managerial concerns in preparing budgets (see the insert for a checklist of these). The concernsvary according to whether the company intends to use its budget primarily for planning or for control.

Planning Issues

From a planning perspective, a budget is the glue that makes the different parts of the organization fit together. It harmonizesthe enterprise’s strategy with its organizational structure, its management and personnel, and the tasks that need to be doneto implement strategy.

When well done, it translates the strategic plans of the organization and its implementation programs into period-orientedoperational guides to company activities.

Initiation and Participation

Who should initiate budgets? What should be the role of top executives? Should they start the process with tightly specifiedobjectives? Or should they set forth the basic planning premises, competitive assumptions, economic forecasts, and so forth,and then play a relatively passive role in formulating the budget? And what should be the role of operating managers? Shouldthey fill in the blanks of a tightly specified budget structure or take responsibility for initiating budget assumptions andcalculations?

One of the first issues to be settled is the extent to which budget formulation involves all management levels. Both thetop-down and bottom-up approaches have advantages whose importance varies in accordance with the nature of thebusiness and the company’s stage of development (see Exhibit 1).


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The top-down approach allows the owner-manager and others at the top to put forward their comprehensive views of theorganization and its economic and competitive environments. Top management knows the company’s goals, strategies, andavailable resources. Indeed, in a small company the owner-manager may be the only one with such knowledge as others arealmost totally involved with day-to-day operations.

Several situations call for a top-down approach—when business unit managers must be given explicit performance objectivesbecause of economic crises, when unit managers lack the perspective to participate in budget setting, and when the nature ofthe business requires close coordination between units. In these situations, the knowledge necessary for good budgetpreparation usually resides at a managerial level one or two steps above that of unit managers.

The bottom-up approach, on the other hand, makes use of operating management’s detailed knowledge of the environmentand the marketplace, knowledge that is available only to those who are involved on a daily basis. The more responsibility unitmanagers have for innovation, the more their inputs are needed in budget formulation, for they are best able to decidecourses of action and targets for their units. They know what must be done, where the opportunities lie, what weaknessesneed to be addressed, and where resources should be allocated.

Furthermore, a budget prepared at the level at which it is to be implemented is more likely to evoke commitment than oneimposed from on high. Moreover, only when unit managers contribute to budget preparation can they be held accountable forthe long-term performance of their operating units.

For companies requiring quick responses to competitive pressures, top-down budgeting can be disastrous. But companieswith a considerable degree of interdependence among operating units need top-down budget guidance for coordination.Perhaps this is why the extensively integrated smokestack industries have found it so difficult to adapt to the rapidly changingenvironment in which they find themselves. They may have to adopt a different set of budgets and other managementcontrols in order to prosper—or even to exist.

Implementation

Simple top-down or bottom-up approaches to budgeting are rare. The decision is not either-or but rather how much of eachtype of approach is appropriate.

Blending the overview of top management with the experience of business-unit operating managers presents a majorchallenge in budget preparation. A cyclical process whereby the initial budget formulation is done in broad terms, with detailsadded after everyone agrees on planning assumptions, can be quite effective. The cycle for companies without a strategic-business-unit (SBU) structure has six steps. (If the company has a SBU structure, a cyclical approach entails additional stepsinvolving SBU management.)2 These six steps are as follows:

1. Top management sets forth in broad terms, and sends to the operating-unit managers, an overview of the environment, thecorporate goals for the year, and the resource constraints.

2. Each operating-unit manager formulates in broad terms the unit’s operating plans, performance targets, and resourcerequirements.

3. Top management collects, combines, and evaluates information from all the operating units.

4. Top management assesses and revises targets and resource availabilities, and assigns preliminary estimates to eachoperating unit.

5. Operating unit managers plan their activities in detail, determine their resource needs, and prepare their final budgets,which are sent to top management.

6. Top management combines these unit budgets, tunes them where necessary, approves them, and sends them back to theoperating-unit managers for implementation.

This type of budgeting provides initial top-level input into the process and allows top management to retain overall control. Italso permits operating-unit managers to make contributions before detail has been built into the budget and before allmanagement levels are committed to estimates that no doubt will be revised anyway.

Timing


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Most operating budgets are based on the passage of time, with revenues and expenses related to calendar periods. In theuncertain atmosphere of start-up companies, the budget might better be related to important actions or events because theorganization often takes longer than anticipated to get products perfected, to land the first big order, or to get financing inplace.3 In other than start-up situations, budgets are related to time periods in the following way:

For budgets based on calendar periods, the length of the operating period is usually a month, although smallercompanies often prepare budgets for calendar quarters, particularly when they first begin the process. One commonvariation in monthly budgeting is dividing the year into thirteen four-week periods both for budgeting and reporting. Thisreduces inequalities in sales or production days between periods within the year and between similar periods inconsecutive years. There is no one best budget period or interval—the period should fit the needs of a company, in termsof its planning horizon, the difficulties of budget preparation, and the link of the budget to strategic planning.

The period covered can range from three to six months in very small companies to two or three years in large corporations.Operating budgets usually cover one year, although some companies also include a general forecast for the second year.Such forecasts normally do not involve the same commitment as operating budgets.

Budget preparation should begin as near the start of the period as possible while still allowing enough time to do athorough job. A participative process takes longer than a top-down budget. A small company using the top-downapproach might initiate the budget process one or two months before the start of the fiscal year, whereas a large companymight start six to nine months earlier. The more complex the company’s products, processes, and environment, of course,the longer the whole process takes. As companies grow and change the nature of their budget processes, they may findthat more time is needed for formulation.4

While small companies usually do not have formal strategic planning, this procedure may develop as they grow anddecentralize. In such cases, the longer the period covered by the operating budget, the closer will be its links to thestrategic plan and the greater the pressure to synchronize at least the first year of the plan with the budget. Moreover, ifthe budget and the strategic plan are prepared during the same time period, the links between them will be close. Usually,however, the strategic plan precedes the budget and the linkage is less pronounced.

Control Options

Large corporations with sophisticated formal planning systems use budgets extensively for control—first for coordinatingdispersed business units and later, for evaluating units’ performances. Small company managers have less need to usebudgets in this way since they control their businesses informally and personally.

But small companies also need up-to-the-minute planning since they must react to events. Having less control over theirenvironment than large corporations, they are more prone to seize opportunities than to make them. Thus, many of themstress the planning side of budgeting and revise their budgets while also rolling them forward on a monthly, quarterly, orsemiannual basis.

Rolling Budgets and Revision

Companies can choose to budget annually for the year ahead or opt for a “rolling budget” always looking ahead 9 to 12months. The latter system involves budgeting an additional quarter at the end of each quarter, and then adding this on to theexisting budget. As shown in Exhibit 2, on April 1, 1984, a three-month period, “Quarter 5,” is added to the 1984 calendaryearbudget to extend it to April 1, 1985. Another quarter is added on June 30, 1984. In this way, management always has atwelve-month budget at the beginning of each quarter.


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The advantage of a rolling budget is its coverage. As one company president stated in early 1983:

“We would have cut our inventories and production early last fall if we then had a budget that looked out into the first quarterof this year. As it was, we moved too late and it cost us a lot of money. That’s why we’re changing to a rolling budget as ofnext July 1.”

On the negative side, a rolling budget takes more of management’s time to prepare and, moreover, operations are disruptedfour times a year, rather than once, for planning.

Those who prefer rolling budgets argue that managers get better at budgeting with practice, and therefore need no more timeto do quarterly budgets than one annual budget. And, as operating managers should always be engaged in planning,budgeting four times a year is not a disruptive process for them.

While a company could have a rolling budget without revising its existing fixed-period budget, most companies that use rollingbudgets revise their budgets at least once during the year as they roll forward.

Budget revision, however, is a highly controversial issue. Should a company revise its annual budget during the course of thefiscal year as conditions change? Revised budgets are more accurate, since they embody the best knowledge available, butrevision makes a budget a rubber yardstick that cannot accurately measure performance or evaluate management.

Consider the budget program of Corcom, an electronics manufacturer with $30 million in sales and owning four plants, one inthe United States and three offshore. The company sells three-fourths of its products to American manufacturers of electricaland electronic equipment and the remainder abroad. For competitive reasons, it tries to maintain an inventory of finishedgoods of seven and ten weeks of sales. It uses skilled labor, and since it is subject to restrictions on layoffs and terminations,it is reluctant to vary production levels more than necessary.

Because of uncertainties in demand, Corcom cannot project revenues accurately very far into the future. It can only watchcarefully what is going on and try to react rapidly. It depends on forecasting and quick responses throughout the organization.

Management prepares an annual budget, composed of four quarterly budgets of thirteen weeks—the “original budget.” Everysix months it revises the annual budget for the remaining six months and adds on a new six-month budget—the “revisedbudget.” At the end of each month, it also prepares a revised forecast for the next 13 weeks, altering the existing quarterbudget when necessary, and adding an additional month. (For example, at the end of January, April is added to February andMarch to form a new quarter and estimates are revised, if necessary.) This becomes the so-called “current 13-week budget.”

Results are compared with both current and revised budgets and, since Corcom is a publicly held company, with the originalbudget for each quarter to see if a revision of the forecasts made to the financial community is necessary. Top managementalso compares current budgets to check the accuracy of planning assumptions and to see if operating units throughout the


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company are using the same common assumptions.

Both the president and the financial vice president of Corcom readily admit that having so many budgets creates confusion asto which one is most important in evaluating results. They hasten to add, however, that the benefits of having a detailed planfor action (the current 13-week budget) that is up-to-date and comprehensive and prepares managers to deal with a rapidlychanging environment far outweigh the ineffectiveness of their budget system as a means of control.

Companies like this electronics manufacturer, which are concerned with external developments and with seizing theopportunities that arise, use budgets mostly for planning, in order to have current thinking implemented throughout thecompany and to compare performance with plans. Large companies use budgets for annual planning and then for control toensure that operations go according to the original plan. On the other hand, a trade-off exists between continually revisedbudgets that permit innovation but are not effective in ensuring efficient operations, and rigid budgets that exert tight controlsover operations but hamper innovations.

Fixed or Flexible Budgets

Successful management through delegation requires a clear set of objectives for individuals responsible for the various tasksin an organization. These objectives can be production standards, sales quotas, or budgets containing estimates of the levelof production and the costs and revenues involved—all variables. Periodically, results are compared against estimates todetermine if corrective actions or revised plans are needed.

When fastchanging markets force small companies into such uncertainty that they seldom achieve even the most preciselycalculated sales and production forecasts, a flexible budget is a powerful tool for analyzing performance. This can separatethe effects of variations between actual and estimated costs, between actual and estimated revenues, and so forth. Forcompanies in uncertain environments, particularly those in manufacturing or distribution, the flexible budget is one of the mostimportant control tools available.

For an example of how it works, assume a delivery budget of $1,000 for a sales level of 200 units. If the delivery cost was$900 for 175 units, the budget would show a $100 delivery-cost underrun or favorable variance. But if delivery costs average$5 a unit, the company should have spent only $875 for 175 units—thus indicating a $25 unfavorable variance.

A flexible budget would substitute results in terms of units or services produced or sold for estimates; use estimated costs andprices, thus providing a standard of comparison; and compare results with estimates on a “flexible” basis, isolating variancesin terms of changes in costs, revenues, price levels, and use of resources. The advantages of a flexible budget are shown inthe Appendix.

Appendix : using a flexible budget

Consider, for example, a company with sales, fixed costs, and variable costs as shown in the table. Planned production is1,000 units, selling price $1 per unit, variable costs of manufacturing 35¢ a unit, and variable selling, general, andadministrative costs 5¢ a unit. Fixed costs include $250 in manufacturing and $150 in selling, general, and administration.Planned profit is $200.

As the table shows, selling prices and operating costs differed from those planned, with 800 units sold and profit reachingonly $95.


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An analysis of results using a fixed budget shows profit before tax $105 less than planned. Sales expenses were asestimated but variable manufacturing expenses were $50 less. The conclusion seems to be that all losses were due to adecrease in sales volume.

An analysis of results using a flexible budget shows that while the decrease in sales volume resulted in a $200 loss inrevenues and $120 decrease in profit before tax (comparing the original budget with the flexible budget), the company hadother differences between estimates and results. Sales revenues were $45 more than planned, variable manufacturingcosts were $20 higher than estimated for that production level, and variable selling costs were $10 more than estimated forthe actual sales volume.

A flexible budget can help management to identify problems since it isolates the effects of changes in sales volume orproduction level from other performance factors.

Bonuses Based on Budget

Most companies use budgets to evaluate, to some extent, managers’ performance. These evaluations result in bonusesbased on the attainment of targeted goals or on achieving a certain percentage of budget, with extra bonuses for exceedingestimates. While bonuses based on budgets can have positive effects, they introduce the possibility of “budget games.”Managers playing these games aim to influence the budgeting process by setting revenue targets low and costs high, thusmaking goals much easier to meet.

If control is the thrust of a company’s budget, evaluating and rewarding performance against estimates is appropriate as longas steps are taken to detect and counter budget games. To do this effectively, top management must have considerableknowledge of the activities being budgeted to determine the extent of any games and to take corrective action. Using thebudget as a basis for evaluation and compensation is very risky for managers who lack the requisite knowledge.

Managers should be wary of rewarding performance against budget in a new business or where an acquisition in a new areaof activity has been made. To use budgets for compensation, a manager must know the territory well.

If the major purpose of the budget is planning, then using estimates as a basis for compensation, by encouraging budget


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games, can detract from accuracy. For a successful planning budget, compensation should be based on other criteria, suchas current achievements compared with previous ones, profits, return on investment, or other agreed-on objectives. Justsetting goals and measuring their achievement is itself a powerful motivational force.

Evaluation Criteria

When using budgets to evaluate performance, top management must decide whether to focus on final net profit or only onthe revenues and expenses for which the business unit is responsible. Final net profit includes expenses that a businessunitmanager cannot control.

This problem is illustrated in Exhibit 3, where the performance of the managers of departments A and B can be judged onseveral levels:

Contribution to overhead and profit—the direct costs and revenues that each manager controls in the short run.

Department profit—contribution to overhead and profit less the fixed costs that are directly attributable to eachdepartment’s operation. The department manager may control these fixed costs either by deciding to replace equipment orto move to a new location or by increasing or decreasing the department’s use of a corporate resource such as a centralcomputer, legal department, or building space. In the latter case, allocations should be made, where possible, on apredetermined basis so that department managers can control use and costs.

Corporate profit—the final “bottom line” after all costs have been deducted, including costs over which departmentmanagers have no control and for which they have no direct responsibility.

In Exhibit 3, the department A manager exceeds budgeted sales by 50%, while the department B manager falls 50% behindthe sales goal. The entry entitled “Contribution to overhead and profit” shows the achievements of both department managersif budgeted volumes, costs, and prices are constant. If fixed expenses remain within budget, the departments’ profits rise andfall by the same amount as their contributions to overhead and profit.

If corporate profit is used to evaluate department management performance, however, the results are different. Becausecorporate overhead is allocated on the basis of either department sales or variable costs, department A’s profit before taxes is$20,000 higher than the budgeted sum, while that of department B is $20,000 lower. The higher sales of department Aincreased corporate overhead charges and reduced profits.

If a company uses incentive compensation, then department profit appears to be a better measure of performance thancorporate profit and operating managers are apt to perceive it as more fair.

Yet two arguments exist for using corporate profit. This is the measure used to evaluate overall company performance,particularly that of public corporations. Thus, the company’s control system should reinforce the importance of this measure,with budgets and bonuses reflecting the economic reality facing the company. This is important when evaluating a managerresponsible for a large or important business unit. The need for bottom-line orientation is not as necessary with first- andsecond-level supervisors and managers.

Moreover, when department, division, or product managers are evaluated and compensated on bottom-line profits, they areprone to question corporate expense allocations and thus exert a control on corporate spending.

How Tight a Budget?


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When individuals are given a goal that is a bit beyond what they initially expect, they will often accept the goal as achievableand then work hard to attain it. But if the goal is set too high, they will probably reject it as unattainable and perform poorly. Inbudgeting, then, a key question is how tight a manager can set a budget and still make it useful in encouraging goodperformance.

As the example at the beginning of this reading showed, the best budget for control may not be the best one for planning.This is particularly true if only one budget is used that has considerable stretch built into it. If a budget is revised, adjusted,and readjusted until it contains the profit top management desires, it can be useless or even harmful to the business bybreeding mistrust and insecurity among unit managers. There is a lot to be said for starting the budget process with anhonest statement of what those at the top see as the market and what performance they think is needed. There is also a lot tobe said for a corporate culture that encourages unit managers with knowledge of operations and opportunities to put togethera realistic budget that takes both long-and short-run considerations into account.

Unusual Uses of Budgets

In addition to the purposes previously discussed—planning, communicating goals, evaluating performances, and motivatingmanagers—budgets can be used to accomplish three other goals not normally associated with budgeting: delegation,education, and better management of subordinates.

Delegation is something that few owner-managers do well. When managers grant authority to other individuals to make andimplement decisions without obtaining approval beforehand, they need to be able to check that the results are what theywant. Without this feedback on performance, “abdication,” not delegation, is occurring.

A good budget is among the best means both for communicating instructions and for evaluating what is being done. A budgetcan support delegation better if the need for performance feedback is considered in its design and construction. The budgetshould carefully pinpoint delegated responsibilities. Its preparation should involve the managers who will assume authority toensure that they understand the objectives, think they are reasonable, and are committed to their attainment.

The educating effect of a budget is perhaps most evident when the process is introduced in a company. Operation managerslearn not only the technical aspects of budgeting but also how the company functions and how their business units interactwith others.

Budgets enhance the skills of operating managers not only by educating them about how the company functions, but also bygiving them the opportunity, and the spur, to manage their subordinates in a more professional manner. This aspect ofbudgeting is often overlooked because the budget is viewed essentially as a tool for the owners and top management of acompany. A business unit manager can use the budget, for instance, to encourage salespeople to think about their customersin terms of long-term strategic goals. The salespeople, in turn can use a budget as an excuse to call on their customers andtalk to them about their advertising needs and plans. Operating managers can, in their turn, use the budget as an excuse toaccomplish distasteful things. They can, as is often done, “blame it on the budget.”

A Powerful Tool

A budget is an important means of accomplishing an assortment of managerial goals. Budgets also have variousramifications, some subtle and some not so subtle. For maximum effect, keep the following in mind:

A budget is a plan.

A budget is a control.

It can guide corporate operations.

It can extend the reach of top management by supporting delegation.

It can coordinate company activities.

It can communicate company objectives and activities during its preparation and serve as a basis for communicationthroughout its term.

It can direct, guide, and reward operating managers and form a basis for performance evaluation.

It can educate company employees as to what is to be done and assist them in doing it.


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It can lead to “games” involving false estimates and other counter-productive behavior.

How it works depends on other management systems in place.

Its effectiveness depends on the way it is used by top management.

(See the Appendix.)

1. See M. Edgar Barrett and LeRoy B. Fraser, III, “Conflicting Roles in Budgeting for Operations,” Harvard Business Review(July–August 1977): 137.

2. See Richard F. Vancil and Peter Lorange, “Strategic Planning in Diversified Companies,” Harvard Business Review(January–February 1975): 81.

3. See Zenas Block, “Can Corporate Venturing Succeed?” Journal of Business Strategy (Fall 1982): 21.

4. For a discussion of the different stages of development of small companies, see Chap. 21, “The Five Stages of SmallBusiness Growth,” coauthored with Virginia L. Lewis, HBR May–June 1983, p. 30.

Mr. Churchill is Distinguished Professor of Accounting and Director of the Caruth Institute of Owner-Managed Businessat Southern Methodist University. He is an authority on corporate control and has written several previous HBR articles,the most recent, coauthored with Virginia Lewis, being “The Five Stages of Small Business Growth” (May–June 1983).

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1 Budget Choice