financial accounting 2

Mälardalen University

Academy HST

EFO023

Cost and Management accounting II 7,5 hp

Corporate Budgeting is Broken – Let’s Fix It

Inl 1: part 2 – 3hspCourse: Cost and management accounting II

Session: HT 2011Wang Shiyang 910209-8218Wang Manheng 920702-1867Gurbet Bedirhanoglu 870129-7445Wang Tong 920918-3046

Contact person: Wang Tong, [email protected]: Per Janze

mailto:[email protected]

Summary of the article

As seeing the title of the article, it’s easy to find out the main idea of the whole essay

—‘Corporate Budgeting is Broken—Let’s Fix it’. Nowadays, most companies use pay-for-

performance system but Jensen's essay points the corporate budgeting in some aspects may

tremendously matter to company's long-term profit. The first one is traditional budgeting

consumes a huge amount of time. However, the more important thing is it encourages

managers to lie and cheat.

Jensen points out that critical part of problem in pay-for-performance is bonus pay out when

performance reaches a certain level of target. And the bonus rises with the increased

performance until the maximum cap. When it was near the hurdle, mangers have an incentive

to accelerate the achievement of revenues. On contrary, when it reaches cap, managers will

transfer the profits into the coming year.

To deal with the problem, Jensen refers to adopt a purely linear bonus schedule. The bonus a

manager receives for a level of performance whether the outcome is beneath or above it. Such

linear compensation plan eliminates the incentives for executives to game the process. In

addition when using the model, some key consideration should be taken: the performance

measures used, the positioning and slope of the bonus line, and the setting of min and max

compensation levels.

Traditional Pay-for-

Performance A linear

compensation plan

compensation plan

Comparation





As what had been introduced early, Jensen reject the traditional budgeting model. It

encourages managers cheating and turns business decisions into elaborate exercises in

gaming. It's so-called Non-Goal-Congruent Behavior. That is consider a company whose

single performance measure is whether employees attain their sales quotas. If an employee is

avoided being fired and no other ways to demonstrate good performance, the employee might

alter his or her actions specifically in an attempt to manipulate a performance indicator

through job-related acts. This is known as gaming the performance indicator. Such as data

falsify and smoothing, a form of earnings management that occurs when individuals

accelerate or delay the preplanned flow of data without altering the organization's activities.

The damage went beyond the walls of individual companies, resulting from overstatement of

earnings and cash flows for many companies and an exaggeration of the extent of the good

times. Consequently, the cumulative effect is to exaggerate the economic weakness.

As for solution to this problem, a pure linear compensation plan, two additional points should

be made here. First, non-monetary rewards also have to be independent of budget targets.

Witch means incentive compensation plans including cash bonus, profit sharing, gain sharing,

stock options, performance shares stock, stock appreciation rights, participation units, and

employee stock ownership plans should be stop. All rewards based on actual performance.

Second, a linear bonus schedule need well control and attentive executives.

'As the of organizations and individuals measure performance send signals to all employees

and stakeholders about what the organization considers as its priorities. Thus need for

multiple measures of performance occur. If organizations choose performance measures

without careful consideration, no congruent behavior can occur'. Besides, when using

performance measures for individual managers, companies should establish a single, clearly

defined measure of overall business success. 'In additional to using multiple performance

measures, MACS designers have to expand their views of the kinds of performance measures

to use. In only past few years have managers become aware of the need for measures of

quality, speed to market, cycle time, flexibility, complexity, innovation, and productivity. '





The book also has some critics argue, which supports Jensen's point of view, toward

traditional budgeting model as follows: First. Reflects a top-down approach to organizing that

is inconsistent with the need to be flexible and adapt to changing organization circumstances.

Second. Focuses on controls(such as meeting the target budget) rather than focusing on

helping the organization achieve its strategic objectives. Third, Causes resource allocations to

be driven by politics rather than strategy-that is, political power in the organization drives

resource allocations rather than the strategic needs that drive traditional budgeting.

In summary, most organizations continue to use some form of budgeting to plan, allocate

resources, and coordinate organization activities.

Time value of money: the concept stating that amounts of money received at different periods

of time must be converted into their value on a common date to be compared. So we know

time has time value, and we believe it is better to have money now than in the future. As old

saying, bird in the hand is worth two in the bush. If they get more money at end of the year,

they could enlarge business in next year, company will make new corporate budgeting and

facility layout system. Because money has time value, we believe it is better to have money

now than in the future. As old saying, bird in the hand is worth two in the bush. If they get

more money at end of the year, they could enlarge business in next year, company will make

new corporate budgeting and facility layout system.

Formula: FV= PV*(1+r). So it is obviously, a lit bit more present value will get us lots profit

in the future.

Managers will do everything to satisfy their own best interest but not company’s. They may

lie to the company, make a high cost for hitting revenue target to fill the vacancy or put

“surplus” profit into next year. First, this action will influence company’s long-term asset by

reduce present value. Further more, waste labor, money, manpower, material, resource and so

on. Last but not least, company’s budget can’t tell people about company’s real situation. So

we had better abolish this pay-for-performance system.





When we mentioned performance system, we can’t forget BSC. Our group think this is

system can help us with the problem. The BSC- Balanced Score Card will build a strategy

map. BSC look forward to long-term design, future growth and profitability. BSC has four

perspectives: financial, customer, internal and learning and growth. BSC can avoid manager

shortsighted view. Make target and goal clear. Manager can’t just thinking about financial

they also need take care of customer and internal because it affect the performance.

Opinions and comments





Nowadays, most companies use the”pay-for-performance” system to measure manager’s

work as well as to pay salary and bonuses. As Jensen mentioned in his article ”A Linear

Compensation Plan” should replace the”pay-for-performance” system. The process of making

a corporate budget might be seen as a boring and tiresome task, but it is a very important part

of the company. Without a good process for setting out the budget the company can end up

making devastating losses. There needs to be a balance between manager’s interests of getting

bonuses and the ability to pay out salaries and the continuity of the business.

By using the linear compensation plan the incentives for employees to “cheat” can be

eliminated. A threshold for manager’s bonuses is created and more profits can be gained. In

our opinion an external department that supervises the executive’s actions should be put in

place. It can be a consulting firm or an objective organization with no real business interaction

with the company.

When using the pay-for-performance system managers are told that they will recieve bonuses

if they achieve certain goals. Two things can be predicted if companies decide to use this

system. First managers will try to set up low targets so that they easily can reach the goals that

they’ve set out. Second, they will do anything they can to achieve the goals no matter of what

costs, if it hurts the company’s interests or even damages its reputation.

These actions will lead to a dark and vicious circle that will affect a comanys budgeting for

the upcoming years. Of course it also depends on the goals that are set out for the company. If

goals are set out from the whole company’s best interests and with certain restrictions, such

negative trend can be avoided. The Linear Compensation Plan provides this and much more.





Documents

financial accounting 2