Week 1 Assignment (405)

▸ Introduction I n the real world, we often observe egregious examples of waste. Given the tools at our command, why do we, as consumers, often think that we are not getting our money’s worth? This belief regularly arises for goods and services not transacted in markets. Buyers do not purchase goods and services they think provide less benefit than other goods and services that could be purchased with the same money. When goods and services are free or heavily subsidized, the public often feels it is getting less than what it expects—shoddy products, poor service, and high costs. Health care and education are two prime examples of heavily subsidized goods. Issues with healthcare access, quality, and cost are routinely debated in public forums. Health-care spending is high because the federal government or private health insurance pays for medical services and patients see little need to reduce their use of care. Patients demand more frequent visits and intensive care because additional consumption often costs them nothing. Providers recognizing that higher prices do not significantly lower the demand for healthcare services have little incentive to control costs. Primary education, a service for which local, state, and federal governments provide the bulk of the funding, is criticized for high cost and declining student performance. These two industries, and the nonprofit and public organizations that inhabit them, respond to a different set of constraints than organizations that sell their products to nonsubsidized customers. This chapter explores how the flow of funds in input and output markets affects the demand for goods and services and organizational performance—employee desire to control costs.

After exploring the different external constraints on organizations, the roles of different personnel in the budgeting process are examined: Who in an organization looks out for the interests of society, customers or clients, resource providers (employees, stockholders, creditors, etc.), and/or taxpayers when market constraints are lacking? After defining budget roles, budget strategies are introduced and explored. Given that managers regularly seek to maximize their budgets, how do they present the best-possible case for more resources? Budgeting is a prime example of the old saying “Be careful what you wish for”; you get what you encourage, and it may not be what you want. Managers respond to the incentives budgets establish and take actions and pursue outcomes that enhance their salaries and status. The choice of budgeting systems, performance measures, and evaluation and control systems will direct employee attention to predictable ends. Senior management should ensure that the ends it desires are encouraged by the budgeting system employed. After describing the flow of funds and incentives within input and output markets, the particulars of the budgeting process, and commonly employed budget strategies, Part 1 concludes with a discussion of what a budget is and is not.

▸ The Flow of Funds in Market and Nonmarket Exchanges All organizations face similar constraints on success: they must satisfy customers or clients, resource owners (employees, stockholder/stakeholders, and creditors), and regulators. Satisfying these constituencies requires rational allocation of resources. Customers and clients want desirable goods and services delivered courteously and timely. Resource owners demand adequate returns on their investments, employees want

high wages, providers of capital want high interest or dividends, and suppliers of buildings and land want high rents. Regulators seek to increase public safety, limit pollution, ensure propriety in financial dealings, etc. Managers must allocate resources to meet these often-conflicting goals and satisfy competing constituencies. High prices would please resource providers but would displease, if not drive off, customers. Government programs that distribute free or heavily subsidized services make clients and resource providers happy but upset the taxpayers who pay production costs. Decisions must be made to determine what to produce and to what standard; how much to produce; how to produce it, including what resources to use; where production should occur; how to finance operations; and how to manage production processes. All of these actions must be taken within the constraints of the resources society is willing to pay to obtain the outputs of the production system. Organizations that cannot effectively manage their costs face the loss of customers or clients, restricted access to resources, and/ or government scrutiny. Increasing the value of for-profit organizations involves maximizing profits to build shareholder wealth. The first requirement for success and profitability in voluntary exchange markets is to produce goods and services people want at prices they are willing to pay. The second requirement is integral to the first: producing goods and services at the least possible cost to keep prices low, while maximizing the difference between price and cost. Maximum efficiency requires operating at the minimum average total cost or maximizing output from a set of inputs. Organizations that depend on voluntary transactions between them and nonsubsidized customers and compete with other producers for customers must be at least as efficient as their competitors. Managers and employees of for-profit organizations are driven by, evaluated on, and often compensated on profit; hence, personal interest and organizational goals are aligned in the pursuit of efficiency. Profits and value are maximized when

the price of the last good or service sold equals its marginal cost of production (P = MC) (FIGURE 3.1).

FIGURE 3.1 Flow of Funds: Market Exchange

Self-interest in voluntary exchange markets restricts the demand for goods and services and encourages efficiency. Customers, being simultaneously providers of resources (inputs), for which they are paid wages, interest, and rents, and consumers, who must pay for the goods and services they consume, have their conflicting interests balanced. As consumers, they want high- quality, low-cost products, low prices, and tight budgets; as

resource providers, they want the highest-possible wages, interest, and rents that is, high costs and loose budgets. The conflict between low prices and high compensation for inputs within a single group ensures that one group’s interest cannot be sacrificed to another—since they are one and the same. In input markets, laborers do not sell their labor for less than what they think it is worth and employers do not purchase labor at prices that exceed its worth (i.e., the marginal revenue product [MRP]). Similarly, the sellers and buyers of land and capital transact these resources at mutually agreed prices. In output markets, consumers do not purchase goods or services for more than they think they are worth. When organizations produce unwanted products or set prices too high, customers refuse to purchase and thus drive output and costs to acceptable levels. Resource providers may have to accept lower compensation or reallocate their resources to markets that are willing and able to pay more for labor, capital, and/or land. Opposing interests are balanced in voluntary exchange markets, and increasing the value of the organization requires producing goods and services at prices customers are willing to pay. The system results in mutually advantageous trade, customers believe the value of what they receive is greater than what they must pay, and producers/resource owners receive the best- possible return for their inputs to the production process. Customers and producers both must believe they benefit from the exchange, otherwise no transaction occurs. Checks over demand and incentives toward efficiency are disrupted when the people who pay for inputs and the people who receive outputs are not the same. The separation of consumption of outputs from payment for inputs weakens, if not destroys, the equilibrium in market systems and encourages excessive and inefficient outputs. Unlike the two parties in voluntary exchange markets, FIGURE 3.2 shows that there may be up to four distinct parties in involuntary or subsidized markets and the interests of resource providers, taxpayers, producers,

and clients do not balance: gains of one group come at the expense of other groups.

FIGURE 3.2 Flow of Funds: Involuntary and Subsidized Exchange

Major changes occur in the input and output markets, and self- regulation is weakened by divorcing payment for output from distribution of goods and services produced. The major change occurs in the output market, where clients may be able to obtain goods and services without contributing to their production costs and taxpayers may receive no benefit but are required to finance production. Medicaid recipients pay little if any taxes and have no incentive to reduce their consumption of healthcare services or concern for production costs. Medicare Part D provides a less extreme case, where patient payments accounted for 14.2% of program outlays in 2015 (Federal Hospital Insurance & Federal Supplementary Medical Insurance Trust Funds, 2016), but this contribution hardly encourages recipients to be conscientious in their use of pharmaceuticals. A subsidized client only asks, is a good or service worth what I have to pay to consume it? In the case of Medicare Part D, recipients obviously believe the $12.8 billion they pay for $89.8 billion in pharmaceuticals is worth it, but do taxpayers think it is worth the $77.0 billion they pay?

The second change is in input markets, where resource owners may or may not be taxpayers. If resource owners are taxpayers, they may be circumspect in how resources are used. But their interest as income recipients outweighs their role as taxpayers, and hence, they seek higher remuneration for their resources. If resource owners do not pay taxes, they would have no reason to seek or demand fiscal restraint over input payments or output. Korte (2014) reported 318,462 federal employees owed the federal government $3.3 billion as of September 30, 2013. The problem in the involuntary and subsidized exchange model is the small influence taxpayers have over the quantity of goods and services produced. Clients and resource owners have a direct interest in expanding the budget of subsidized operations: they are net beneficiaries (or winners) of expanding budgets. Resource owners want higher budgets because their incomes are directly tied to output: budget increases tied to higher wages, interest payments, or rents directly benefit resource owners. Expanding output also calls forth a need for more labor, capital, and land and may increase the prices of these inputs. The second group seeking expansion consists of subsidized clients. Expansion could occur by increasing the amount or quality of goods or services provided to current clients or increasing the number of people eligible for subsidized goods and services. The opposing interest in involuntary exchange markets is the taxpayers who provide the funds to produce free or below-cost goods and services. Taxpayers, being net benefactors (or losers) in this exchange, have an interest in restricting the quantity of goods and services provided and want output produced as efficiently as possible. Opposition to expanding budgets, however, must be made through the political process and must abide by the majority rule. Federal taxpayers amounted to only 29.9% of the total population and 65.3% of employed persons in 2013. Unlike voluntary market exchanges, taxpayers in involuntary markets cannot choose not to withhold their resources.

Nonprofit and public organizations, like for-profits, should strive to maximize the value of their organizations; however, complications immediately arise over how to define and measure value. Nonprofit and public managers often claim that ideas of value maximization are foreign and perhaps inappropriate for their operations. This belief may stem from a simple misunderstanding: these organizations serve broad constituencies and produce goods or services that are provided free or at substantial subsidies to their clients, but the idea of value remains pertinent. The question of value revolves around the question of the worth of the output, and defenders of subsidized operations argue that the nonmonetary benefits produced exceed the monetary value of the resources consumed. While it is true that not everything can be measured in dollars and cents, we are still left with the perplexing question of whether the value of a subsidized output is worth more than the resources consumed to produce it. The problem is that self-interest leads those who receive free or heavily subsidized services or whose livelihood depends on providing resources to nonprofit or public organizations to conclude that total benefit exceeds total cost. Clients receiving free goods or services, of course, think the outputs are worth more than what they pay. If subsidized clients pay 10% of the cost of a good or service, their calculation is simple: is the benefit received greater than or equal to the 10% they paid? Clients are generally unconcerned about where the other 90% is coming from to pay for the resources consumed by production. In tax-subsidized operations, there is an inherent incentive toward excessive and inefficient production. Expenditures on both Medicaid, an example of a free good, and Medicare, an example of a heavily subsidized good, have increased faster than the total healthcare spending or the U.S. economy. People (as customers, clients, or taxpayers) desire the maximum benefit from invested resources, but the problem in subsidized markets is to determine whose benefit is to be maximized.

Subsidized clients seeking the maximum benefit will demand more output as long as what they pay is less than the value they derive. Taxpayers who receive little from subsidized services may want to restrict output in order to reduce their taxes. Clients who do not pay the entire cost of the goods and services they consume and taxpayers who receive little or no benefit from subsidized services often cannot balance the cost and benefits of subsidized products, unlike customers in voluntary markets, who pay the entire cost of production and receive most, if not all, of the benefits of consuming a product. Failure to see both sides of production and consumption ensures non optimal resource decisions. It is easy to see that the total quantity of goods and services that could be distributed among the population is reduced when too many resources are used in production. But living standards are also reduced when too many (excessive consumption) or too few (insufficient output) goods and services are produced. Budgeting, by explicitly recognizing outputs, costs, and choices, should address the question of whether too many or too few subsidized goods are produced. The conflict over output and efficiency can be illuminated by considering an example of two hospitals. It makes a significant difference to society if the cost to treat a patient (assuming similar medical problems and outcomes) is $10,000 in one hospital versus $8,000 in another hospital. A budget of $100 million allows 10,000 patients to be treated in the high-cost hospital and 12,500 patients to be treated in the low-cost hospital. Society is better off when more output is produced from a set of resources; however, in the high-cost hospital, employees may benefit from receiving higher wages (and possibly doing less work) and patients may enjoy more amenities and services. Inefficiency in any organization reduces output, but the problem is that organizations whose revenues come from compulsory taxes are likely to produce less output than possible and have excessive costs. The societal problem is that fewer subsidized goods and services are available to consumers, and ironically, too many high-cost, low-value goods and services are produced.

Society could obtain greater value from another set of goods and services than what it receives from consuming subsidized products, or, in this case, overpaying for health care. Evaluating the performance of nonprofits and government agencies is more complex than for-profits because it is more difficult to identify the components of value: what is the value of a subsidized good that is distributed free? Cost does not establish value: the value of a product may be higher, lower, or equal to the cost of resources used to create it. The lack of a profit mechanism, an easy-to-measure metric that indicates whether customers believe the value of a good or service exceeds its production cost, requires another mechanism to guide resource allocation. In the absence of prices and voluntary exchange, budgets should guarantee that the value of an output is greater than or at least equal to its production cost. The differences between for-profit, nonprofit, and public organizations can now be highlighted. In for-profits, owners carry the risk of failure and enjoy the profits of success. The sources of funds in for-profits (ability to acquire labor, capital, and land and pay wages, interest, and rent) are equity, debt, and the sale of goods and services. The return on operations is total revenue less total cost. The demand for products comes from the ability of for-profits to produce goods and services that are desired by consumers at prices they are willing and able to pay. Failure to produce a desirable product at an acceptable price jeopardizes owners’ investments since there is no requirement that their products be purchased at prices that cover the costs. In contrast, the owners of a nonprofit hospital are the community. The hospital’s sources of funds are the sale of goods and services, debt, grants, and donations. Returns to the community include net income, uncompensated care, and higher-than- market wages paid to employees. Demand, rather than being based on desire, may be based on the need for medical care, and the inability to pay does not preclude patients from obtaining services. Nonprofit hospitals are often committed to providing charity care, and hospitals participating in the Medicare program

are required by the Emergency Medical Treatment and Labor Act (EMTALA) to provide emergency care. The desire and requirement to provide uncompensated care complicates the financial situation; hospitals must find other sources of funds to cover services for which they receive no payment. These funds must come from providing other profitable services, donations, or government grants. In public organizations, like public health and police departments, all the owners are citizens. Unlike a nonprofit organization, where nonusers of services may not have to provide any financial support to the organization, in public organizations, all taxpayers must provide support. Public organizations also access the debt markets for funds and pay lower interest rates because of their ability to tap taxes to meet debt obligations and the tax preferences given to state and federal interest payments. The demand for the output of nonprofit and public organizations revolves around the necessity of their services and the potential inability of for-profits to supply goods and services in the desired or optimal quantities because of externalities or the public-good nature of the output or a desire for income redistribution. For these reasons, there does not have to be a direct link between consumption and financing, as cash inflows supported by compulsory taxes may be unrelated to the production of goods and services. The returns of public organizations are often stated in broad terms, such as improving equity, maintaining order, and promoting stability. Controlling performance is difficult as the lack of a profit motive and mandatory tax support, in addition to being the sole provider of a good or service, undermines fiscal discipline (TABLE 3.1).

TABLE 3.1 Ownership Differences

For-profit Nonprofit Public

Organizations thrive by moving resources to the point where they generate the highest-possible value. This simple rule requires resources to be continually reallocated from low-value uses to those more highly valued by the public. The simple economic rule for profit maximization is that price (P) or marginal revenue (MR) should be equal to or greater than marginal cost (MC). This rule demands that the benefit of a good should exceed its production cost. While the benefit of consuming a good or a service does not have to be quantified in dollars to satisfy this rule, we still need to ask the question, is the value greater than, less than, or equal to the MC? Consumers regularly purchase goods and services where the benefit or return cannot be quantifiable in dollars. We may not be comfortable saying that the value of hunger is $3.99, but we can definitely determine whether we are willing to spend $3.99 to

Owners Stockholders Community All citizens

Sources of funds

Sale of output

Sale of output Taxes

Investment (equity)

Debt Debt

Debt Donations, grants

Sale of output

Returns Profit Net income plus community need

Equity and stability

Demand Ability to pay Ability to pay plus community need

Voting

purchase a Big Mac. Likewise, we all evaluate whether preventive health services are worth what we have to pay to receive them, even though it is commonly held that “you can’t put a price on health.” This belief implies we should be willing to pay any price for health care, which is clearly untrue. While “you can’t put a price on health” may apply to efforts to stop a patient from bleeding out, it does not apply with equal force to preventive care. Flu vaccinations, for example, may not create substantial value, given the possibility that unvaccinated individuals may not contract the flu, vaccinated individuals may contract the flu, the cost of contracting the flu may be a miserable couple of days, and there may be rare but catastrophic adverse side effects of vaccination. Although the Centers for Disease Control and Prevention (CDC) reports tens of thousands deaths each year due to the flu, the Statistical Abstract of the United States: 2012 documented only 411 deaths due to the flu in 2007. Individuals spending their own money evaluate the value of health against all other goods to determine whether they want health care or food, clothes, and entertainment. Customers make purchasing decisions to maximize satisfaction and purchase goods and services that they believe will provide them with the greatest satisfaction for money expended, that is, products most urgently wanted, given the budget. The resource allocation decisions of nonprofits are similarly made using a mix of qualitative (value ≥ MC) and quantitative (P ≥ MC) measures, that is, they may choose a mix of a few profitable programs where revenues exceed expenses and a few unprofitable programs that meet a community need. A nonprofit may consciously trade-off higher net income to provide needed but unprofitable community services. Organizations may choose to provide some essential, high-value services where costs cannot be recouped, and forego more profitable but less essential services. TABLE 3.2 categorizes and prioritizes programs by profitability and community need; it is understood that programs that provide high profits and meet

pressing community needs should be pursued first. Programs producing high profits are not urgently needed, and those with poor financial returns but meeting pressing community needs require greater consideration. Obviously, money-losing programs cannot be pursued if other sources of support are not available; hence, high-profit programs (whether urgently needed or not) must exist to support money-losing, high community needs. In the end, no organization can survive if its operating expenses consistently exceed operating revenues, unless it can obtain other, non operating sources of revenue to cover the deficit. Unprofitable programs that do not serve pressing community needs should be avoided if other options can be funded.

Budgeting should assist in determining the mix between profitable and unprofitable services. Profitable services are essential to ensuring that unprofitable but needed services can continue and the organization can operate and replace its equipment and facilities over the long run. A for-profit hospital may have a better net income than a nonprofit hospital by providing fewer community services (emergency care, charity care, etc.), but this is a single, monetary measure of value. It may be that nonprofit and public hospitals create greater value when value is measured as an improvement in health per dollar consumed or a lower cost per patient served. Of course, the opposite could also be true: a for-profit hospital may have a

TABLE 3.2 Program Mix, Profitability, and Need

Profitability Community Need

High Low

High profit Pursue Pursue

Low profit/ loss

Provide and offset

Avoid

higher net income and produce greater improvement in health per dollar expended than either nonprofit or public hospitals. A public health department providing free vaccinations may create more value per dollar expended than any hospital despite generating no revenue from the sale of its services. The least fiscally constrained and flexible organizations are government agencies. Public organizations are least responsive to changing tastes and preferences, that is, once started, government agencies are slow to adapt to a changing demand for their services. Often, government agencies provide a service for which there are no other suppliers and taxpayers supplying funds cannot withhold their support. The lion’s share of funding for public organizations comes from involuntary taxes, thus insulating their production process from market forces. The public organizations’ unresponsiveness to a changing demand arises from the small portion of their funds generated from usage fees. In public organizations, a declining demand for their goods and services may have little or no impact on their revenue, and they may not alter their processes or reduce output. A second complication is that public organizations often operate as income redistribution vehicles, taking resources from one group to give to another. Politicians and public agency managers may see it as desirable to take a dollar from high-income groups and give 80¢ or 80¢ of service to a low-income group and maintain that society is better off as the loss to the first group is less than the gain to the second. That is, lawmakers may judge that 80¢ of medical service to a poor person is worth more than the $1.00 tax on a wealthy person. It is impossible to transfer resources from one group to another without costs due to the expense of collecting revenue and administering redistribution programs (i.e., Okun’s “leaky bucket”). Transaction costs ensure that high-income groups pay more in taxes than other groups receive in goods or services. A final problem is that public agencies often judge their own performance: they decide how to measure their output and establish their own thresholds for

success. All of these things, as well as political oversight, produce systems where efficiency is not a major goal. A typical response to weakening demand in for-profit and nonprofit organizations is to cut back or eliminate services, but public agencies often do not respond this way. Public agencies often seem impervious to changing economic conditions because of the “iron triangle” (Rosen, 1988, p. 110). The iron triangle describes how the interactions of interested parties prevent resource reallocation and explains the difficulty encountered when people attempt to cut public budgets (FIGURE 3.3).

FIGURE 3.3 The Iron Triangle

The reinforcing interests of each party in the iron triangle (decision-makers, producers, and consumers) make it desirable to cater to and work with the other two groups. In the iron triangle, each group controls items of value desired by the others. Politicians want to be elected or re-elected; hence, they work to secure votes. An easy way to obtain votes is to campaign for and support legislation for increased spending and fight attempts to reduce programs and public sector payrolls.

Politicians expect that the returns from more government services to clients and more jobs and higher pay for public employees will be votes in their favor. Imagine a politician wanting to cut social security: the majority of senior citizens and social security administration (and federal) employees would vote against him or her. Managers of public agencies desire higher budgets (to secure their position, increase their power, increase their salaries, etc.) and, for that, cultivate relationships with clients and politicians. Expanded programs provide more benefits to clients and secure the support of politicians. Public agency managers have the power to withhold resources from politicians and clients who do not support them. Hence, an imaginary politician (one who supports reducing the size of government) may see poor service in his or her district, new government offices built in other districts, etc. Likewise, a client group that provides lukewarm support to an agency may see expansion of benefits for more supportive groups. Politicians and clients find it less risky and more advantageous to support an agency’s expansion than oppose it. Finally, clients want free or subsidized services, and politicians who do not cooperate in this pursuit lose votes and may be voted out of office, and uncooperative agency employees may face angry constituents, who might take their demands to their superiors, elected officials, and/or the media to press their case. The path of self-interest and least resistance leads public agencies to submit to, if not encourage, client and political demands in order to solidify political and public support for expanding public sector employment. In the iron triangle, there is no countervailing power: the providers of resources, taxpayers, who stand to lose from the expansion of operations, lie outside the triangle. The question is, how much will taxpayers tolerate before demanding changes in public programs? The problem taxpayers face is concentrated benefits and diffused costs: those who receive direct and large direct benefits from public programs fight hard to maintain the status

quo or increase the scale or scope of the programs. Taxpayers footing the bill may see the amount they pay as trivial and may be unwilling to devout significant time or energy into altering the current system. If 94.5 million individuals pay federal income tax and are concerned about an operation that costs the U.S. Treasury $3.7 billion, for example, sugar subsidies, the average cost per taxpayer is only $39.15—individual taxpayers will not see it as worth their time and energy to eliminate or reduce a program with a multibillion-dollar budget. The problem with sugar subsidies is that the majority of the cost does not come directly from the treasury but rather from higher retail prices, spreading the cost over 316 million people, a cost of $11.71 per citizen, while sugar producers receive, on average, $787,234 (Will, 2013). Groups in the iron triangle pursue different goals, but all recognize that achieving their particular goal is based on the goodwill and cooperation of the other two groups. Each group controls and is controlled by the other two groups. Few, if any, individuals within the triangle have an interest in reducing the flow of resources. Missing in this system is the consideration of opportunity costs: can new or existing funds be more wisely spent on other things? Part of the problem in the public sector is the ease of seeing what could be lost (benefits, jobs, and votes) and the difficulty in seeing what could be gained (greater value and higher efficiency). The outsiders, taxpayers, may not see what they will gain (and hence not lobby for resource reallocation), whereas the present beneficiaries see clearly what they will lose if their programs are reduced. There is also the simple problem of change; it is easier to look back than it is forward. Programs are routinely developed for a specific crisis. For example, sugar subsidies were a “temporary” program started during the depression of the 1930s, but the assumption of continuing need has not changed in the intervening years. The challenge for management and budgeting is to look ahead to determine what people will want in the future.

A second challenge is the inertia that afflicts most organizations; change agents fight uphill battles in attempting to alter systems in response to changes in the world. This is true in all organizations, but those that produce goods and services whose costs are not recovered by voluntary payments have the luxury of maintaining the status quo as the world changes around them. The World Bank (1995) held that in the absence of political desirability (a crisis and/or a change in leadership), political feasibility (the ability to purchase the support of opposition groups), and credibility (a reputation for keeping promises or restraints on reversing course), change would not occur in public organizations. Improvements in budgeting systems are needed to ensure that all organizations have incentives to minimize their costs similar to for-profits, whose revenues result from voluntary exchange with customers and battle with competitors to provide better and lower-priced goods and services.

▸ Budget Participants and Roles Developing a budget involves three basic functions: budget preparation, review, and approval (FIGURE 3.4). These three functions, and the people performing them, find themselves variously in concert and at odds, depending on and competing against each other. The budget goal, maximizing value, is more effectively served if preparers, reviewers, and approvers share a common goal and utilize one another’s strengths and knowledge.

FIGURE 3.4 Budget Functions and the Organization Chart

Besides knowledge of the operation being budgeted, managers preparing their budgets should be familiar with efficiency, bargaining, and program evaluation (i.e., the assessment of the need, design, and impact of a program). Rather than being an accounting exercise, budgeting should be a dynamic, forward- looking process to realize organizational or social goals in the most efficient manner. A budget should serve the organization’s reason for being, identify its objectives, define how those objectives will be pursued, and establish how performance will be evaluated. After the start of the fiscal year, the budget should provide a management guide (i.e., what is expected to be accomplished in the upcoming year), a tool to correct and improve operations, and a mechanism for measuring performance and establishing accountability. Budget preparation, review, and approval require that budgets be constructed in concert with different members of the organization, where each member has a different set of knowledge and responsibilities. If any member’s knowledge is omitted or a member shirks his or her responsibility, a non optimal plan will result. Each budget participant should supply accurate and relevant information and act in a manner that ensures what is best for the organization. This would be easy if goals were mutually reinforcing; however, budgeting processes must often navigate the conflict that arises when individual, department, and organizational goals are not the same.

Budget Preparation Department managers are tasked with constructing the financial plan of operation for the following fiscal year. The financial plan may be as simple as specifying a given dollar amount (e.g., $2 million) and leaving the resources and what is to be done undefined. On the other hand, the plan may require identifying (1) what is to be accomplished, (2) what resources are needed for success, (3) how much the resources should cost and (4)

providing a detailed plan that traces the dollar amount to a defined set of resources required to produce the quantified output. An operating manager’s primary concerns are departmental functions and customers or clients, whether they are the final consumers of a product or other members of the organization who use the department’s output as an input in another production process. Managers are responsible for designing and managing how the operations of their departments are performed. Deming (1982, p. 315) holds that more than 90% of problems and the possibilities for improvement are due to the system and that system performance is management’s responsibility. Managers should ensure their departments produce the output required by consumers and meet required quality standards. Managers should ensure consumers are happy with the output (what is produced) and the service they receive (how goods and services are delivered), while keeping expenses at or below the budget. Meeting all three objectives is easier with more resources, so the managers’ primary objective in budget preparation is to obtain the highest-possible budget. The managers’ performance is often assessed by whether they get the job done and whether they remain within the budget. Delivering consumer-pleasing products but overrunning the budget may be as unacceptable as not getting the job done but staying within the budget. Maximizing the size of a budget produces a curious mix of optimistic and pessimistic (or best-case/worst-case) thinking in managers. Estimates of anticipated output are often overstated, while pessimism rules over the capability of resources employed to justify higher resources. Managers underestimate what resources can produce, including employee productivity, while they overstate unproductive time, the need for supplies, maintenance on existing equipment and facilities, and the need for new investments. Each appraisal is designed to maximize resources (or reserve capacity) to guarantee that unanticipated

disruptions can be handled within the confines of the budget. Overstating of resource needs should be expected, as incomplete work is more noticeable than padded budgets. Constructing an operating plan from scratch (see Chapter 5) is difficult because of all the variables that must be considered, and consequently, most budgets are built from past budgets or current performance. Budgets typically reflect where an organization has been rather than where it hopes to go. Future expenses are routinely based on past resource consumption and the anticipated prices for those resources in the following fiscal year (i.e., incremental budgets; see Chapter 6). Using past performance as a base for estimating future expenses simplifies budget calculations and plays into the mix of optimism and pessimism used in budget construction. To maximize budgets, managers assume few, if any, resources will be freed up or rendered unnecessary if output declines. This type of expense is a fixed cost, and given this assumption, the budget should be stable despite projections of falling output. On the other hand, when output is expected to increase, all expenses are classified as variable costs to obtain large budget increases. While unwarranted budget maximization is wasteful, it is consistent with the managers’ self-interest. A manager’s job is to complete the tasks assigned, and the primary concern is not alternative resource uses. A manager’s goal of maximizing the budget produces competition between departments and divisions, and it is the budget approvers’ job to ensure that this competition allocates resources to their best uses. A manager’s job should be to maximize the value of the organization, and managers should strive to increase output and reduce costs in order to demonstrate why budget increases should flow to their departments rather than other areas. Should a manager maximize his or her budget or lower costs? Although these goals appear to be in conflict, they are not a contradiction; a budget should be maximized if, and only if, it provides greater benefits than alternative resource allocations.

The role of the budget approvers is to evaluate alternatives and ensure resources are allocated to the best uses. On the other hand, a budget can be maximized without providing corresponding benefits, that is, one can simply increase costs without providing any service (i.e., featherbedding). The production of high-cost, low-benefit output should be a short-run phenomenon; it should only continue if the organization lacks competition and has a management team that does not or cannot weigh value and costs. The review and approval processes should supply oversight to determine where resources produce their highest value.

Budget Review Finance is charged with monitoring and controlling the financial health of the organization. The primary budget job of finance is to ensure that planned expenses are equal to or less than anticipated revenues, or can the operating plan be achieved with available resources? When budgeted expenses exceed revenues, finance must make senior management aware of monetary constraints and push them to develop a new plan with lower expenses, higher revenues, or both. Managers often see a conflict between their goal of getting a job done and their view that finance simply wants to maximize profits by starving departments of resources. While this conflict may be real in some cases, it does not negate the fact that managers often seek budget increases that add little to the value of the organization. When unwarranted expenses are requested, the budget office has the unen-viable duty to call the expenses into question. Finance is responsible for reviewing budget requests and asking tough and sometime impolite questions: Is this expenditure needed? Can the expense be reduced? Are existing resources used effectively (or can more output be produced from existing resources)? Senior management and division directors are responsible for reviewing their subordinates’ budget requests. A narrow view of this duty is to ensure that their areas of responsibility obtain all

the resources they want. Reviewers at the division level should understand the broader issues facing the organization and be willing to forego resources if the funds could produce higher benefit in other areas. To encourage this broader view, senior management compensation should be partially based on the overall performance of the organization versus solely on the performance of the divisions. Like operating managers, vice presidents (VPs) and division directors should be expected to be partial to their own areas and interests. While attempting to maximize their divisions’ budgets, self-interest should lead the senior managers to ensure the best- possible allocation of resources within their areas of responsibility. VPs and division directors may be willing to see resources reallocated within their divisions or between their departments, but we should not expect them to eagerly accept resource shifts from their divisions to other divisions. In the contest for resources, senior managers generally can be expected to make the best case for own areas’ budget requests and forcefully push back any attempts to reduce their budgets.

Budget Approval At the budget approval stage, there should be a pronounced shift from a division or departmental perspective to the organizational view. Those approving the budget are responsible for the entire organization, and they should balance the conflicting, parochial interests of their subordinates. The primary player in approving the budget is the chief executive officer (CEO) or president. CEOs are responsible for, and therefore should be evaluated on, the overall performance of the organization. A CEO should establish global priorities and direct resources to uses that produce the greatest benefit for the organization. When budgeted expenses exceed revenues and program cutbacks are required, we cannot expect VPs, division directors, or operating managers to scale back their operations; it is the job of the CEO to determine when cutbacks are needed, which programs receive funding, and which do not. This is an

unenviable task, but it is the duty of the person sitting at the head of an organization. Likewise, when additional funds are available and multiple claims are made, it is the CEO’s job to determine which of the emerging opportunities should be funded. The final stop in the process is approval by the board of directors (or legislature for government agencies). The role of the board is typically thought to involve setting strategy, hiring, assessing, setting compensation, removing the CEO (when necessary), and approving budgets. On the other hand, many think that the board does not play an active role in management in for-profits and nonprofits. The text follows the “what the board should do” model versus “what boards actually do” and assumes that board members play an active role in planning and budgeting. The role of board members (or legislators) is to represent their constituents. In the private sector, board members typically include business leaders, members of the executive staff, employee representatives, and outside directors representing the larger community. In the public sector, the focus on particular constituencies is clear when we observe that a legislator takes a vastly different position on issues of spending and taxes according to who voted the legislator into office. In the private sector, the role of the board parallels the role of the CEO; board members should focus on increasing the value of the organization regardless of whether this means maximizing profits or benefits to the community. Board members have a legal duty to protect the organization. For example, Worldcom and Enron directors had to pay $18 million and $13 million, respectively, out of their own funds to compensate investors for the frauds carried out at these institutions. The author doesn’t expect directors to be sued as a result of constructing a poor budget. Worldcom and Enron are examples of the worst-possible misconduct by management, but they highlight the fact that directors should not shirk their responsibilities of assessing management and establishing the direction of organizations. The usefulness of the budget is determined by how well each party fulfills its role. Operating managers, finance, and the CEO

and the board must bring to the budgeting process their expertise on production processes, financial constraints, and goals and customers. The final budget should advance the best ends and find a proper balance between alternative resource uses. This requires determining what should be produced, how it should be produced, and who will receive the output. Answering these questions requires navigating the contentious issues of what should be funded and what will be foregone, what should be produced, and who should be served and making sure that enough, but no more than are needed, resources are committed to a production process.

▸ A Budget Construction Calendar and Overlapping Budget Cycles Budget construction typically starts 6 months before the beginning of the following fiscal year (or 6 months prior to the end of the current fiscal year) to provide sufficient time to perform all the necessary budget-building tasks. Multiple months are needed to allow for budget preparation, review, and approval and to obtain participation from employees on the department floor to the C-suite. The process should begin with a set of programs detailing what senior management expects to accomplish in the upcoming year, including the type and quantities of output to be produced. Defining programs is the responsibility of senior management and/or planning. The budget office then develops a budget package, including instructions, forms, inflation forecasts, and output estimates, for distribution to department managers. After receiving the budget package, managers may receive a month to complete and return their budgets. After managers submit their budgets, the budget office compiles the master

budget by aggregating the department budgets to determine total expected revenues and expenses for the organization. If total expenses exceed total revenue, the department budgets may be returned to the managers for reducing expenses or to planners for reducing the scope of programs. The assessment of feasibility and the revision process may occur multiple times; hence, an early start is needed to ensure that the final budget can be completed before the start of the following fiscal year. Once the revenues and expenses are reconciled, the budget is sent to senior management and the board of directors for approval. FIGURE 3.5 shows what budget work is needed, when it should occur, and which party is responsible for the task.

FIGURE 3.5 Budget Construction Schedule

Budget construction is the prospective phase of the process, and despite the fact that the concurrent and retrospective phases follow sequentially, organizations and operating managers have to operate in different budget phases at the same time. Managers may have to prepare the upcoming budget while executing the current budget and reviewing the results of operations of the previous fiscal year. A single budget cycle may require 24 months to complete from initial budget preparation through the final performance evaluation. FIGURE 3.6 highlights the three budget functions and how they overlap in a single budget year. The preparation phase often begins 6 months prior to the start of a fiscal year and lays out the budgeting process, specifies resource needs, reconciles planned

expenditures with expected revenues, and obtains necessary approvals. For example, in July 2016, the 2017 budget cycle begins with projections of programs and output from senior management, continues with the distribution of budgeting instructions and forms, and culminates with the approval of the final budget before the end of the year. The facilitation and control phase for 2017 spans from January to December 2017 and includes implementing the budget, managing the budget (modification of resource consumption according to output and/ or environmental changes), and performing monthly analysis of variances. The final phase, evaluation and accountability, begins after the budget year is completed and accounting records finalized. Finalizing the year-end income statement and balance sheet for 2017, for example, may take a month or more, and assessing performance, the retrospective phase, could continue through June 2018. The complete 2017 budget cycle, highlighted in Figure 3.6, may, thus, last from July 2016 through June 2018.

FIGURE 3.6 Overlapping Budget Cycles

The overlap of evaluation of the prior budget and execution of the current budget in the first months of a fiscal year and the overlap of execution and estimation of the following year’s budget in the final months of a fiscal year show that managers, senior management, and the budget office have to work in two

budget cycles at the same time. If reviews of prior budgets require more than 6 months to complete or budget preparation begins more than 6 months before the start of a new fiscal year, managers may find themselves working in three budget years at the same time. Working on two budget years at the same time may be confusing, but it is easy to see that understanding the prior year’s performance (e.g., fiscal year 2016) may provide insight into how current operations (fiscal year 2017) should be managed and that understanding performance in the prior and current years should inform the construction of the 2018 fiscal year budget. It is worth repeating that only when the budget is seen as a dynamic instrument to understand, control, and plan operations will organizations and managers reap the rewards of effective budgeting. If budgeting is treated as a one-time exercise to estimate expenses, where the results of one year are not utilized to improve current operations or plan future actions, the value of budgeting will be largely lost.

▸ Budget Strategy Resources are valuable, and their control is always a source of conflict. Conflict is widely regarded as regrettable, if not outright undesirable, but many great thinkers believe that conflict can produce the best-possible outcomes. Conflict and competition are constructive and beneficial when they ensure that resources are employed in their most productive uses. In economics, competition manifests itself as rivalry between firms attempting to attract customers by producing better product or reducing the price below that of other firms. Competition among organizations benefits consumers. James Madison, in The Federalist No. 51, notes the necessity of competition in political systems and that “ambition must be made to counteract ambition.” His vision was to divide the government and set the executive, legislative, and judicial branches of the government in competition with each

other to ensure the rights of citizens. If one branch of the government should attempt to overstep its constitutional duties, it impinges on the authority of the other two branches. Madison expected that each branch would jealously protect its prerogatives and prevent transgressions by the other branches, while it itself is also held in check. Budgeting is a similar, though smaller, version of a system of checks and balances. All organizations, whether for-profit, nonprofit, or public, have limited resources. Within organizations, managers are expected to strive for the maximum amount of the limited resources available, and resource grabs should be countered by those who will lose if another department or division obtains a large budget increase. The managers, directors, and VPs whose departments stand to lose resources should question why others need additional resources. They should ask what end the additional resources will serve, whether the end is more important than other things the organization is doing or could undertake, and whether present resources are being used effectively and efficiently. Every manager should be prepared to respond to these questions when his or her request for more resources is challenged. The role of the CEO and/or the board is to adjudicate conflicting resource claims and ensure resources flow to the areas that create the greatest value for the organization. The difficulty in expanding a budget “beachhead,” grabbing a greater share of the organization’s resources, will hopefully produce a system where only truly worthy undertakings survive the gauntlet. Unfortunately, the idealist view espoused by marginal decision- making and competition for resources is regularly supplanted by the managers’ desire to maximize their budgets. The choice of a budgeting system establishes incentives, and a poor choice leads directly to budget maximization rather than value maximization. Rosen (1988, p. 110) notes that the unwritten rule of the Congressional Ways and Means Committee was not to question the budget requests of other House members. In return

for not questioning others’ budget requests, the members do not question yours; this trade-off negates competition and leads to bloated, non value-maximizing budgets. Brickley, Smith, and Zimmerman (1997, p. 27) recount how Soviet lighting manufacturers were compensated on the basis of the total weight of lamps produced. The use of a weight-based performance measurement system resulted in manufacturers producing the heaviest lighting fixtures possible because it was easier to meet production goals (measured in kilograms) by producing fewer and heavier fixtures than more lightweight lamps. In the end, chandeliers were produced, which were so heavy that they pulled down ceilings. Similarly, Moscow taxi drivers were compensated on the mileage driven, and to maximize mileage (and their pay), the drivers ran empty vehicles up and down the highways rather than transporting fares through busy Moscow streets. The mileage-based compensation system completely failed to achieve the desired results of transporting people, but mileage was maximized because higher speeds could be maintained and little time was wasted picking up or letting off passengers. Bureaucrats everywhere recognize that people need incentives, yet they fail to see that their evaluation measures and compensation systems lead directly to actions that reduce rather than increase value. Unintended negative consequences are obvious in retrospect, yet we do little to train people how to anticipate predictable ill effects before systems are put in place.

Winning the Budget Game The predictable consequence of implementing a budgeting system is that managers attempt to secure the greatest amount of resources they can and win the budget game. The obstacle to resource maximization is that this end must be pursued in a system where everyone else is pursuing the same goal and is inclined to see another’s gain as his or her loss and vice versa. The author does not advocate the following actions but rather

reports what happens versus what should happen. There are three simple rules for maximizing a budget: Rule #1: Always request more resources than you need. In the budget game, give-and-take is expected; managers should build excess resources into their initial expense estimates and plan to give back in the budget negotiations funds that were not needed. When budget requests are overstated, budget reductions can be achieved pain-lessly; that is, it is better to cut “fat” than “muscle,” but if there is no fat in your budget, you may have no other choice than to cut muscle. Rule #2: Be prepared and present the best-possible case for your budget request. When requesting resources, managers should present the best- possible case to ensure favorable reception by reviewing and approving personnel. Know your audience; understand its goals; prepare a clear presentation, including graphs; highlight critical points or changes from the past; anticipate questions and provide support, as needed; and summarize key points in your conclusion. The last thing a manager wants is to have his or her competence questioned because of a poor budget presentation. Questions of competency give birth to increased scrutiny of budgets and performance. It is better to be prepared and project competence than to be forced to defend past and current performance and the necessity of future budget requests. Rule #3: Always spend your entire budget.* Once a budget is approved, it should be completely spent, as most budgeting systems unfortunately discourage cost reduction and thrift. If a manager does not spend all the money budgeted in a year, he or she will probably receive less funding in subsequent years. Senior management and finance assume that unspent monies prove that a department did not need the funding provided and that resources should be reallocated in future budgets. Using the same thought process (see the footnote), if managers overspend, they “prove” that more money was needed and that

their departments should receive higher funding in subsequent years. Many organizations employ this perverse incentive: managers receive fewer resources (are punished) for holding costs down and receive more resources (are rewarded) when costs go overbudget. The primary objective of many managers is to maximize their budgets. The benefits flowing from a large budget include higher prestige, greater power over resources (the ability to hire, select suppliers, etc.), and potentially an increase in one’s compensation. There is nothing inappropriate with large budgets unless they supply more resources than necessary to complete work. Given the pecuniary advantages accruing to large budgets, managers have multiple reasons to seek the largest-possible amount of resources. The budget review and approval processes should prevent individual managers from undermining the larger goal of maximizing the value of the organization. Besides an increase in prestige, control, and income, managers also request more resources than they require because it is easier to manage with a cushion than when one has only enough and no more resources than are necessary to produce the expected outputs. Budget padding is a time-honored tradition. In some cases, excess resources are mandated to provide reserve capacity in emergencies, and more often than not, managers simply want the security that budget cushions provide. Just-in-time inventory systems are similar to tight budgets in that both signal when resources are being used inappropriately. In just-in-time inventory systems, only enough supplies are held to complete a planned production run. As the production run approaches completion, additional material should be delivered by suppliers—the Kanban system. If supplies are misused, damaged, or stolen, the loss of resources will not allow the planned production run to be completed. The consumption of more resources than necessary alerts managers to the fact that the production system is not working as it should. This information motivates the managers to identify the problem and

restore the system to optimal performance. A tight budget performs the same role: if the minimal level of resources is budgeted for a fixed amount of output and this output is produced but at a higher-than-expected cost, it indicates problems. The challenge of operating at maximum efficiency may be one that managers and employees would rather avoid. Inefficient budgets also arise from managers’ attempts to please employees, customers, or clients. It is important to recognize that one person’s cost is another person’s income and that a budget is an income and product distribution mechanism; employees want higher wages and lobby managers and the organization for higher compensation. Salary increases are one tool managers have to motivate and keep their employees happy (Herzberg categorizes money as a maintenance factor capable of making employees dissatisfied but ultimately unable to motivate them). Higher salaries for subordinates also provide a compelling reason for managers to seek raises for themselves. On the consumption side, customers or clients want more and/or higher-quality outputs, especially when others pay the additional production costs. Managers could request more or better-skilled employees to improve output or increase timeliness, purchase higher-quality supplies, and/or provide more luxurious or customer-friendly facilities. The question that again arises is, at whose expense? In markets relying on voluntary transactions between buyers and sellers, the drive for more and better products or facilities is tempered by the realization that customers must pay for increases in quantity or quality. While some people are willing to pay the additional expense to shop at Macy’s or other retailers providing more personal service, it is clear that more shoppers prefer the less luxurious facilities and lower-priced merchandise of Walmart. Clients receiving subsidized goods and services, however, will be more adamant in their demands, since the cost of expanding the output or service or improving facilities will be paid partially or entirely by others.

When goods and services are sold in voluntary exchange markets, increased costs arising from higher input prices, increased output, and/or higher quality (without higher productivity) must increase the price to the consumer. Demands by workers for higher wages or by consumers for more output or higher-quality output are moderated by the knowledge that these costs must be paid through higher prices. The problem that arises in nonprofit and public organizations is that the people receiving the benefit and those paying for the resources used in production may not be the same. Subsidized consumers will attempt to overconsume products when production costs are partially or fully paid by others (i.e., moral hazard). Consumption of healthcare services among the elderly and the poor whose costs are primarily paid by workers is a prime example of the iron triangle and moral hazard. Politicians seek expansions in public financing of health care to capture votes of the elderly and the poor, healthcare workers see an expanded demand from these groups as a means to increase their incomes, and the elderly and the poor receive additional goods and services subsidized by others. All three groups benefit from expanding healthcare budgets, and taxpayers are left with lower disposable incomes. Public financing of health care succeeds because of concentrated benefits and diffused costs. The elderly, the poor, the healthcare industry, and politicians have a direct interest in expanding medical coverage and work for its realization. Taxpayers pay hundreds of billions of dollars a year to support Medicare and Medicaid, but this cost is diffused over tens of millions of workers. Taxpayers do not see it in their interest to actively oppose Medicare or Medicaid expansion, as the cost of opposing expansion is greater than the anticipated increase in taxes. Further undermining opposition to the expansion of government programs is the use of debt financing. In an era of trillion-dollar federal deficits, taxpayers have less incentive to oppose expansion of government programs. Since the programs are

funded by selling treasury bonds, they can be expanded, and taxes do not increase as costs are passed to future generations. The costs of federal programs today are not fully paid by the current generation; future generations, including those too young to vote and the unborn, have been co-signed to satisfy the debt. The point is that budgeting in nonprofit and public organizations substitutes for the role of a market and should ensure that resources are used intelligently, that is, the value of what is created should be greater than or equal to the value of the resources consumed in the production process. Budgeting should equate the total costs and total benefits of an operation and be concerned with who pays. Economics seeks Pareto improvements, that is, reallocation of resources that make one or more persons better off without making anyone else worse off. At the point of Pareto optimality, no resource reallocation can occur without reducing another’s well-being. Before any program is implemented, we should be certain that the benefit to one group (the consuming group) exceeds the cost imposed on another group (the payer group). The next section reviews budget strategies recognizing that individuals’ incentive to maximize their budgets and the organizational goals of maximizing output from a set of resources may not be in concert. Knowledge of the various strategies to increase or defend a budget can be used to protect value-adding activities or to prevent excess and unnecessary resources from being reallocated to better uses. Like all tools, budget strategies can be used for good or bad ends: they can support the efficient allocation of resources or be employed to maintain or expand nonproductive resources.

Economic Reasons for Budget Increases Budgets should increase with changes in the environment that are beyond the control of managers and that increase the cost of producing the expected goods or services. Change is constant,

and organizations simultaneously face factors that increase and decrease the cost of production. The discussion in this section assumes for the sake of simplicity that only one change arises at a time and there are no countervailing events. Managers attempting to maximize their budgets will make budget reviewers and approvers aware of changes driving costs higher, such as increases in input prices, output, production technology, and product standards, while withholding information on cost- lowering changes. Higher Input Prices Budgets are typically constructed using current expenses increased for anticipated increases in resources prices (the change in the consumer price index, producer price index (PPI), or another measure of inflation). As input prices increase, budgets have to grow at the same pace to enable the organization to purchase the same set of resources and produce the same output. The problem (as well as a budget-padding opportunity) is that not all prices change at the same rate. Managers should be knowledgeable about specific price changes for the major inputs used and use this information to maximize their budgets. For example, the PPI in April 2017 (Bureau of Labor Statistics, 2017)) showed that all commodities increased in price by 5.3% from the previous year; however, fuel and related products increased by 17.6%, while healthcare services increased by only 1.7%. The use of the all-commodity increase would dramatically understate the rate of change in fuel and related products and their budget. On the other hand, the price increase for all commodities would overstate the increase in the price of healthcare services. If specific input prices are expected to increase faster than general inflation, managers should ensure that their budgets increase at the specific rate. On the flip side, if the prices of major inputs are less than general inflation, managers may want to accept the average price change and thus introduce an element of fat into the budget. Increased Workload

Increases in the demand for the output produced, for example, a 5.0% increase in output, will require more inputs, and the budget should be augmented for the increased amount of inputs expected to be used, in addition to any anticipated increase in input prices. Expected increases in output provide another opportunity to pad the budget: a 5.0% increase in output should not produce a 5.0% increase in expenses, given the existence of fixed costs. Budget allocations should increase only to the extent that variable costs increase with higher output. On the other hand, when demand and output fall, managers do not voluntarily forego resources but wait to see whether others will identify and attempt to reduce their budgets. When others note that the falling output should translate into fewer resources, managers often argue that their costs are fixed and, thus, no reduction is appropriate. Cost Increasing Change in Production Technology Changes in production processes are often introduced to reduce costs. The classic case of cost-reducing technology is Henry Ford’s introduction of the assembly line in 1913 (Ford, 1923). Before the assembly line was introduced, chassis assembly took 12 hours and 28 minutes; after its introduction, it took 1 hour and 33 minutes. Ford responded to this leap in productivity by increasing employee wages and reducing the price of the Model T. Health care is a prime example of the introduction of cost- increasing technology. The decline of simple X-rays in favor of magnetic resonance imaging (MRI) increased costs for the same number of tests. MRIs produce higher-quality images, and hence, it may be argued that the output is better. But the point remains that health care, as opposed to other industries, often adopts cost-increasing technology. Changes in production technologies often lead to greater productivity and lower costs and again provide an opportunity for budget padding. A budget-maximizing manager would withhold information on cost-saving advances to

appropriate those savings rather than letting them flow to the organization or its customers. Pollution control regulations are a second example of cost- increasing technological change, Greenstone, List, and Syverson (2012) estimate that air quality regulations add roughly $21 billion annually to the manufacturing sector’s costs. Change in Output or Quality Improvements Budgets should increase with changes in product features, such as improved appearance or expanded functionality and improvements in quality, that increase production time or require more qualified and higher-paid staff and/or better supplies and equipment. Again, changes may run in the opposite direction, and the substitution of cheaper components in a product or the acceptance of lower quality (less durable, etc.) would permit budget reductions that a budget-maximizing manager would ignore in his or her budget estimates. Budgets should only increase when changes in the environment increase production costs. Legitimate or real reasons for higher budgets include higher production process, expanded output, cost-increasing technology change (often driven by regulation), and improvements to products. On the other hand, any of these factors moving in the opposite direction should translate directly into smaller budgets. Managers can be expected to identify factors that justify a higher budget and to ignore cost-reducing changes. The outcome will be higher budgets as budget approvers are at an information disadvantage in identifying cost- reducing factors.

Political Strategies to Increase or Defend a Budget As opposed to legitimate reasons for higher budgets, there are a myriad of strategies employed to unnecessarily increase a budget or prevent budget reductions. The first set of strategies includes all-purpose strategies as their intent is to preclude

budget scrutiny by cultivating defenders, developing the confidence of budget reviewers, and/or obfuscating department operations. The second set of strategies, offensive strategies, is employed to secure larger budgets, and these strategies are built on overstating the need for outputs and/or production costs. The last set, defensive strategies, is designed to prevent budget reductions during periods of austerity and include delay, responsibility shifting, and increase in the real or imagined costs of budget cuts. All-Purpose Strategies All-purpose strategies can be relied upon to seek additional funding or prevent budget cuts. All-purpose strategies are designed to lift a budget above scrutiny. Resources are valuable, and astute managers should never be complacent nor should they assume that current funding levels will persist. Dynamic and dramatic changes can affect the resources an organization or department will be able to call upon to fund its expenses and produce goods or services. Astute managers act to ensure that new funds flow their way, funding reductions are aimed at others’ budgets, and demand (or need) for their goods and services grows. Cultivate a Clientele and Advocates. This calls for increased funding or exemption from budget reductions. These requests coming from managers are seldom given complete consideration, since they originate from people with a stake in higher funding and represent a small number of people. Astute managers know that greater consideration is accorded to requests coming from external parties, typically consumers of the output produced, and the weight given to the request increases with the number of petitioners. Third-party demands for increased funding show a need (or at least a strong desire) for the good or service, a committed clientele that sees its interest as being tied to the funded program, department, or organization, and a large group, not simply employees, will be impacted. In 2013, the United States saw proposals to cut back the postal

service being actively opposed by the postal employees’ union, who ran television commercials to whip up greater public opposition to the proposed cuts. The union successfully emphasized how the public and small businesses would be negatively impacted by ending Saturday mail service. Cultivate Confidence. Cultivating confidence requires demonstrating the effectiveness and/or efficiency of your operation. The goal is to be respected and liked by those who review and approve your budget. When money is tight, the first targets for budget cuts are operations that are known to be ineffective or inefficient. One may not be ineffective or inefficient, but if the department has the appearance of either, it will rank high on the list of programs to reduce when budget cuts are needed. On the other hand, a department need not be either effective or efficient if it can maintain the appearance of each. To paraphrase Machiavelli, “Man lives by the eye rather than the mind”—all see, few understand. Obfuscate. Obfuscation keeps operations a mystery. Mystery and indecipherability are often equated with complexity, skill, and value. Simplicity is often undervalued: if reviewers can understand an operation, they may think they can do the work better, cheaper, and faster. To avoid undesired contributions from direct supervisors, finance, senior management, and approving bodies, it is beneficial if these parties believe that the operation is beyond their comprehension and that they should defer to the operating manager’s judgment. Obfuscation can use one or more of the following tactics: ▪ The voluminous data and numbers tactic inundates

reviewers with details and makes it impossible for them to wade through data. Data is unorganized information, and managers should provide the maximum amount of data and a minimum amount of information. Data is difficult to deal with, organize, and summarize into information. The aim is to lead reviewers or approvers to the conclusion that data volume equates to complexity.

▪ You should provide half the picture. Describe the benefits created and ignore costs. Airbags are a perfect example: autosafety advocates reporting the number of lives saved, while ignoring the cost of installing hundreds of millions of airbags since 1989. According to Miller, Benjamin, and North (2001), in the first eight years when airbags were installed, 2600 lives were saved. However, 80 children were killed by exploding airbags in low-speed collisions, and 100 million airbags were installed in vehicles at a cost of $400 per airbag. The cost per life saved was $15,873,016 ($40,000,000,000/(2,600 – 80)). No one argues against saving 2,520 lives; however, many question the wisdom of spending $15,873,016 to save a single life and note that more lives could be saved at a lower cost through other interventions.

▪ You should selectively use numbers and percentages. When the output is large, report output increases as numbers, for example, demand increased by 10,000 units (if 1 million units are being produced, this amounts to a 1.0% increase). When 10,000 units are produced, an increase of 10,000 units should be trumpeted as a 100% increase.

▪ The policy or regulation trap tactic defends budget increases behind policy, regulation, and/or legislation changes and blocks budget cuts by asserting that reductions would violate existing edicts. In the latter case, managers only need to argue that existing expenditures must be continued because regulations demand it. The assertion may not be completely true, but budget reviewers and approvers will probably be outside their area of expertise and not challenge what must be done, why it needs to be done, how it should be done, and how much it should cost. Similarly, how organizations respond to new or pending regulations will be determined by managers with an interest in responding quickly with a request for large

increases in funding to meet the new or imagined requirements.

▪ Gold or chrome plating recommends that when you have nothing to say, say it well. Gold plating means adding expensive and unnecessary features to products and shifts the focus away from what is being spent to nurturing awe. Darrel Huff (1954) reported how a company that could not prove its cold remedy worked enhanced its appeal by changing the subject. The manufacturer demonstrated the nostrum killed germs, 31,108 in 11 seconds with only 1/2 oz. While this level of germ-killing ability seems impressive, it did not address the question of whether the germs killed caused colds. The goal of gold plating is to create in the minds of others the perception that the department’s work is valuable, effective, and efficiently performed, often using visually appealing and sound-enhanced PowerPoint slides, strategically structured graphs, and irrelevant or biased statistics. In many situations, success is measured and reported as the use of inputs rather than higher output or better outcomes.

▪ Exclusive terminology resorts to the use of the proprietary language of the profession or field to obfuscate budget issues. Accountants, lawyers, doctors, and engineers resort to the arcane lexicon of their fields to perplex budget reviewers and approvers. The use of exclusive terminology is designed to suggest to noninsiders that they are unqualified to hold opinions regarding issues in consideration.

▪ A final tactic is to flatter and dissemble. Budget managers agree with the wisdom of those seeking budget reductions but act in a contrary yet nonconfrontational manner. Managers provide vigorous verbal support for an objective or directive, such as budget cutting and efficiency, but continue current operations as before or seek more resources. The goal of flattery and dissembling is to

ingratiate one’s self to reviewers and approvers, while actively opposing change.

All-purpose strategies recognize that budgeting is a political process. Managers must not only be able to provide legitimate reasons for increases in resources but also be capable of using political maneuvers to protect and enlarge the resources at their command.

Budget Increasing or Offensive Strategies The primary purpose of budget-increasing strategies is to maximize funding. Legitimate reasons cover the increased cost of providing a good or a service, expansion, or quality improvement. Offensive strategies are predominantly illegitimate attempts to obtain more resources than needed and build an empire. These strategies are invoked when work does not require additional resources to be competently performed but resources may be available and managers want to pad their budgets. Over Estimate Resource Needs Estimate larger-than-expected increases in output. For example, a 10.0% increase in output is projected (although it may not be expected); therefore, the budget should be increased by 10.0% above inflation. Does the budgeting process, current or retrospective evaluation, recognize when anticipated increases are not realized? Overestimation is only effective when organizations use an incremental budgeting system and do not retroactively adjust the budget on the basis of actual production as flexible budgeting does. The reader should recall that requesting a 10.0% funding increase due to a 10.0% growth in output erroneously assumes that all costs are variable. Round up Rounding up is the systematic process of requesting slightly more resources than necessary. For example, instead of requesting the amount of resources needed, managers may

round up budget requests to the nearest thousand, ten thousand, or hundred thousand dollars to increase their budgets. Less aggressive budget maximizers may round up an expenditure of $65,500–$66,000; managers who are more aggressive may request $70,000 or $100,000. The advantage of rounding up every expense line to the nearest thousand dollars is that it may achieve the same effect as rounding up a single line item from $65,500 to $100,000 and be more difficult for budget reviewers or approvers to detect. Sprinkle Sprinkling adds small amounts, $100 or $1,000, to every expense line. The logic, similar to rounding up, is that small amounts spread across multiple expense lines will be impossible for budget reviewers and approvers to detect. In the last example, rounding up from $65,500 to $70,000 ($4,500) in a single line item may be easy to detect (in this case, it would be 6.9% over what is required [$4,500/$65,500]), but if $100 is added to 45 line items, it would be next to impossible to detect. The impact on the budget is the same, but the budget padding is not as obvious. Backlogs and Customer Complaints The backlog and complaint strategy uses existing production problems to argue that the budget must be too low to support required operations. This could be a legitimate reason if the department has been underfunded and cannot keep up with the demand, or it could be the result of poor management. If backlogs and complaints are the basis for budget increases, incentives are established for managers to fall behind on production or deliveries to gain larger budget allocations— inefficiency and ineffectiveness would be rewarded in this system. The first question that needs to be asked is, should the function be backlogged, given its present resources? Similarly, are customer complaints due to underfunding or poor management of operations?

Crisis The crisis strategy uses real or imagined crises as an opportunity for budget increases to prevent or minimize adverse outcomes. A fortunate or unfortunate point of emergency funding is that departments are seldom asked to relinquish funds after the conclusion of the crisis. Does a plane crash indicate that the Federal Aviation Administration (FAA) is underfunded or that it is poorly managed? The story the FAA will tell is one of previous understaffing, inadequate wages, and/or antiquated equipment and thus the need for budget increases. As seen by the Department of Defense and the Federal Emergency Management Agency (FEMA), federal departments seldom return to their prior size after a war or natural disaster. New Programs This strategy argues that the implementation of previously unperformed activities requires additional funding. If these activities or programs are valuable, then the overarching questions that should be asked are why they aren’t presently funded and whether there is higher value in the existing or new services. Tactics for securing new programs include the following: ▪ Old wine in a new bottle—repackaging existing programs to

appear as new work to secure higher funding. Organizations often set aside funds for new initiatives to encourage efforts to provide better goods and services. A key weakness is that managers relabel existing programs to obtain new funding, and new initiatives are not undertaken.

▪ The foot-in-the-door or camel-nose-under-the tent tactic knowingly starts programs with inadequate funds, builds a constituency, and then demands more funds to continue the work. Rejecting an expensive program is more likely before a constituency is created; after the constituency is built, it may be irrelevant that the original expense estimates were purposely understated. More funding is now needed to continue the program and ensure that the prior investment

is not lost. The question that should be asked is will additional funding throw good money after bad? The initial request understated resource needs, oversold potential benefits, or did both, so what is the guarantee that the supplemental request does not have the same flaws?

▪ The pays-for-itself tactic proposes new investments that are projected to produce revenues in excess of capital and operating costs. Fortunately, for managers using this tactic, postinvestment reviews (were the additional revenues realized?) are unlikely to take place. When undertaken, they often do not consider the impact of the project on other areas: if revenue increased, did it cannibalize another revenue stream? For example, do franchise food service operations in hospitals drain resources from the cafeteria, or do outpatient surgery centers reduce inpatient surgeries? Proposals that subsequently fail to deliver their promised results generally do not see funding cuts.

▪ Use of the spend to save tactic promises funding increases will allow greater reductions in current expenses (labor, supplies, utilities, etc.). Thanks to short attention spans, additional resources are often invested and the expected cost savings are seldom followed up. For example, do electronic medical record (EMR) systems reduce documentation costs (or improve quality of care)? Like the pays for itself tactic, funding cuts are unlikely, even if the expected reductions in expenses do not occur and are recognized as failing to reach their targeted savings.

▪ Mislabeling is an appealing tactic that deliberately misstates the purpose of an expenditure to increase the probability of its acceptance. Mikesell (1995) gave a classic example of mislabeling pertaining to blast suppression areas around military bases and ammunition dumps. Blast suppression areas are designed to protect civilian populations from injury due to unintended denotation of munitions—an appropriate use of funds. Blast suppression areas, open green spaces,

often end up as golf courses; if the Department of Defense asked Congress to fund recreation areas, it would receive a more severe review than in the case of seeking funds to improve safety.

▪ Requests for higher funding in anticipation of third-party actions argue that additional funding is needed to meet anticipated competitive threats or customer needs. The additional resources may be squandered if competitors’ actions do not materialize or customers do not demand more output or seek improvements in products or services, but this cannot be known at the time of the request. Managers are incented to be proactive and overstate needs to capture additional resources, but postexpenditure reviews are essential to determine whether managers are crying wolf—how often do contingencies fail to be realized?

▪ Overreaction to third-party actions are requests for higher funding after a change has occurred, where managers select the most expensive means to meet the competitor actions or expand services to a growing customer population. Why budget for an ounce when a pound can be had? The question that should be asked is, are there other less expensive means to meet the challenge?

▪ Finally, the bandwagon tactic argues for higher funding to implement programs because everyone else is doing it. Following the bandwagon is a response to competition and the fear of being left behind. While this is a persuasive argument, it is also susceptible to the “if everyone jumps off a bridge” rejoinder—caution, patience, and skepticism are often underappreciated.

Even though the discussion of legitimate and illegitimate budget increases is drawn clearly, in the real world, things are rarely black or white. Legitimate increases are anything that requires a larger budget to complete the organization or department’s goals, that is, price increases, higher output, changes in production processes, and service or product changes. Unfortunately, all of these factors can be gamed. Illegitimate

tactics may be based on real or anticipated needs; however, these factors must be considered illegitimate if they do not result in changes in input prices, output, production processes, or services or products or if inappropriate (excessively costly) approaches are pursued. Legitimate reasons for budget increases can also be leveraged to obtain higher-than-needed budget augmentations, including selective use of price changes, workload increases, and production process or product changes. The line between warranted and unwarranted budget increases is often blurred, reinforcing the need for all parties to be knowledgeable of what is being produced, how it is being produced, and how it could be produced. The lines between justifiable budget increases, prudent contingency planning (i.e., budget cushions), and outright budget padding are seldom clear. The other important point is factors that increase the demand for resources are always highlighted in the budgeting process. When these factors move in the opposite directions, suggesting the need for fewer resources, they are ignored or withheld. Over time, budgets necessarily grow beyond the efficient point;

▸ What a Budget Is and What It Is Not A budget is a means to understand an organization and its priorities, operations, and incentive structures. Budgets explain how organizations are expected to work in monetary terms. Monetary quantification of performance is an efficient means to organize information, facilitate decision-making, and gauge the effectiveness of actions. Managerial decisions should not be based on vague performance descriptors, such as over- or underbudget, but should be based on how far actual results differ from the target. If actual expenses exceed the budget,

required actions will depend upon how far over expenses are as well as changes in output and revenues. Ultimately, budgets are a means to manage and safeguard resources. A budget is not an end in itself; it is a means to achieve the larger mission and goals of an organization. The goal is not to create a financial plan but rather to create an operating plan that can achieve organizational goals. Unfortunately, the way many budgets are used, employees believe that creating a budget is the end. The primary purpose of a budget is lost if the completed budget is placed on the shelf and more time is spent estimating expenses rather than controlling processes. Budgets are not straitjackets; they neither demand nor justify continuing to do things as they were done in the past. A budget should be a means to identify better ways of doing things and react to contemporaneous changes: are new production methods better and/or cheaper than current methods? A budget should facilitate comparison of current costs with expected costs under new production methods and identify when production processes should change. A budget should also allow managers to quickly identify environmental or internal changes that do not allow the budget to be met and the size of their financial impact. Negative and positive impacts need to be communicated up the organization to determine whether departmental or organizational changes are needed. A budget is an information system, and if variations in plans are not recognized, communicated, and acted upon, a budget loses most, if not all, of its usefulness. Budgeting is a tool, and it is only valuable if the information it provides is worth its cost; a complex, time-consuming (or destroying), and uninformative budget is not worth the effort. Budgeting is not and should not be equated to mindless cost control; it should ensure effectiveness and efficiency by providing just enough resources to complete a task at the level of performance expected—no more and no less. Budgeting can degenerate into all the things it should not be because of a lack of understanding of budgeting methods and goals, the inability or failure to use budgeting information to enhance operations,

inappropriate use that is detrimental to operations, and assembling budgets primarily to satisfy external parties. Customers, owners, and employees benefit when managers at all levels understand budgeting goals and practices and incorporate budgeting information into daily decision-making and action.

Summary This chapter describes how goods and services transacted in voluntary exchange markets are regulated by the opposing interests of producers and customers. In voluntary exchange markets, excessive output or pricing is prevented by the ability of customers to refuse to purchase (thus putting downward pressure on production, costs, and prices). When goods and services are transacted in subsidized markets, typically by nonprofit or public organizations, excessive demand can be unleashed. While budgets are important to all organizations to control resource use, budgets often substitute for the spontaneous order provided by market processes for nonprofit and public organizations. This chapter also discusses the roles budget preparers, reviewers, and approvers play in the budgeting process and the various strategies used to increase, defend, or cut allocations. Legitimate reasons for budget increases are input price increases, higher output, quality increases, and shifts to cost- increasing production methods. One of the primary difficulties in constructing tight budgets that supply only needed resources is that legitimate reasons can be manipulated to maximize budgets. In addition, there is a host of political strategies developed to ensure that inefficient budgets are approved year after year. Some people think that discussing strategies and tactics to unnecessarily increase funding is tantamount to encouraging waste, but exposing the ways budget information is manipulated is the only way to improve budgeting and reduce waste. The major parties and tasks in the budget-building process are described to pave the transition to the budget construction chapters. Part 1 concludes by recognizing what a budget is and

what it is not. The goal of budgeting is to obtain the maximum value from available resources, but its ability to achieve this end is determined by the type of budgeting system chosen, the manager’s understanding of budget practice, and the way individual interest is managed. Part 2 explores the focus of different budgeting systems and details how each type of budget is created and what its strengths and weaknesses are.

Key Terms and Concepts Iron triangle Moral hazard Pareto improvement Pareto optimality

Discussion Questions 1. Discuss how opposing interests are balanced in the market

exchange model and how the introduction of subsidies and taxes impact the balance between producers and consumers.

2. Compare budgeting processes across for-profit, nonprofit, and public organizations.

3. Identify the parties in the iron triangle and their objectives. 4. Describe the major steps required to create a budget, who

is responsible, and when they should be completed. 5. What are the three rules for winning the budget game? 6. What are legitimate reasons for budget increases? 7. Describe the differences between all-purpose budget

strategies and budget-increasing strategies. 8. What are the best and the worst ways to cut budgets? 9. Discuss the differences between budgets as operating and

financial plans. What is the proper role of a budget? 10. What are the major reasons budgeting often fails to reach it

potential?

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* If you can get away with it, spend more than you have been budgeted (to increase the base from which the following year’s budget will be calculated).