Panarude Airfreight is an international air freight hauler with more than 45 jet aircraft operating in the United States and the Pacific Rim. The firm is headquartered in Melbourne, Australia, and is organized into five geographic areas: Australia, Japan, Taiwan, Korea, and the United States. Supporting these areas are several centralized corporate function services (cost centers): human resources, data processing, fleet acquisition and maintenance, and telecommunications. Each responsibility center has a budget, negotiated at the beginning of the year with the vice president of finance. Funds unspent at the end of the year do not carry over to the next fiscal year. The firm is on a January-to-December fiscal year.
After reviewing the month-to-month variances, Panarude senior management became concerned about the increased spending occurring in the last three months of each fiscal year. In particular, in the first nine months of the year, expenditure accounts typically show favorable variances (actual spending is less than budget), but in the last three months, unfavorable variances are the norm. In an attempt to smooth out these spending patterns, each responsibility center is reviewed at the end of each calendar quarter and any unspent funds can be deleted from the budget for the remainder of the year. The accompanying table shows the budget and actual spending in the telecommunications department for the first quarter of this year.
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PANARUDE AIRFREIGHT
Telecommunications Department: First Quarter
Budget and Actual Spending (Australian Dollars)
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*F = Favorable; U = Unfavorable
At the end of the first quarter, telecommunications’ total annual budget for this year can be reduced by $7,000, the total budget underrun in the first quarter. In addition, the remaining nine monthly budgets for telecommunications are reduced by $778 (or $7,000 ÷ 9). If, at the end of the second quarter, telecommunications’ budget shows an unfavorable variance of, say $8,000 (after the original budget is reduced for the first-quarter underrun), management of telecommunications is held responsible for the entire $8,000 unfavorable variance. The first-quarter underrun is not restored. If the second-quarter budget variance is also favorable, the remaining six monthly budgets are each reduced further by one-sixth of the second-quarter favorable budget variance.
Required:
a)What behavior would this budgeting scheme engender in the responsibility center managers?
b)Compare the advantages and disadvantages of the previous budget regime, where any end-of-year budget surpluses do not carry over to the next fiscal year, with the system of quarterly budget adjustments just described.
a) This budgeting scheme would likely encourage responsibility center managers to spend more towards the end of each quarter to ensure that their budgets are not reduced for the following months. Knowing that any unspent funds will be deleted from the budget for the remainder of the year, managers would want to avoid having a surplus at the end of each quarter. This behavior could result in unnecessary or wasteful spending, as managers may feel pressured to use up their budgets rather than saving funds for future needs.
b) The previous budget regime, where end-of-year surpluses do not carry over to the next fiscal year, has both advantages and disadvantages. On one hand, it helps in controlling expenses and prevents the accumulation of excessive budget surpluses, forcing managers to spend within their allocated budgets. This can promote cost-consciousness and efficiency in spending. On the other hand, it may encourage managers to overspend towards the end of the year to fully utilize their budgets, even on unnecessary items, leading to inefficient resource allocation.
In contrast, the system of quarterly budget adjustments described in the scenario has advantages in terms of smoothing out spending patterns and allowing for flexibility in budget adjustments based on performance. The quarterly reviews and reductions can help align budgets with actual needs and avoid large fluctuations in spending. However, it also has potential disadvantages. Managers may feel pressured to spend more at the end of each quarter to avoid budget reductions, as mentioned earlier. Additionally, it creates administrative overhead and additional workload to review and adjust budgets every quarter.
Overall, both budgeting schemes have their own pros and cons, and the choice between them depends on the specific goals and priorities of the organization.