Budget Devices

Short-Term versus Long-Term Budgets

Most organizations have annual budgeting processes.

Starting in the prior year, organizations develop detailed plans of how many units of each product they expect to sell, at what prices, the cost of such sales, and the financing necessary for operations .

These budgets then become the internal “contracts” for each responsibility center (cost, profit, and investment center) within the firm.

These annual budgets are short term in the sense that they only project one year at a time. But most firms also project two, five, and sometimes 10 years in advance. These long-term budgets are a key feature of the organization’s strategic planning process.

Strategic planning is the process whereby managers select the firm’s overall objectives and the tactics to achieve those objectives.

Strategic planning is primarily concerned with how the organization can add customer value and respond to competitors.

For example, Air Canada is faced with the strategic question of how to respond to the environmental concerns related to air travel.

Making this decision requires specialized knowledge of the various aircraft technologies and flight services on which Air Canada and other market participants compete, and knowledge of the future demand for air travel, along with consideration of potential regulatory changes to deal with global warming.

At the operating level, the airline works to combine in-house programs with the greening of its supply chain to reduce waste, energy use, and noise, along with offering customers the option to purchase carbon offsets to reduce their carbon footprint.

Air Canada has won numerous international awards for its leadership in eco-initiatives and its response to customer demands for green travel.

Long-term budgets, like short-term budgets, encourage managers with specialized knowledge to communicate their forecasts of future expected events.

Such long-term budgets contain forecasts of large asset acquisitions (and financing plans) for the manufacturing and distribution systems required to implement the strategy.

Research and development (R&D) budgets are long-term plans of the multi-year spending required to acquire and develop the technologies to implement the strategies.

A typical firm integrates the short-term and long-term budgeting process into a single process. As next year’s budget is being developed, a five-year budget is also produced.

The first year of the five-year plan is next year’s budget. The second and third years are fairly detailed, and the second becomes the base on which to establish next year’s one-year budget. The fourth and fifth years are less detailed, but incorporate new market opportunities. Each year, the five-year budget is rolled forward one year and the process begins anew.

The short-term (annual) budget involves both planning and control functions, thus a trade-off arises between these two functions.

Long-term budgets are rarely used as a control (performance evaluation) device because many of the managers who prepared the budget have either left the firm or are in new position. Instead, long-term budgets are used primarily for planning.

Five-and ten-year budgets force managers to think about strategy and to communicate their specialized knowledge of potential future markets and technologies. Thus, long-term budgets have much less conflict between planning and control, since much less emphasis is placed on using the long-term budget as a performance-measurement tool.

Long-term budgets also reduce manager’s focus on short-term performance. Without long-term budgets, managers have an incentive to cut expenditures, such as maintenance, marketing, and R&D, in order to improve short-term performance.

Alternatively, managers might seek to balance short-term budgets at the expense of the firm’s long-term viability. Budgets that span five years increase the likelihood that top management and/or the board of directors are informed of the long-term trade-offs that are being taken to accomplish short-term goals.