A Framework for Budget Prioritization

 

One of the most important functions for managers and leaders in all organizations is the development and execution of budgets.  It’s important to develop a framework that allows the organization to set priorities, conserve funds, invest in high-priority objectives, and fight the growth of bureaucracies.

I developed and refined a budget approach that I found to be useful during normal budget cycles but especially during expansions or contractions.  It’s also been shown to be useful for both for-profit and not-for-profit organizations.

Here is a synopsis of the framework:

Budget Prioritization Framework
Category	Type	Working Definitions
1	Revenue Growth	Investments that will yield incremental revenue within an acceptable payback period.
2	Expense Savings	Investments that will yield cost savings within an acceptable payback period.
3	Strategic	Expenditures that support the adopted strategic plan.
4	Unmet Needs	Expenditures to reduce bottlenecks, increase productivity, or improve customer satisfaction.

During budget planning, I think it’s best to put incremental decisions into priority categories 1 through 4. Category 1 is budget investments that add to revenue.  Category 2 is budget investments that reduce expenses.  Category 3 is budget expenditures that support the adopted strategic plan.  Category 4 is most other budget expenditures that improve overall operations.

Generally, Categories 1 and 2 should be funded before Categories 3 and 4.

My experience is that most budget managers will try to argue that their budget requests are 1 and 2.  I have found it best to put the organization’s CFO in charge of analytically determining the payback of a particular investment.  The payback period should be estimated based upon the incremental revenue generated or incremental savings generated.  Payback is the time it takes for that particular investment to start adding beyond its costs.  During budget reductions, this could be used to save positions.

During periods of severe budget concerns, I’ve seen payback metrics of as quick as six months.  For less cautious times, I’ve seen payback periods of up to two years.  In either case, the CFO should feel comfortable transparently sharing a data-driven computation justifying the payback period for each item being ranked.

Example 1:  A budget request comes in to hire a new salesperson.  The CFO reviews data that shows the ramp-up period for a new salesperson is averaging about 3 months and the sales cycle is 6 to 12 months.  Also, a fully performant salesperson generates about 6 times their cost in sales.  So, the CFO might conservatively estimate that at the 1-year point an average high-quality salesperson has generated 2 times their costs.  This would probably indicate a payback period of 9 months.

Example 2:  A budget request comes in to buy some software that will increase productivity and is proposed as a Category 2 investment.  The CFO needs to find a way that organizational costs actually go down.  If the software just enables tasks to be done faster or more completely, then it is category 4.  However, if the organization can be downsized as a result of bringing the software onboard, then it has a computable payback period for a Category 2 investment.  If the organization is growing rapidly and adopting the software allows the required tasks to be done by the same number of people while scaling, there could be an argument for Category 3, assuming organization scaling is part of the strategic plan.

Example 3:  Marketing may start by saying their entire budget is category 1, since the goal is to influence revenue.  Under this framework that is not acceptable and marketing expenditures are generally category 3 or 4.  However, the CFO should look at data-driven metrics by individual programs.  Attending a particular tradeshow last year may have resulted in 4 new customers with an average sales price that can be used to estimate the payback.  Alternatively, previous advertising campaigns were shown to yield a certain success rate that could be used to estimate an incremental revenue stream for estimating a payback.

Note that the CFO doesn’t have to generate these estimates from scratch.  It is OK for the organization units making the requests to provide the data, analytics, and models.  However, the CFO needs to review the computations and feel comfortable supporting the analysis as is or making adjustments.  The CFO should also be willing to have the estimates reviewed in the future to understand the success of the predictive models.

After items have been categorized and then ranked by payback, the business leadership can then review the budgets and proposed items and make selections.  This framework helps to focus the entire organization on the most important deliverables.

Incidentally, most of the expenditures that grow bureaucracy and organizational bloat occur in category 4. There are several posts in this blog that discuss the challenges of holding back growth in bureaucracy.  I have used this approach to help identify the most important investments and to reduce the amount of funding for items that increase bureaucracy.

Generally, everyone is working too hard, so additional personnel is required.  Just as likely key people want to add capabilities to the organization.  The easiest way to accomplish these goals is to request additional budget.  However, many times the best approach should be to stop doing things that are less effective or less important to fund these new activities.  Budget constraint helps to force this kind of innovation at the working unit levels.

by Steve Sliwa

https://cutt.ly/D9Udmoq

Consumption I: Indifference curves. Budget constraint. Utility maximisation

 

Indifference curves

Indifference curves are lines in a coordinate system for which each of its points express a particular combination of a number of goods or bundles of goods that the consumer is indifferent to consume. This is, the consumer will have no preference between two bundles located in the same indifference curve, since they all provide the same degree of utility. The indifference curves, as we move away from the origin of coordinates, imply higher consumption and, therefore, increasing levels of utility.

An indifference map is a combination of indifference curves, which allows understanding how changes in the quantity or the type of goods may change consumption patterns.

Francis Y. Edgeworth, developed the mathematics concerning the drawing of indifference curves in his book “Mathematical Psychics: an Essay on the Application of Mathematics to the Moral Sciences”, 1881, from earlier works by William Stanley Jevons. However, Vilfredo Pareto was the first economist to draw indifference maps as we know them nowadays, in his book “Manual of Political Economy”, published in 1906.

The first example of indifference map showed in the adjacent graph is the most common representation. It shows four convex indifference curves (red), showing each curve what amount of a good or bundle of goods x1 the consumer has to give up in order to be able to consume more goods, or bundles of goods, x2. This relation gives us the marginal rate of substitution (MRS) between these goods, which is the slope of the curve in each of its points.

Our second example is an indifference map with four parallel lines (green). This is the case for goods or bundles of goods, y1 and y2, which are perfect substitutes, since the lines are parallel and MRS = 1, that is the slope has an angle of 45º with each axis. It can also be the case for goods or bundles of goods that are perfect substitutes but in different proportions. In that case, the slope will be different and the MRS can be defined as a fraction, such as 1/2 ,1/3 , and so on. For perfect substitutes, the MRS will remain constant.

Our third example shows an indifference map with four indifference curves (blue) that represent perfect complementary goods, z1 and z2. This is, there will not be an increase on the consumer’s utility unless both goods increase in the required proportion. The best example of complementary goods are shoes, since the consumer’s utility will not increase when he or she gets a new right shoe without getting a new left shoe. Notice that the elbows are collinear, and the line crossing them defines the proportion in which each good needs to increase in order to have an increase in the utility. In this case the horizontal fragment of each indifference curve has a MRS = 0 and the vertical fractions a MRS = ∞.

These explanations of indifference curves can also be applied to production. In that case, the MRS turns into marginal rate of technical substitution and marginal rate of transformation.
Video – Indifference curves:

Budget constraint

Consumer behaviour is a maximisation problem. It means making the most of our limited resources to maximise our utility. As consumers are insatiable, and utility functions grow with quantity, the only thing that limits our consumption is our own budget (assuming, of course, we are dealing with normal goods, not negative or harmful goods which consumption we want to limit).

A budget constraint (green line in the adjacent figure) provides the second half of the maximisation problem. We need to balance the utility we derive from consumption with the budget we have.

Supposing we have a choice of two goods, 1 and 2, then our restriction is as follows:

which simply means that our budget must be at least as much as the price of the two goods times their respective price.

This simply shows that our consumption is capped and that the more we spend on one good, the less we can on the other.
Video – Budget constraint:

Utility maximisation

Utility maximisation must be seen as an optimisation problem regarding the utility function and the budget constraint. These two sides of the problem, define Marshallian demand curves.

An individual is therefore faced with the following problem: faced with a set of choices, or baskets of goods, and a fixed budget, how to choose the basket which maximises their utility?

If we know an individual’s utility function, and we know their budget, we have the two restrictions necessary to maximise their utility. This can be done graphically, with the point where budget and utility function meet defining an optimum, as shown in the adjacent figure.

It can be also done mathematically, through a Lagrangian, where the first derivatives determine a system of equations that can be resolved by submitting our utility function to the restriction presented by the budget:

Video – Utility maximisation:

We have started by learning about the very basics of consumer theory. How much we like (or need) goods configure utility functions representing our preferences. This utility functions, when contrasted with our budget constraint, lead us to resolve our maximisation problem: get the most utility with a given budget.

However, we could ask ourselves: what if I wanted to get a given utility for the lowest possible cost? How price changes affect our wellbeing? Is there some way to actually draw these utility functions?

https://bit.ly/3FymW54

Module 3 – Budget Constraint

 The Policy Question: Hybrid Car Purchase Tax Credit—Is it the Government’s Best Choice to Reduce Fuel Consumption and Carbon Emissions?

The U.S. government policy of extending tax credits toward the purchase of electric and hybrid cars can have consequence beyond decreasing carbon emissions. For instance, a consumer that purchases a hybrid car could spend less money on gas and have more money to spend on other things. This has implications for both the individual consumer and the larger economy.

Even the richest people – from Bill Gates to Oprah Winfrey – can’t afford to own everything in the world. Each of us has a budget that limits the extent of our consumption. Economists call this limit a budget constraint. In our policy example, an individual’s choice between consuming gasoline and everything else is constrained by his or her current income. Any additional money spent on gasoline is money that is not available for other goods and services and vice-versa. This is why the budget constraint is called a constraint.

The budget constraint is governed by income on the one hand, how much money a consumer has available to spend on consumption, and the prices of the goods the consumer purchases on the other.

Exploring the Policy Question

What are some of the budget implications for a consumer who owns a hybrid car? What purchase decisions might this consumer make given his or her savings on gas, and how does this, in turn, affect the goals of the tax subsidy policy?

3.1 Description of the Budget Constraint

LO1: Define a budget constraint, conceptually, mathematically, and graphically.

3.2 The Slope of the Budget Line

LO2: Interpret the slope of the budget line.

3.3 Changes in Prices and Income

LO3: Illustrate how changes in prices and income alter the budget constraint and budget line.

3.4 Coupons, Vouchers, and Taxes

LO4: Illustrate how coupons, vouchers, and taxes alter the budget constraint and budget line.

3.5 Policy Example: The Hybrid Car Subsidy and Consumers’ Budgets

3.1 Description of the Budget Constraint

LO1: Define a budget constraint, conceptually, mathematically, and graphically.

The budget constraint is the set of all the bundles a consumer can afford given that consumer’s income. We assume that the consumer has a budget – an amount of money available to spend on bundles. For now, we do not worry about where this money or income comes from, we just assume a consumer has a budget.

So what can a consumer afford? Answering this depends on the prices of the goods in question. Suppose you go to the campus store to purchase energy bars and vitamin water. If you have $5 to spend, energy bars cost fifty cents each, and vitamin water costs $1 a bottle, then you could buy 10 bars, and no vitamin water, no bars and 5 bottles of vitamin water, 4 bars and 2 vitamin waters and so on.

This table shows the possible combinations of energy bars and vitamin water the student can buy for exactly $5:

Energy Bars	Bottles of Vitamin Water
10	0
8	1
6	2
4	3
2	4
0	5

It is also true that you could spend less than $5 and have money left over. So we have to consider all possible bundles −including consuming none at all.

Note that we are focusing on bundles of two goods so that we maintain tractability (as explained in module 1), but it is simple to think beyond two goods by defining one of the goods as “money spent on everything else.”

Mathematically, the total amount the consumer spends on two goods, A and B, is:

(3.1) , $P_{A}A+P_{B}B$

where $P_A$  is the price of good A and $P_B$ is the price of good B. If the money the consumer has to spend on the two goods, his income, is given as I, then the budget constraint is:

(3.2)$P_{A}A+P_{B}B\le I$

Note the inequality: This equation states that the consumer cannot spend more than his income but can spend less. We can simplify this assumption by restricting the consumer to spending all of his income on the two goods. This will allow us to focus on the frontier of the budget constraint. As we shall see in Module 4, this assumption is consistent with the more-is-better assumption – if you can consume more (if your income allows it) you should because you will make yourself better off. With this assumption in place, we can write the budget constraint as:

(3.3)$P_{A}A+P_{B}B=I$

Graphically, we can represent this budget constraint as in Figure 3.1. We call this the budget line: The line that indicates the possible bundles the consumer can buy when spending all his income.

Figure 3.1 The budget line is the graph of the budget constraint equation (3.3).

LO2: Interpret the slope of the budget line

From the graph of the budget constraint in section 3.1, we can see that the budget line slopes downward and has a constant slope along its entire length. This makes intuitive sense: If you buy more of one good, you are going to have to buy less of the other good. The rate at which you can trade one for the other is determined by the prices of the two goods, and they don’t change.

We can see these details in Figure 3.2

Figure 3.2 Intercepts and slope for the budget line

We can find the slope of the budget line easily by rearranging equation (3.3) so that we isolate B on one side. Note that in our graph, B is the good on the vertical axis, so we will rearrange our equation to look like a standard function with B as the dependent variable:

(3.4) $B=\frac{I}{P_B}-\frac{P_A}{P_B}A$

Now, we have our budget line represented in point-slope form where:

The first part, $\frac{I}{P_B}$, is the vertical intercept.

The second part,$-\frac{P_A}{P_B}$ , is the slope coefficient on A.

Note that the slope of the budget line is simply the ratio of the prices, also known as the price ratio. This is the rate at which you can trade one good for the other in the marketplace. To see this, let’s return to the campus store with $5 to spend on energy bars and vitamin water.

Suppose you originally decided to buy 5 bottles of vitamin water and placed them in a basket. After some thought, you decided to trade 1 bottle for 2 energy bars. Now you have 4 bottles of vitamin water and 2 energy bars in the basket. If you want even more bars, the same trade off is available: 2 more bars can be had if you give up one bottle of vitamin water, and so on.

The slope of the budget line is also called the economic rate of substitution (ERS).

The slope of the budget line also represents the opportunity cost of consuming more of good A because it describes how much of good B the consumer has to give up to consume one more unit of good A. The opportunity cost of something is the value of the next-best alternative given up in order to do get it. For example, if you decide to buy one more bottle of vitamin water, you have to give up two energy bars. Note that opportunity cost is not limited to the consumption of material goods. For example, the opportunity cost of an hour’s nap might be the hour of studying microeconomics that did not happen because of it.

Changes in Prices and Income

LO3: Illustrate how changes in prices and income alter the budget constraint and budget line.

From our mathematical description of the budget line, we can easily see how changes in prices and income affect the budget line and a consumer’s choice set —the set of all the bundles available to her at current prices and income. Let’s go back to equation (3.3):

(3.3)$P_{A}A+P_{B}B=I$

We know from the previous Figure 3.3 that the vertical intercept for equation (3.3) is $\frac{I}{P_B}$ and the horizontal intercept is $\frac{I}{P_A}$.

Now consider an increase in the price of good A. Notice in Figure 3.3 that this increase does not affect the vertical intercept, only the horizontal intercept. As $P_A$  increases,$\frac{I}{P_A}$  decreases, moving closer to the origin. This change makes the budget line ‘steeper’ or more negatively sloped as we can see from the slope coefficient: $-\frac{P_A}{P_B}$. As $P_A$  increases, this ratio increases in absolute value, so the slope becomes more negative or steeper. What this means intuitively is that the trade-off or opportunity cost has risen. Now, the consumer has to give up more of good B to consume one more unit of good A.

Figure 3.3 Changing the price of one good changes the slope of the budget line.

Next, consider a change in income. Suppose the consumer gets an additional amount of money to spend, so I increases. I affects both intercept terms positively, so as I increases both $\frac{I}{P_B}$  and $\frac{I}{P_A}$ increase or move away from the origin. But I does not affect the slope: $-\frac{P_A}{P_B}$. Thus the shift in the budget line is a parallel shift outward – the consumer with the additional income can afford more of both.

4 Coupons, Taxes, and Vouchers

LO4: Illustrate how coupons, vouchers and taxes alter the budget constraint and budget line.

Budget constraints can change due to changes in prices and income, but let’s now consider other common features of the real-world market that can affect the budget constraint. We start with coupons or other methods firms use to give discounts to consumers.

Consider a coupon or a sale that gives consumers a discount on the price of one item in our budget constraint problem. A coupon that entitles the bearer to a percentage off in price is essentially a reduction in price and has precisely the same effect. For example, a 20% off coupon on a good that normally costs $10 is the same as reducing the price to $8.

More complicated is a coupon that gives a percentage off the entire purchase. In this case, the percentage is taken from the price of both items A and B in our budget constraint problem. In this case, the price ratio, or the slope of the budget constraint, does not change.

For example, if the price of A is regularly $10 and the price of B is regularly $20 then with 20% off the entire purchase, the new prices are $8 and $16 respectively. Intuitively, we can see that this is equivalent to increasing the income, and achieves the same result: by expanding the budget set, the consumer can now afford bundles with more of both goods.

Product	Regular Price	New Price with 20% discount on entire purchase
A	$10	$8
B	$20	$16

Another common discount is on a maximum number of items. For example, you might see an advertisement for 20% off up to three units of good A. This discount lowers the opportunity cost of A in terms of B for the first three units, but reverts back to the original opportunity cost thereafter. Figure 3.4 illustrates this.

Figure 3.4 The effect of a 20% discount on the first A̅ units of A.

Taxes have the same effects as coupons but in the opposite direction. An ad valorem tax is a tax based on the value of a good, such as a percentage sales tax. In terms of the budget constraint, an ad valorem tax on a specific good is equivalent to an increase in price, as shown in Figure 3.5. A general sales tax on all goods has the effect of a parallel shift of the budget line inward. Note also that income taxes are, in this case, functionally equivalent to a general sales tax, they cause a parallel shift inward of the budget line.

Figure 3.5 An ad valorem tax changes the slope and horizontal intercept of the budget line.

Vouchers that entitle the bearer to a certain quantity of a good (either value or quantity) are slightly more complicated. Let’s return to your purchase of vitamin water and energy bars. Suppose you have a voucher for 2 free energy bars.

You have $5

The price of 1 energy bar is $0.50

The price of 1 bottle of vitamin water is $1.

How would we now draw your budget line?

One place to start is to consider the simple bundle that contains2 energy bars and 2 bottles of vitamin water. Note that giving up 1 or 2 bars does not allow the student to consume any more vitamin water. The opportunity cost of these 2 bars is 0, and so the budget line in this part has a 0 slope. After using the voucher, if the student wants more than 2 bars the opportunity cost is the same as before – .05 a bottle of vitamin water – and so the budget line from this point on is the same as before. The new budget line with the voucher has a kink.

5 Policy Example: The Hybrid Car Subsidy and Consumers’ Budgets

For several modules, we have considered the policy of a hybrid car tax credit. In Module 1, we thought about various driving preferences of a typical consumer. In Module 2, we translated these preferences into a type of utility function and corresponding indifference curve. Now, let’s think about the appropriate budget line for our policy example.

To start, let’s use the same two axes as we used for the indifference curve map as shown in Figure 3.6. In other words, let’s place ‘miles driven’ on the horizontal axis and $, which is all the money spent on other consumption on the vertical axis. For now, we won’t specify the precise level of income..

Now we can ask, what is the price of ‘other consumption?’ Since we are talking about money left over after paying for miles driven, the price for other consumption is simply 1. This is because we are talking about money itself and the price of a dollar is a dollar. So, the intercept on this axis is simply the value of I.

But what is the price of a mile driven? This question is more complicated and includes the cost of maintenance and depreciation. However, because we are focused on the effect of increasing the miles per gallon of gas, let’s concentrate on only the cost as it relates to the purchase of gasoline. In this case, the cost of driving a mile is the price of gasoline divided by the car’s miles per gallon (MPG). Since we are again interested not in an individual but a group, we can use the average price of a gallon of regular gas divided by the average MPG of cars driven in the United States as a reasonable approximation of the cost of a mile driven in a non-hybrid cr. Now we have the ‘price’ of driving a mile; dividing income by this price gives us the intercept on the ‘miles driven’ axis.

Figure 3.6 A consumer’s budget constraint for the hybrid car policy

Now that we have a budget constraint for our electric and hybrid car subsidy policy example, we can see the effect of the policy on the constraint. Doubling the MPG from 20, say, to 40, dramatically reduces the price of driving a mile . This reduction causes the ‘miles driven’ intercept to move upwards and the entire budget constraint to move outward. Note that now the typical consumer can afford to consume bundles with more of both miles driven and everything else – bundles that were unavailable to them prior to the policy.

Equation (3.4) summarizes the budget constraint for miles driven and other goods.

(3.4) Income = (PMiles Driven)(Miles Driven) + Dollars Spent on Other Consumption

https://bit.ly/3gDBvcN