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Budgeting
by Rosemarie Kelly, PhD, FCA, MBS, Dip Acc, Examiner, F2 Management Accounting, January 2019.
This short article provides an overview of some of the key aspects of budgeting. First, it describes a budget and how it fits in an organisation’s strategic planning process. Next, it outlines the purposes of budgeting, why budgets are prepared. This is followed by a brief summary of budget preparation and the types of budgets that are produced. The distinction between fixed and flexible budgets is then presented and two common forms of budgeting, incremental and zero based are described. Finally, some behavioural issues arising from the budgeting process are outlined.
Budgets and the strategic planning process An organisation develops its strategic or long term objectives and identifies, evaluates and selects suitable courses of action to achieve those objectives. An annual budget is an integrated part of the strategic (long term) planning process as it represents one such course of action. A budget is a detailed plan of action prepared for a specific period of time, usually twelve months.
(Source: Drury, 2015)
Purposes of budgets – why prepare budgets? (Figure 1)
To aid the planning of operations by forcing managers to consider how conditions might change and what steps should be taken now.
To co-ordinate the activities of the organisation by compelling managers to examine relationships between their own operations and those of other departments.
To communicate plans to various responsibility centre managers so that everyone in the organisation has a clear understanding of the part they are expected to play in achieving the annual budget.
To motivate managers to strive to achieve the budget goals by focusing on participation and providing a challenging target.
To control activities by comparison of actual with budget (this is attention directing/management by exception).
To evaluate the performance of managers by providing a means of informing managers of how well they are performing in meeting targets they have previously set. (Drury, 2015)
Figure 1: The purposes of budgeting
Purposes of
Budgeting
Plan
Co-ordinate
Communicate
Motivate
Control
Evaluate
Figure 2: Preparation of functional budgets
Fixed and flexible budgets
In budgeting a distinction is made between two forms of budget, a fixed budget and a flexible (or flexed) budget.
A fixed budget, once developed and agreed, is not changed or altered if actual activity differs from budgeted activity.
A flexible budget is ‘ a budget which, by recognising the difference in behaviour between fixed and variable costs in relation to fluctuations in output, turnover, or other variable factors such as number of employees, is designed to change appropriately with such fluctuations’ (Griffith College Manual).
A flexible budget is prepared based on actual activity and shows what the budgeted costs and revenues would have been if the budget had been based on actual activity achieved. A flexible budget thus allows comparison of actual and budgeted costs and revenues based on the same activity level. It is much more useful than a fixed budget as it allows more meaningful variances to be calculated.
Incremental budgeting
Incremental budgeting starts with the budget from the previous period and adds or subtracts an incremental amount to cover inflation and other known expenses. It is suitable for stable businesses, where costs are not expected to change significantly and where there is good cost control and limited discretionary expenses.
Direct materials
usage budget
(in UNITS)
Production budget
(in UNITS)
Sales budget
Direct labour
budget
Production
overhead
budget
Selling &
administration
expenses budget
Direct materials
purchases
budget
Master Budgets
Income statement & Statement of financial position
Advantages/benefits of incremental budgeting Disadvantages/drawbacks of incremental budgeting Quick and easy method of budgeting Carries forward previous problems and inefficiencies to the next budgeting period Only the increment (extra amount) needs to be justified in organisations that have stable and historic figures
Uneconomic activities may be continued
Managers may spend unnecessarily to use up their budgeted expenditure to ensure that they will get the same or a larger budget next year
Zero based budgeting (ZBB)
Zero based budgeting (ZBB) emerged in the late 1960s as a response to incremental budgeting. With ZBB, all budgets start at zero and activities/costs are only allowed if they are justified under investigation. All requests for resources must be presented and they are evaluated on the basis of cost-benefit – i.e. where is the value in the spend? ZBB is best suited to discretionary spending where there is no clearly defined input-output relationship (e.g. marketing, research & development, training, etc.) or public sector organisations such as local councils.
Advantages/benefits of ZBB Disadvantages/drawbacks of ZBB Should reduce inefficiencies as past waste is not carried into the next year
Expensive and time consuming process
Cost-benefit analysis approach – promotes focus on organisational activities and costs
In a highly pressured environment it may become overly competitive Questions are asked, rather than just accepting figures
Can give rise to a short-term focus to the detriment of long term goals Inefficient or obsolete operations can be identified and discontinued
Managers may feel demotivated due to the large amount of time spent on the budgeting process ZBB leads to increased staff involvement as more information and work is required to complete the budget
Budgeting process may become too rigid and unable to react to unforeseen opportunities or threats Resources should be allocated efficiently and economically
The necessary management skills to apply ZBB may be absent ZBB responds to changes in the business environment
Behavioural issues arising from the budgeting process
Earlier in the article the purposes of budgeting were outlined. Three of these purposes specifically relate to behaviour, control , evaluation and motivation. Budgets facilitate control over costs by highlighting any differences arising between actual costs and budgeted costs. Budgets are used to evaluate managerial performance and also to motivate staff to perform better. Consequently it is important to address these three aspects when developing budgets otherwise behavioural problems may arise. Examples of potential problems/issues that may arise and how they may be avoided are noted below.
Control
