Budgetary Systems

TRADITIONAL BUDGETARY SYSTEMS

A budget is a quantified plan of action for a forthcoming accounting period.

A budget can be set from the top down (imposed budget) or from the bottom up (participatory budget).

Budget preparation

You will have covered budget preparation in your earlier studies and will not be required to prepare sales, production, materials etc budgets in this exam.

The following are the key points of budget preparation to remind you.

Point	Detail
Long-term plan	The starting point, this will show what the budget has to achieve (the introduction of new production, the required return, and so on) and outline how it is to be done. It will also contain general guidelines on allowable price increases such as wage rates. The longterm policy needs to be communicated to all managers responsible for preparing budgets so that they are aware of the context within which they are budgeting and how their area of responsibility is expected to contribute.
Limiting factor	The factor that limits the scale of operations, this is usually sales demand, but it may be production capacity where demand is high. Budgeting cannot proceed until the budget for the limiting factor has been prepared, since this affects all the other budgets.
Budget manual	Prepared to assist functional managers, this will show how figures and forecasts are to be arrived at and give any other information that is to apply across the organisation. It is likely to include proformas showing how the information is to be presented. If budgeting is done with spreadsheets, layouts and computations may be pre-programmed, requiring only the entry of the figures. It may include a flow diagram showing how individual budgets are interlinked and specify deadlines by which first drafts must be prepared.
Sales budget	This contains information on the expected volume of sales (based on estimates or market research), the sales mix, and selling prices. The total revenues indicated will be used to compile the cash budget,
	although this information needs to be adjusted to allow for the expected timing of receipts. The volume of sales indicates the level of production required and the extent of spending on distribution and administration.
Production capacity	The level of sales anticipated is matched against opening inventory and desired closing inventory to establish the level of production. From this can be calculated the need for materials (again allowing for opening and closing inventory), labour and machine hours. In other words production budgeting is done in terms of physical resources initially and costed afterwards. At this stage, too, it is likely that needs for new capital expenditure will be identified. This information will be used in preparing the capital budget.
Functional budgets	Budgets for other areas of the organisation like distribution and administration take the anticipated sales level as their point of reference. Vehicle costs, carriage/distribution costs, stationery, IT and communication costs, and above all staff costs feature in these budgets.
Discretionary costs	Training and R&D are known as ‘discretionary costs’ and have special features.
Consolidation             and coordination	This can begin once all parts of the organisation have submitted their individual budgets. It is most unlikely that all of the budgets will be in line with each other at the first attempt. Areas of incompatibility must be identified and the budgets modified in consultation with individual managers. Spreadsheets are invaluable at this stage, both for the consolidation itself and to allow changes to be made quickly and accurately.
Cash budget	This can only be prepared at this stage because it needs to take account of all of the plans of the organisation and translate them into expected cash flows. Cash must be available when it is needed to enable the plans to be carried out. Overdraft facilities may need to be negotiated in advance, or some activities may need to be deferred until cash has been collected.
Master budget	The final stage, once all of the necessary modifications have been made, is to prepare a summary of all of the budgets in the form of a master budget, which generally comprises a budgeted income statement, a budgeted balance sheet and a budgeted cash flow statement.

 

Incremental budgeting

The traditional approach to budgeting, known as incremental budgeting, bases the budget on the current year’s results plus an extra amount for estimated growth or inflation next year. It encourages slack and wasteful spending to creep into budgets.

Incremental budgeting is so called because it is concerned mainly with the increments in costs and revenues which will occur in the coming period.

Incremental budgeting is a reasonable procedure if current operations are as effective, efficient and economical as they can be. It is also appropriate for budgeting for costs such as staff salaries, which may be estimated on the basis of current salaries plus an increment for inflation and are hence administratively fairly easy to prepare.

In general, however, it is an inefficient form of budgeting as it encourages slack and wasteful spending to creep into budgets. Past inefficiencies are perpetuated because cost levels are rarely subjected to close scrutiny.

Question

Can incremental budgeting be used to budget for rent? What about for advertising expenditure?

Answer

Incremental budgeting is appropriate for budgeting for rent, which may be estimated on the basis of current rent plus an increment for the annual rent increase. Advertising expenditure, on the other hand, is not so easily quantifiable and is more discretionary in nature. Using incremental budgeting for advertising expenditure could allow slack and wasteful spending to creep into the budget.

Incremental budgeting in the public sector

The traditional approach to budgeting in the public sector has been incremental and this has resulted in existing patterns of public expenditure being locked in. For instance, the public spending round in the UK established an annual cycle of year-on-year incremental bids by departments rather than an analysis of outputs and efficiency.  How is the annual government budgeting process carried out in Rwanda?

We will look at public sector objectives and performance measurement in more detail in Study Unit  20.

FIXED AND FLEXIBLE BUDGETS

Fixed budgets remain unchanged regardless of the level of activity; flexible budgets are designed to flex with the level of activity.

Fixed budgets

A fixed budget is a budget which is designed to remain unchanged regardless of the volume of output or sales achieved.

The master budget prepared before the beginning of the budget period is known as the fixed budget. The term ‘fixed’ means the following.

• The budget is prepared on the basis of an estimated volume of production and an estimated volume of sales, but no plans are made for the event that actual volumes of production and sales may differ from budgeted volumes.
• When actual volumes of production and sales during a control period (month or four weeks or quarter) are achieved, a fixed budget is not adjusted (in retrospect) to the new levels of activity.

The major purpose of a fixed budget is at the planning stage, when it seeks to define the broad objectives of the organisation.

 

Flexible budgets

A flexible budget is a budget which, by recognising different cost behaviour patterns, is designed to change as volumes of output change.

 

Flexible budgets may be used in one of two ways.

• At the planning stage. For example, suppose that a company expects to sell 10,000 units of output during the next year. A master budget (the fixed budget) would be prepared on the basis of these expected volumes. However, if the company thinks that output and sales might be as low as 8,000 units or as high as 12,000 units, it may prepare contingency flexible budgets, at volumes of, say 8,000, 9,000, 11,000 and 12,000 units and then assess the possible outcomes.
• Retrospectively. At the end of each month (control period) or year, the results that should have been achieved given the actual circumstances (the flexible budget) can be compared with the actual results. As we shall see, flexible budgets are an essential factor in budgetary control.

The preparation and use of flexible budgets were looked at in more detail in Chapters 9 & 10 Linear Programming.

 

ZERO BASED BUDGETARY SYSTEMS

The principle behind zero based budgeting (ZBB) is that the budget for each cost centre should be made from ‘scratch’ or zero. Every item of expenditure must be justified in its entirety in order to be included in the next year’s budget.

ZBB, in theory,  rejects the assumption inherent in incremental budgeting; that this year’s activities will continue at the same level or volume next year, and that next year’s budget can be based on this year’s costs plus an extra amount, perhaps for expansion and inflation.

Zero based budgeting involves preparing a budget for each cost centre from a zero base. Every item of expenditure has then to be justified in its entirety in order to be included in the next year’s budget.

 

In reality, however, managers do not have to budget from zero, but can start from their current level of expenditure and work downwards, asking what would happen if any particular aspect of current expenditure and current operations were removed from the budget. In this way, every aspect of the budget is examined in terms of its cost and the benefits it provides and the selection of better alternatives is encouraged.

 

Implementing zero based budgeting

There is a three-step approach to ZBB.

• Define decision units
• Evaluate and rank packages
• Allocate resources

The implementation of ZBB involves a number of steps but of greater importance is the development of a questioning attitude by all those involved in the budgetary process. Existing practices and expenditures must be challenged and searching questions asked.

• Does the activity need to be carried out?
• What would be the consequences if the activity was not carried out?
• Is the current level of provision current?
• Are there alternative ways of providing the function?
• How much should the activity cost?
• Is the expenditure worth the benefits achieved?

 

The basic approach of ZBB has three steps.

Step 1 Define decision packages, comprehensive descriptions of specific organisational activities which management can use to evaluate the activities and rank them in order of priority against other activities. There are two types.

• Mutually exclusive packages contain alternative methods of getting the same job done. The best option among the packages must be selected by comparing costs and benefits and the other packages are then discarded.
• Incremental packages divide one aspect of an activity into different levels of effort. The ‘base’ package will describe the minimum amount of work that must be done to carry out the activity and the other packages describe what additional work could be done, at what cost and for what benefits.

Suppose that a cost centre manager is preparing a budget for maintenance costs. He might first consider two mutually exclusive packages.

• Package A might be to keep a maintenance team of two men per shift for two shifts each day at a cost of Rwf6,000,000 per annum
• Package B might be to obtain a maintenance service from an outside contractor at a cost of Rwf5,000,000

A cost-benefit analysis will be conducted because the quicker repairs obtainable from an in-house maintenance service might justify its extra cost. If we now suppose that package A is preferred, the budget analysis must be completed by describing the incremental variations in this chosen alternative.

• The ‘base’ package would describe the minimum requirement for the maintenance work. This might be to pay for one man per shift for two shifts each day at a cost of RWF3,000,000.
• Incremental package 1 might be to pay for two men on the early shift and one man on the late shift, at a cost of RWF4,500,000. The extra cost of RWF1,500,000 would need to be justified, for example by savings in lost production time, or by more efficient machinery.
• Incremental package 2 might be the original preference, for two men on each shift at a cost of RWF6,000,000. The cost-benefit analysis would compare its advantages, if any, over incremental package 1; and so on.

Step 2

Evaluate and rank each activity (decision package) on the basis of its benefit to the organisation. This can be a lengthy process. Minimum work requirements (those that are essential to get a job done) will be given high priority and so too will work which meets legal obligations. In the accounting department these would be minimum requirements to operate the payroll, purchase ledger and sales ledger systems, and to maintain and publish a set of accounts.

Step 3

Allocate resources in the budget according to the funds available and the evaluation and ranking of the competing packages.

 

Question

What might the base and incremental packages for a personnel department cover?

Answer

The base package might cover the recruitment and dismissal of staff. Incremental packages might cover training, pension administration, trade union liaison, staff welfare and so on

The advantages and limitations of implementing ZBB

The advantages of zero based budgeting are as follows.

• It is possible to identify and remove inefficient or obsolete operations.
• It forces employees to avoid wasteful expenditure.
• It can increase motivation.
• It responds to changes in the business environment.
• ZBB documentation provides an in-depth appraisal of an organisation’s operations.
• It challenges the status quo.
• In summary, ZBB should result in a more efficient allocation of resources.

 

The major disadvantage of zero based budgeting is the volume of extra paperwork created. The assumptions about costs and benefits in each package must be continually updated and new packages developed as soon as new activities emerge.

The following problems might also occur.

• Short-term benefits might be emphasised to the detriment of long-term benefits.
• It might give the impression that all decisions have to be made in the budget. Management must be able to meet unforeseen opportunities and threats at all times, however, and must not feel restricted from carrying out new ideas simply because they were not approved by a decision package, cost benefit analysis and the ranking process.
• It may call for management skills both in constructing decision packages and in the ranking process which the organisation does not possess. Managers may have to be trained in ZBB techniques.
• The organisation’s information systems may not be capable of providing suitable information.
• The ranking process can be difficult. Managers face three common problems.
  • A large number of packages may have to be ranked.
  • It can be difficult to rank packages which appear to be equally vital, for legal or operational reasons.
  • It is difficult to rank activities which have qualitative rather than quantitative benefits – such as spending on staff welfare and working conditions.

 

In summary, perhaps the most serious drawback to ZBB is that it requires a lot of management time and paperwork. One way of obtaining the benefits of ZBB but of overcoming the drawbacks is to apply it selectively on a rolling basis throughout the organisation. This year finance, next year marketing, the year after personnel and so on. In this way all activities will be thoroughly scrutinised over a period of time.

Using zero based budgeting

ZBB is particularly useful for budgeting for discretionary costs and for rationalisation purposes.

ZBB is not particularly suitable for direct manufacturing costs, which are usually budgeted using standard costing, work study and other management planning and control techniques. It is best applied to support expenses, that is expenditure incurred in departments which exist to support the essential production function. These support areas include marketing, finance, quality control, HR/personnel, IT/data processing, sales and distribution. In many organisations, these expenses make up a large proportion of the total expenditure. These activities are less easily quantifiable by conventional methods and are more discretionary in nature.

ZBB can also be successfully applied to service industries and non-profit-making organisations such as local and central government departments, educational establishments, hospitals and so on, and in any organisation where alternative levels of provision for each activity are possible and where the costs and benefits are separately identifiable.

ZBB can also be used to make rationalisation decisions. ‘Rationalisation’ is often a euphemism for cutting back on production and activity levels and cutting costs. The need for service departments to operate above a minimum service level, or the need for having a particular department at all, can be questioned and ZBB can be used to make rationalisation decisions when an organisation is forced to make spending cuts.

        

ACTIVITY BASED BUDGETING

At its simplest, activity based budgeting (ABB) is merely the use of costs determined using ABC as a basis for preparing budgets.

Activity based budgeting involves defining the activities that underlie the financial figures in each function and using the level of activity to decide how much resource should be allocated, how well it is being managed and to explain variances from budget.

Implementing ABC  (see Chapter 1) leads to the realisation that the business as a whole needs to be managed with far more reference to the behaviour of activities and cost drivers identified. For example, traditional budgeting may make managers ‘responsible’ for activities which are driven by factors beyond their control: the personnel department cost of setting up new employee records is driven by the number of new employees required by managers other than the personnel manager.

Principles of ABB

ABB involves defining the activities that underlie the financial figures in each function and using the level of activity to decide how much resource should be allocated, how well it is being managed and to explain variances from budget.

ABB is therefore based on the following principles.

• It is activities which drive costs and the aim is to control the causes (drivers) of costs rather than the costs themselves, with the result that in the long term, costs will be better managed and better understood.
• Not all activities add value and so activities must be examined and split up according to their ability to add value.
• Most departmental activities are driven by demands and decisions beyond the immediate control of the manager responsible for the department’s budget.
• Traditional financial measures of performance are unable to fulfil the objective of continuous improvement. Additional measures which focus on drivers of costs, the quality of activities undertaken, the responsiveness to change and so on are needed.

Benefits of ABB

Some writers treat ABB as a complete philosophy in itself and attribute to it all the good features of strategic management accounting, zero base budgeting, total quality management and other ideas. For example, the following claims have been made.

• Different activity levels will provide a foundation for the ‘base’ package and incremental packages of ZBB.
• It will ensure that the organisation’s overall strategy and any actual or likely changes in that strategy will be taken into account, because it attempts to manage the business as the sum of its interrelated parts.
• Critical success factors will be identified and performance measures devised to monitor progress towards them. (A critical success factor is an activity in which a business must perform well if it is to succeed).
• Because concentration is focused on the whole of an activity, not just its separate parts, there is more likelihood of getting it right first time. For example what is the use of being able to produce goods in time for their despatch date if the budget provides insufficient resources for the distribution manager who has to deliver them?

         

 

               ROLLING BUDGETS

Rolling budgets (continuous budgets) are budgets which are continuously being updated by adding a further period (say a month or a quarter) and dropping the earliest period.

Dynamic conditions

Actual conditions may differ from those anticipated when the budget was drawn up for a number of reasons.

• Organisational changes may occur.
  • A change in structure, from a functional basis, say, to a process-based one
  • New agreements with the workforce about flexible working or safety procedures
  • The reallocation of responsibilities following, say, the removal of tiers of middle management and the ’empowerment’ of workers further down the line

 

• Action may be needed to combat an initiative by a competitor.
• New technology may be introduced to improve productivity, reduce labour requirements or enhance quality.
• Environmental conditions may change: there may be a general boom or a recession, an event affecting supply or demand, or a change in government or government policy.
• The level of inflation may be higher or lower than that anticipated.
• The level of activities may be different from the levels planned.

 

Any of these changes may make the original budget quite inappropriate, either in terms of the numbers expected, or the way in which responsibility for achieving them is divided, or both.

If management needs the chance to revise their plans, they may decide to introduce a system of rolling budgets.

A rolling budget is a budget which is continuously updated by adding a further accounting period (a month or quarter) when the earlier accounting period has expired.

Rolling budgets are an attempt to prepare targets and plans which are more realistic and certain, particularly with a regard to price levels, by shortening the period between preparing budgets. 

Instead of preparing a periodic budget annually for the full budget period, there would be budgets every one, two, three or four months (three to six, or even twelve budgets each year). Each of these budgets would plan for the next twelve months so that the current budget is extended by an extra period as the current period ends: hence the name rolling budgets.

Suppose, for example, that a rolling budget is prepared every three months. The first three months of the budget period would be planned in great detail, and the remaining nine months in lesser detail, because of the greater uncertainty about the longer-term future. If a first continuous budget is prepared for January to March in detail and April to December in less detail, a new budget will be prepared towards the end of March, planning April to June in detail and July to March in less detail. Four rolling budgets would be prepared every 12 months on this 3 and 9 month basis, requiring, inevitably, greater administrative effort.

The advantages and disadvantages of rolling budgets

The advantages are as follows.

• They reduce the element of uncertainty in budgeting because they concentrate detailed planning and control on short-term prospects where the degree of uncertainty is much smaller.
• They force managers to reassess the budget regularly, and to produce budgets which are up to date in the light of current events and expectations.
• Planning and control will be based on a recent plan which is likely to be far more realistic than a fixed annual budget made many months ago.
• Realistic budgets are likely to have a better motivational influence on managers.
• There is always a budget which extends for several months ahead. For example, if rolling budgets are prepared quarterly there will always be a budget extending for the next 9 to 12 months. This is not the case when fixed annual budgets are used.

The disadvantages of rolling budgets can be a deterrent to using them.

• They involve more time, effort and money in budget preparation.
• Frequent budgeting might have an off-putting effect on managers who doubt the value of preparing one budget after another at regular intervals.
• Revisions to the budget might involve revisions to standard costs too, which in turn would involve revisions to stock valuations. This could replace a large administrative effort from the accounts department every time a rolling budget is prepared.

 

Continuous budgets or updated annual budgets

If the expected changes are not likely to be continuous there is a strong argument that routine updating of the budget is unnecessary. Instead the annual budget could be updated whenever changes become foreseeable, so that a budget might be updated once or twice, and perhaps more often, during the course of the year.

When a fixed budget is updated, a ‘rolling’ budget would probably not be prepared. If a budget is updated in month 8 of the year, the updated budget would relate to months 8 – 12. It would not be extended to month 7 of the following year.                      

BLANK

BEYOND BUDGETING

Beyond Budgeting is a model that proposes that traditional budgeting should be abandoned. Adaptive management processes should be used rather than fixed annual budgets.

 

Criticisms of budgeting

In our discussion of the budgetary planning process we have come across many difficulties with budgets and criticisms of how they are used in organisations.

The Beyond Budgeting Round Table (BBRT), an independent research collaborative, proposes that budgeting, as most organisations practise it, should be abandoned. Their website at www.bbrt.org lists the following ten criticisms of budgeting as put forward by Hope and Fraser Beyond Budgeting, 1st edition, Harvard Business School Press, 2003.

 

• Budgets are time consuming and expensive. Even with the support of computer models it is estimated that the budgeting process uses up to 20 to 30 per cent of senior executives’ and financial managers’ time.
• Budgets provide poor value to users. Although surveys have shown that some managers feel that budgets give them control, a large majority of financial directors wish to reform the budgetary process because they feel that finance staff spend too much time on ‘lower value added activities’.
• Budgets fail to focus on shareholder value. Most budgets are set on an incremental basis as an acceptable target agreed between the manager and the manager’s superior. Managers may be rewarded for achieving their short term budgets and will not look to the longer term or take risks, for fear of affecting their own short term results.
• Budgets are too rigid and prevent fast response. Although most organisations do update and revise their budgets at regular intervals as the budget period proceeds the process is often too slow compared with the pace at which the external environment is changing.
• Budgets protect rather than reduce costs. Once a manager has an authorised budget he can spend that amount of resource without further authorisation. A ‘use it or lose it’ mentality often develops so that managers will incur cost unnecessarily. This happens especially towards the end of the budget period in the expectation that managers will not be permitted to carry forward any unused resource into the budget for next period.
• Budgets stifle product and strategy innovation. The focus on achieving the budget discourages managers from taking risks in case this has adverse effects on their short term performance. Managers do not have the freedom to respond to changing customer needs in a fast changing market because the activity they would need to undertake is not authorised in their budget.
• Budgets focus on sales targets rather than customer satisfaction. The achievement of short term sales forecasts becomes the focus of most organisations. However this does not necessarily result in customer satisfaction. The customer may be sold something inappropriate to their needs, as in recent years in the UK financial services industry. Alternatively if a manager has already met the sales target for a particular period they might try to delay sales to the next period, in order to give themselves a ‘head start’ towards achieving the target for the next period. Furthermore, there is an incentive towards the end of a period, if a manager feels that the sales target is not going to be achieved for the period, to delay sales until the next period, and thus again have a head start towards achieving the target for the next period. All of these actions, focusing on sales targets rather than customer satisfaction, can have a detrimental effect on the organisation in the longer term.
• Budgets are divorced from strategy. Most organisations monitor the monthly results against the short term budget for the month. What is needed, instead, is a system of monitoring the longer term progress against the organisation’s strategy.
• Budgets reinforce a dependency culture. The process of planning and budgeting within a framework devolved from senior management perpetuates a culture of dependency. Traditional budgeting systems, operated on a centralised basis, do not encourage a culture of personal responsibility.
• Budgets lead to unethical behaviour. For example building slack into the budget in order to create an easier target for achievement.

 

Beyond Budgeting concepts

Two fundamental concepts underlie the Beyond Budgeting approach.

• Use adaptive management processes rather than the more rigid annual budget. Traditional annual plans tie managers to predetermined actions which are not responsive to current situations. Managers should instead be planning on a more adaptive, rolling basis but with the focus on cash forecasting rather than purely on cost control. Performance is monitored against world-class benchmarks, competitors and previous periods.
• Move towards devolved networks rather than centralised hierarchies. The emphasis is on encouraging a culture of personal responsibility by delegating decision making and performance accountability to line managers.

         

 

INFORMATION USED IN BUDGET SYSTEMS

Information used in budget systems will come from a wide variety of sources.

Past data may be used as a starting point for the preparation of budgets but other information from a wide variety of sources will also be used. Each function of the organisation will be required to estimate revenue and expenditure for the budget period. For example, marketing, personnel and research and development.

Sales budget information

As we have seen, for many organisations, the principal budget factor is sales volume. The sales budget is therefore often the primary budget from which the majority of the other budgets are derived. Before the sales budget can be prepared a sales forecast has to be made. Sales forecasting is complex and difficult and involves the use of information from a variety of sources.

•        Past sales patterns	•        New legislation
•        The economic environment	•        Distribution
•        Results of market research	•        Pricing policies and discounts offered
•        Anticipated advertising	•        Legislation
•              Competition •              Changing consumer taste	•        Environmental factors

 

 

Production budget information

Sources of information for the production budget will include:

• Labour costs including idle time, overtime and standard output rates per hour.
• Raw material costs including allowances for losses during production.
• Machine hours including expected idle time and expected output rates per machine hour.
• Production required by the sales department to meet their sales targets/budgets

Apart from (d), this information will come from the production department and a large part of the traditional work of cost accounting involves ascribing costs to the physical information produced.

 

CHANGING BUDGETARY SYSTEMS

An organisation which decides to change its budgetary practices will face a number of difficulties.

The business environment has become increasingly complex, uncertain and dynamic and organisations need to be able to adapt quickly to changing conditions. It has been argued that traditional budgets are too rigid and prevent fast response to changing conditions.

However, an organisation which decides to change its type of budget used, or budgetary system, will face a number of difficulties.

 

• Resistance by employees. Employees will be familiar with the current system and may have built in slack so will not easily accept new targets. New control systems that threaten to alter existing power relationships may be thwarted by those affected.
• Loss of control. Senior management may take time to adapt to the new system and understand the implications of results.
• In order for the new budget to operate effectively, everyone within the organisation will need to be fully trained. This is time-consuming and expensive.
• Costs of implementation. Any new system or process requires careful implementation which will have cost implications.
• Lack of accounting information. The organisation may not have the systems in place to obtain and analyse the necessary information.

 

BUDGET SYSTEMS AND UNCERTAINTY

Uncertainty can be allowed for in budgeting by means of flexible budgeting, rolling budgets, probabilistic budgeting and sensitivity analysis.

Causes of uncertainty in the budgeting process include:

• They may decide to buy less than forecast, or they may buy more.
• Products/services. In the modern business environment, organisations need to respond to customers’ rapidly changing requirements.
• Inflation and movements in interest and exchange rates.
• Volatility in the cost of materials.
• They may steal some of an organisation’s expected customers, or some competitors’ customers may change their buying allegiance.
• They may not work as hard as was hoped, or they may work harder.
• They may break down unexpectedly.
• There may be political unrest (terrorist activity), social unrest (public transport strikes) or minor or major natural disasters (storms, floods).

 

Rolling budgets are a way of trying to reduce the element of uncertainty in the plan. There are other planning methods which try to analyse the uncertainty such as probabilistic budgeting (where probabilities are assigned to different conditions – see Chapter 14) and sensitivity analysis. These methods are suitable when the degree of uncertainty is quantifiable from the start of the budget period and actual results are not expected to go outside the range of these expectations.

 

CHAPTER ROUNDUP

• A budget is a quantified plan of action for a forthcoming accounting period.
• A budget can be set from the top down (imposed budget) or from the bottom up (participatory budget).
• The traditional approach to budgeting, known as incremental budgeting, bases the budget on the current year’s results plus an extra amount for estimated growth or inflation next year. It encourages slack and wasteful spending to creep into budgets.
• Fixed budgets remain unchanged regardless of the level of activity; flexible budgets are designed to flex with the level of activity
• The principle behind zero based budgeting (ZBB) is that the budget for each cost centre should be made from ‘scratch’ or zero. Every item of expenditure must be justified in its entirety in order to be included in the next year’s budget.
• There is a three-step approach to ZBB.
  • Define decision units
  • Evaluate and rank packages
  • Allocate resources
• ZBB is particularly useful for budgeting for discretionary costs and for rationalisation purposes.
• At its simplest, activity based budgeting (ABB) is merely the use of costs determined using ABC as a basis for preparing budgets.
• Rolling budgets (continuous budgets) are budgets which are continuously updated by adding a further period (say a month or a quarter) and deducting the earliest period. Information used in budget systems will come from a wide variety of sources.
• An organisation which decides to change its budgetary practices will face a number of difficulties.
• Uncertainty can be allowed for in budgeting by means of flexible budgeting, rolling budgets, probabilistic budgeting and sensitivity analysis.