7.3 Approaches to budgeting

Question 1

A periodic budget shows

Answer 1

The costs and revenue for one period of time and is updated on a periodic basis, eg for a year updated every 12 months

Question 2

A rolling budget (aka continuous budget) is

Answer 2

Continuously updated by adding a further accounting period (month or qtr) when the earliest accounting period has expired

Question 3

Reasons for rolling budgets

Answer 3

• To deal with the problem of uncertainty where accurate forecasts can’t be made (fast moving environments subject to rapid financial change, eg exchange rate)
• Or for areas of bus that need tight control (eg: for cash budgeting org could produce rolling budgets / revised forecasts for cash flow)

Question 4

Advantages of rolling budgets

Answer 4

• They reduce uncertainty in budgeting
• They can be used for cash management
• They force managers to look ahead continuously
• When conditions are subject to change, comparing actual results with a rolling budget is more realistic than comparing actual results with a fixed annual budget

Question 5

Disadvantages of rolling budgets

Answer 5

• Preparing new budgets regularly is time consuming
• It can be difficult to communicate frequent budget changes

Question 6

Incremental budgeting is the

Answer 6

• Traditional approach to budgeting and involves taking the previous years budget and adding on a % to allow for inflation, other cost increases and adjustments for specific items (eg extra machine)
• Fairly small changes are made to current years budget (eg: adjustments for planned increase or decrease in sales volume)
• A check is then done to ensure that the budget produced meets the performance targets of the org (eg: operating costs to sales ratio less than 60%)

Question 7

Advantages of incremental budgeting

Answer 7

• Simple, low-cost budgeting system
• Quick to administer
• Suitable in stable environments
• Most practical for certain items of cost where next years budget can reliably be based on current years cost (eg telephone expenses)

Question 8

Disadvantages of incremental budgeting

Answer 8

• Backward looking in nature since next years budget is based on what happened in the past, therefore unsuited to changing environments
• Assumes all current activities should be continued at the current level of operations and with the same allocation of resources, this builds on previous inefficiencies and doesn’t look to reduce waste
• Encourages over-spending, managers know if they fail to spend their budget is is likely to be reduced next period so spend their whole budget regardless of whether justified
• Targets are often unchallenging, based on past performance, which doesn’t encourage managers to look for ways to improve
• Consideration is not given to the justification of each activity, it is simply done because it was done previous year

Question 9

Zero based budgeting (ZBB) is a method of budgeting whereby

Answer 9

• All activities and costs are re-evaluated each time a budget is formulated and budgeted from scratch (zero base)
• For every activity managers look at its costs and purpose and consider if there are alternative ways of doing it
• Inessential activities and costs are identified and removed from next years budget
• Each functional budget starts with the assumptions that the function does not exist and is at zero cost
• Increments of costs are compared with increments of benefits culminating in the planned maximum benefit for a given budgeted cost

Question 10

Zero based budgeting is suitable for

Answer 10

• Allocating resources in areas where spend is discretionary (eg: R&D, advertising and training)
• Public sector org (eg: local authorities)
• New functions (new department or service)

Question 11

Advantages of ZBB

Answer 11

• It creates an org environment where change is accepted, enabling org to be more responsive to changes in bus environment
• It promotes a better focus on org goals, it moves budgeting away from number crunching towards analysis and decision making
• It forces managers to examine activities, identifying inefficient or obsolete operations and wasteful spending
• It establishes a measure of performance for each decision package which can be used to monitor actual performance and compare actual with budget
• It involves managers and many of the employees in the budgeting process, which allows their views to be considered
• It is forward looking, focusing on future rather than past

Question 12

Disadvantages of ZBB

Answer 12

• It is time consuming and costly, unlikely to be able to be done yearly
• There is a temptation to concentrate on short term cost savings (eg R&D, staff training) at expense of longer term benefits
• Might require training for management in budgeting skills
• The budgeting process may become too rigid and the org may not be able to react to unforeseen opportunities or threats
• The ranking process can be difficult since widely differing activities cannot be compared on quantitative measures alone
• It is less useful when budgeting for standard costs, where costs and efficiency levels should already be well-controlled

Question 13

Activity based budgeting (ABB) is a method of

Answer 13

• Budgeting based on an activity framework and utilising cost driver data in the budget-setting and variance feedback processes
• Uses costs determined by ABC to prepare budgets for each activity

Question 14

The basic approach of ABB is to budget the costs for each cost pool or activity as follows

Answer 14

• The cost driver for each activity is identified - A forecast is made of the number of units of the cost driver
• Given this estimate the activity cost is estimated. Where appropriate a cost per unit of activity known as the cost driver rate is calculated
• General overhead costs are budgeted separately

Question 15

Advantages of ABB

Answer 15

• It draws attention to the costs of overhead activities (important where overheads are large proportion of costs)
• It recognises the activities which drive costs (if managers can control these drivers then costs will be better managed and controlled)
• It can provide useful info for a TQM programme, by relating the cost of an activity to the level of service provided

Question 16

Disadvantages of ABB

Answer 16

• It is expensive to implement, new info systems are required and managers have to be trained to use them
• It will rely on the use of activity based costing (ABC) as the std costing system

Question 17

Beyond budgeting is an idea that

Answer 17

• Companies need to move beyond budgeting because of the inherent flaws in budgeting especially when used to set contracts
• It is argued that a range of techniques such as rolling forecasts and market related targets can take the place of traditional budgeting
• Beyond budgeting approaches are commonly used in org that face regular environmental changes or where continuous improvement is critical to the org success

Question 18

Common features of beyond budgeting systems

Answer 18

• The use of rolling budgets on a quarterly or monthly basis as an alternative to annual budgeting. These are flexible and have more timely allocation of resources
• A wider range of performance measures are assesses such as customer satisfaction, production times, innovation, staff utilisation
• Targets are often set based on benchmarks observed externally (what competitors are doing)
• There is a greater focus on determining and explaining what might happen in the future, rather than what has happened in the past
• Innovation is encouraged and rewarded
• Budgets are set at a local level rather than being prepared centrally based on organisational goals and then having these provided to local managers who might actually understand the local environment better

Question 19

Advantages of beyond budgeting

Answer 19

• Planning is continuous and the org is more likely to be proactive rather than reactive to changes in its environment
• Targets become more challenging and more market focused, they stretch staff and encourage staff to find better ways to do things, they also make the org more customer focused
• The org becomes more innovative and continuously improves
• Managers are more involved in the decision making process which provides better info for decisions as well as providing better motivation for managers
• Managers can make decisions much more quickly
• It creates info systems which provide fast and open info throughout the org

Question 20

Disadvantages of beyond budgeting

Answer 20

• Planning, coordination and performance evaluation become more complicated (reward systems also become more complex)
• If benchmarks are seen as unachievable then effort to achieve them is reduced rather than improved
• Org goals are less clear and are not communicated throughout the org
• May face resistance from staff and managers where traditional budgeting is ingrained in culture
• May be impractical for org to adopt the culture of decentralization which BB depends on
• The need for more up to date and accurate info requires costly investment