Budgeting Flashcards
Types of budgeting
Fixed Flexible Rolling Activity Based Budgeting Zero Based Budgeting (ZBB) Incremental
Purpose of Budgeting
Planning Control Communication Co-ordination Evaluation Motivation Authorisation Delegation
Advantages of bottom-up
budgeting
• Improved motivation due to a sense of ownership and empowerment. • It increases divisional managers’ understanding (which has an additional benefit if personal targets are set from the budget). • Frees up senior management resource. • Improves the quality of decision making since divisional managers are close to their product markets.
Advantages of top-down
budgeting
• Avoids budgetary slack
(i.e. divisional managers may be
tempted to set targets that are
too easy to achieve).
• Avoids dysfunctional behaviour (i.e. divisional managers lack a strategic perspective, focusing on the needs of the division and, as a result, budgets may not be in line with corporate objectives).
• Senior managers retain control.
• Budget setting process can be
quicker.
• Avoids the problem of bad
decisions from inexperienced
Advantages and disadvantages of flexible budgeting
Advantage
Should enable better
performance evaluation as
comparing like with like.
Disadvantages
• May be perceived by some as ‘moving
the goal posts’ resulting in demotivation –
especially if bonuses are lost despite
beating the original budget.
• Difficulties splitting costs into fixed and
variable elements.
• In the long run it could be argued that all
costs are variable.
Incremental budgets
An incremental budget starts with the previous period’s budget or actual results, and adds (or subtracts) an incremental amount to cover inflation and
other known changes.
Suitability
- It is suitable for stable businesses, where costs are not expected to change significantly.
- There should be good cost control.
- There should be limited discretionary costs.
Incremental budgets - Advantages
• Quickest and easiest method.
• Assuming that the historic
figures are acceptable, only the
increment needs to be justified.
• Avoids ‘reinventing the wheel’ if
there is good cost control, a
stable business and limited
discretionary spend.
Incremental budgets - Disadvantages
• Builds in previous problems and
inefficiencies.
• Simply increasing the budget by an increment does not encourage managers to be more efficient in controlling costs or to find new, innovative ways of doing things.
• Uneconomic activities may be
continued.
• Managers may build in slack (i.e. make the budget easy to achieve), for example, to help secure the receipt of a reward that is aligned to the achievement of the budget.
• Managers may spend up to their budget to ensure that they get an increment from the highest possible base figure in the following year.
Zero based budgets (ZBB)
Zero based budgeting (ZBB) is a method of budgeting that requires each cost element to be specifically justified, as though the activities to which the budget
relates were being undertaken for the first time. Without approval, the budget allowance is zero.
Suitability
- Fast moving businesses/industries.
- Discretionary costs such as research and development (R&D).
- Public sector organisations such as local authorities.
ZBB process
There are four distinct stages in the implementation of ZBB:
(1) Managers should specify for their responsibility centres those activities
that can be individually evaluated.
(2) Each of the individual activities is then described in a decision package.
The decision package should state the costs and revenues expected from
the given activity. It should be drawn up in such a way that the package
can be evaluated and ranked against other packages.
(3) Each decision package is evaluated and ranked usually using cost/benefit
analysis.
(4) The resources are then allocated to the various packages.
Advantages of ZBB
• Inefficient or obsolete operations
can be identified and
discontinued.
• ZBB leads to increased staff
involvement at all levels. This
should lead to better
communication and motivation.
• It responds to changes in the
business environment.
• Knowledge and understanding of
the cost-behaviour patterns of
the organisation will be
enhanced.
• Resources should be allocated
efficiently and economically.
Disadvatage of ZBB
• The time involved and the cost of
preparing the budget are much
greater than for less elaborate
budgeting methods.
• It may emphasise short-term
benefits to the detriment of longterm
benefits.
• The budgeting process may become too rigid and the company may not be able to react to unforeseen opportunities or threats.
• There is a need for management
skills that may not be present in
the organisation.
Advantages of ABC
Provides a more accurate cost per unit leading to better pricing, decision making and performance management. • It provides a better insight into what drives overhead costs resulting in better control of costs. • It recognises that overhead costs are not all related to production and sales volumes. • It can be applied to all overhead costs, not just production overheads. • It can be used just as easily in service costing
Disadvantages of ABC
• Limited benefit if overheads are
primarily volume related or a
small proportion of total costs.
• It is impossible to allocate all
overheads to specific activities.
• The choice of activities and cost
drivers might be inappropriate.
• The benefits might not justify the costs (initial set up costs, staff training costs, cost of potential staff resistance, cost of changing systems to capture information required and the ongoing cost of using ABC).
• It may be difficult to assign
responsibility for individual costs
pools.
Activity-based budgeting
Activity-based budgeting (ABB) uses the principles of ABC to estimate the
firm’s future demand for resources and hence can help the firm to acquire these
resources more efficiently.