Chapter 13 Budgetary System

1.      Objectives

1.1       Select and explain appropriate budgetary systems for an organization, including top-down, bottom-up, rolling, zero base, activity-base, incremental and feed-forward control.
1.2       Describe the information used in budget systems and the sources of the information needed.
1.3       Explain the difficulties of changing a budgetary system.
1.4       Explain how budget systems can deal with uncertainty in the environment.
1.5       Indicate the usefulness and problems with different budget types.
1.6       Explain the difficulties of changing the type of budget used.

 

2.      Traditional Budgetary Systems

2.1       A budget is a quantified plan of action for a forthcoming accounting period.
2.2       A budget can be set from the top down (imposed budget) or from the bottom up (participatory budget).

2.3       Budget preparation

2.3.1    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 like wage rates. The long-term 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 budget	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 budget	Budgets for other areas of the organisation like distribution and administration take the anticipated sales level as their point of reference. Vehicle costs, carriage costs, stationery 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.

 

2.4       Incremental budgeting

2.4.1

Incremental budgeting

It bases the budget on the current year’s result plus an extra amount for estimated growth and/or inflation next year. It encourages slack and wasteful spending to creep into budgets. 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.

2.4.2    Advantages and disadvantages

Advantages	Disadvantages
Considered to be quickest and easiest method of budgeting	Builds in previous problems and inefficiencies
Suitable for organizations that operate in a stable environment where historic figures are reliable and are not expected to change significantly	Managers may spend for the sake of spending in order to use up their budget for the year and thus ensure that they get the same (or larger) budget next year
	Uneconomic activities may be continued. For example, a car manufacturer may continue to make parts in-house when it may be cheaper to outsource

 

3.      Fixed and Flexible Budgets

3.1	Fixed and flexible budgets
	(a)    A fixed budget is a budget which is designed to remain unchanged regardless of the volume of output or sales achieved. (b)    A flexible budget is a budget which, by recognizing different cost behavior patterns, is designed to change as volumes of output change.

3.2

Example 1

Ayres & Co. makes a single product and have an average production of 5,000 units a month although this varies widely. The following extract from the overhead statement for the extrusion department shows the make-up of the budget and a month’s actual results.     Budget Actual     5,000 units 4,650 units   $ $ $ Indirect labour       Fixed 3,000     Variable $1/unit 5,000 8,000 7,900 Consumables (variable)   15,000 14,250 Variable overheads   20,000 18,200 Fixed overheads   12,500 12,500     55,500 52,850 Budgetary control statement Fixed budget vs actual results   Fixed budget Actual results Variance   $ $ $ Indirect labour 8,000 7,900 100 (F) Consumables 15,000 14,250 750 (F) Variable overheads 20,000 18,200 1,800 (F) Fixed overheads 12,500 12,500 -   55,500 52,850 2,650     Budgetary control statement Flexed budget vs actual results   Fixed budget Actual results Variance   $ $ $ Indirect labour 7,650 7,900 250 (A) Consumables ($3/unit) 13,950 14,250 300 (A) Variable overheads ($4/unit) 18,600 18,200 400 F) Fixed overheads 12,500 12,500 -   52,700 52,850 150 (A)

 

4.      Zero Based Budgetary Systems

4.1	Zero based budgeting (ZBB)
	The principle behind 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.

4.2

Three steps involved in ZBB

(a)       Define decision packages – These are detailed descriptions of the activities to be carried out. There will be some standardisation within the data to allow comparison with other activities (costs, time taken and so on). A cost-benefit analysis is often carried out at this stage to ensure the most cost effective and beneficial approach to the activity is taken. (b)       Evaluation and ranking of activities – Each activity is assessed; those that are perhaps part of a legal obligation become ‘must do’ activities; others may be viewed as discretionary. The company will have to decide which of the activities offer the greatest value for money (VFM) or the greatest benefit for the lowest cost. (c)       Allocation of resource – The budget will then be created for the accepted activities.

4.3       Advantages of ZBB
(a)        It is possible to identify and remove inefficient or obsolete operations.
(b)       It forces employees to avoid wasteful expenditure.
(c)        It can increase motivation.
(d)       It responds to changes in the business environment.
(e)        ZBB documentation provides an in-depth appraisal of an organisation's operations.
(f)        It challenges the status quo.
(g)       In summary, ZBB should result in a more efficient allocation of resources.
4.4       Disadvantages of ZBB
(a)        The volume of extra paperwork is created.
(b)       Short-term benefits might be emphasised to the detriment of long-term benefits.
(c)        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.
(d)       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.
(e)        The organisation's information systems may not be capable of providing suitable information.
(f)        The ranking process can be difficult. Managers face three common problems.
(i)        A large number of packages may have to be ranked.
(ii)       It can be difficult to rank packages which appear to be equally vital, for legal or operational reasons.
(iii)      It is difficult to rank activities which have qualitative rather than quantitative benefits – such as spending on staff welfare and working conditions.
4.5       Using ZBB:
(a)       It is particularly useful for budgeting for discretionary costs and for rationalization purposes.
(b)       ZBB can also be successfully applied to service industries and non-profit-making organizations such as local and central government departments, educational establishments, hospitals and so on, and in any organization where alternative levels of provision for each activity are possible and where the costs and benefits are separately identifiable.
(c)        ZBB can also be used to make rationalisation decisions. 'Rationalisation' is 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.
(d)       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, personnel, 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.

5.      Activity Based Budgeting

5.1	Activity based budgeting (ABB)
	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.

5.2       Benefits of ABB
(a)        Different activity levels will provide a foundation for the 'base' package and incremental packages of ZBB.
(b)       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.
(c)        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).
(d)       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?

6.      Rolling Budgets

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

6.2       Advantages of rolling budgets
(a)        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.
(b)       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.
(c)        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.
(d)       Realistic budgets are likely to have a better motivational influence on managers.
(e)        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.
6.3       Disadvantages of rolling budgets
(a)        They involve more time, effort and money in budget preparation.
(b)       Frequent budgeting might have an off-putting effect on managers who doubt the value of preparing one budget after another at regular intervals.
(c)        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.

7.      Criticisms of Budgeting

7.1       Criticisms of budgeting
(a)        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.
(b)       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'.
(c)        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.
(d)       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.
(e)        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.
(f)        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.
(g)       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, will have a detrimental effect on the organisation in the longer term.
(h)       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.
(i)        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.
(j)        Budgets lead to unethical behaviour. For example building slack into the budget in order to create an easier target for achievement.

8.      Changing Budgetary Systems

8.1       An organisation which decides to change its type of budget used, or budgetary system, will face a number of difficulties.
(a)        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.
(b)       Loss of control. Senior management may take time to adapt to the new system and understand the implications of results.
(c)        Training. 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.
(d)       Costs of implementation. Any new system or process requires careful implementation which will have cost implications.
(e)        Lack of accounting information. The organisation may not have the systems in place to obtain and analyse the necessary information.

9.      Budget Systems and Uncertainty

9.1       Uncertainty can be allowed for in budgeting by means of flexible budgeting, rolling budgets, probabilistic budgeting and sensitivity analysis.
9.2       Causes of uncertainty in the budgeting process include:
(a)        Customers. They may decide to buy less than forecast, or they may buy more.
(b)       Products/services. In the modern business environment, organisations need to respond to customers' rapidly changing requirements.
(c)        Inflation and movements in interest and exchange rates.
(d)       Volatility in the cost of materials.
(e)        Competitors. They may steal some of an organisation's expected customers, or some competitors' customers may change their buying allegiance.
(f)        Employees. They may not work as hard as was hoped, or they may work harder.
(g)       Machines. They may break down unexpectedly.
(h)       There may be political unrest (terrorist activity), social unrest (public transport strikes) or minor or major natural disasters (storms, floods).

Examination Style Questions

Question 1
Northland’s major towns and cities are maintained by local government organisations (LGO), which are funded by central government. The LGOs submit a budget each year which forms the basis of the funds received.

You are provided with the following information as part of the 2010 budget preparation.

Overheads
Overhead costs are budgeted on an incremental basis, taking the previous year’s actual expenditure and adding a set % to allow for inflation. Adjustments are also made for known changes. The details for these are:

Note 1: One new staff member will be added to the overhead team; this will cost $12,000 in 2010
Note 2: A move towards the paperless office is expected to reduce stationery costs by 40% on the 2009 spend

Road repairs
In 2010 it is expected that 2,000 metres of road will need repairing but a contingency of an extra 10% has been agreed.

In 2009 the average cost of a road repair was $15,000 per metre repaired, but this excluded any cost effects of extreme weather conditions. The following probability estimates have been made in respect of 2010:

Inflation on road repairing costs is expected to be 5% between 2009 and 2010.

New roads
New roads are budgeted on a zero base basis and will have to compete for funds along with other capital projects such as hospitals and schools.

Required:

(a)        Calculate the overheads budget for 2010.                                                           (3 marks)
(b)       Calculate the budgets for road repairs for 2010.                                                 (6 marks)
(c)        Explain the problems associated with using expected values in budgeting by an LGO and explain why a contingency for road repairs might be needed.                                                (8 marks)
(d)       Explain the process involved for zero based budgeting.                                     (3 marks)
(20 marks)
(ACCA F5 Performance Management June 2009 Q5)

Question 2
Explain why incremental budgeting is a common method of budgeting and outline the main problems with such an approach.                                                                                                                    (6 marks)
(ACCA F5 Performance Management December 2008 Q4(c))

Question 3
Many local government organisations operate incremental budgeting as one of their main budgeting techniques. They take a previous period’s actual spend, adjust for any known changes to operations and then add a % for expected inflation in order to set the next period’s budget.

Required:

Describe two advantages and two disadvantages of a local government organisation funded by taxpayer’s money using incremental budgeting as its main budgeting technique.                          (6 marks)
(ACCA F5 Performance Management December 2009 Q3(c))

Question 4
Some commentators argue that: ‘With continuing pressure to control costs and maintain efficiency, the time has come for all public sector organisations to embrace zero-based budgeting. There is no longer a place for incremental budgeting in any organisation, particularly public sector ones, where zero-based budgeting is far more suitable anyway.’

Required:

(a)     Discuss the particular difficulties encountered when budgeting in public sector organisations compared with budgeting in private sector organisations, drawing comparisons between the two types of organisations.                                                                                                         (5 marks)
(b)     Explain the terms ‘incremental budgeting’ and ‘zero-based budgeting’.             (4 marks)
(c)     State the main stages involved in preparing zero-based budgets.                         (3 marks)
(d)     Discuss the view that ‘there is no longer a place for incremental budgeting in any organisation, particularly public sector ones,’ highlighting any drawbacks of zero-based budgeting that need to be considered.                                                                                                                               (8 marks)
(20 marks)
(ACCA F5 Performance Management December 2010 Q5)