CIMA BA2 Syllabus C. PLANNING AND CONTROL - Types of Budgets - Notes ^{5 / 6}

Incremental budgeting is a process whereby this year’s budget is set by reference to last year’s actual results after an adjustment for inflation and other incremental factors.

It is commonly used because:

1. It is quick to do and a relatively simple process. 

   This makes it possible for a person without any accounting training to build a budget.

2. The information is readily available, so very limited quantitative analysis is needed.

3. It is appropriate in some circumstances. 

   For example, in a stable business, the amount of stationery spent in one year is unlikely to be significantly different in the next year, so taking the actual spend in year one and adding a little for inflation should be a reasonable target for the spend in the next year.

There are problems involved with incremental budgeting:

1. It builds on wasteful spending (inefficiencies). 

   If the actual figures for this year include overspends caused by some form of error then the budget for the next year would potentially include this overspend again.

2. It encourages organisations to spend up to the maximum allowed (encourages slack) in the knowledge that if they don’t do this then they will not have as much to spend in the following year’s budget.

3. Assessing the amount of the increment can be difficult.

4. It is not appropriate in a rapidly changing business.

5. Can ignore the true (activity based) drivers of a cost leading to poor budgeting.

Zero-based budgeting requires that activities be re-evaluated as part of the budget process so that each activity, and each level of activity, can justify its consumption of the economic resources available.

This is in contrast to incremental budgeting, where the current budget is increased to allow for expected future conditions. Zero-based budgeting prevents the carrying forward of past inefficiencies that can be a feature of incremental budgeting and focuses on activities rather than departments or programmes.

Each activity is treated as though it was being undertaken for the first time and is required to justify its inclusion in the budget in terms of the benefit expected to be derived from its adoption.

Steps in zero-based budgeting

Zero-based budgeting involves three main stages

1. Activities are identified by managers. These activities are then described in what is called a ‘decision package’. 

   This decision package

   a. Analyses the cost of the activity

   b. States its purpose

   c. Identifies alternative methods of achieving the same purpose

   d. Establishes performances measures for the activity

   e. Assesses the consequence of not performing the activity at all or of performing it at different levels.

   This decision package is prepared at the base level, representing the minimum level of service or support needed to achieve the organisation’s objectives. Further incremental packages may then be prepared to reflect a higher level of service or support

2. Management will then rank all the packages in the order of decreasing benefits to the organisation. 

   This will help management decide what to spend and where to spend it.

3. The resources are then allocated based on order of priority up to the spending level

Advantages claimed for zero-based budgeting

1. It eliminates the inefficiencies that can arise with incremental budgeting.

2. It fosters a questioning attitude towards current activities.

3. It focuses attention on the need to obtain value for money from the consumption of organisational resources.

Disadvantages claimed for zero-based budgeting

1. Departmental managers will not have the skills necessary to construct decision packages. They will need training for this and training takes time and money.

2. In a large organisation, the number of activities will be so large that the amount of paperwork generated from ZBB will be unmanageable.

3. Ranking the packages can be difficult, since many activities cannot be compared on the basis of purely quantitative measures. Qualitative factors need to be incorporated but this is difficult.

4. The process of identifying decision packages, determining their purpose, costs and benefits is massively time consuming and therefore costly.

5. Since decisions are made at budget time, managers may feel unable to react to changes that occur during the year. This could have a detrimental effect on the business if it fails to react to emerging opportunities and threats.

It could be argued that ZBB is more suitable for public sector than for private sector organisations. This is because, firstly, it is far easier to put activities into decision packages in organisations which undertake set definable activities.  Local government, for example, has set activities including the provision of housing, schools and local transport.

Secondly, it is far more suited to costs that are discretionary in nature or for support activities. Such costs can be found mostly in not for profit organisations or the public sector, or in the service department of commercial operations.

Since ZBB requires all costs to be justified, it would seem inappropriate to use it for the entire budgeting process in a commercial organisation. Why take so much time and resources justifying costs that must be incurred in order to meet basic production needs?

It makes no sense to use such a long-winded process for costs where no discretion can be exercised anyway. Incremental budgeting is, by its nature, quick and easy to do and easily understood. These factors should not be ignored.

Activity-based budgeting (ABB) would need a detailed analysis of costs and cost drivers so as to determine which cost drivers and cost pools were to be used in the activity-based costing system.

However, whereas activity-based costing uses activity-based recovery rates to assign costs to cost objects, ABB begins with budgeted cost-objects and works back to the resources needed to achieve the budget.

The budgeted activity levels are determined in the same way as for conventional budgeting in that a sales budget and a production budget are drawn up.

ABB then determines the quantity of activity cost drivers (e.g. number of purchase orders, number of set-ups) needed to support the planned sales and production.

Standard cost data would be compiled that include details of the activity cost drivers required to produce a product or number of products.

The resources needed to support the budgeted quantity of activity cost drivers would then be determined (e.g. number of labour hours to process purchase orders, number of maintenance hours needed to complete set-ups).

This resource need would then be matched against the available capacity (i.e. number of purchase clerks to process purchase orders) to see whether any capacity adjustment were needed.

Advantages of ABB

1. Organisational resources are allocated more efficiently due to the detailed cost and activity information obtained by implementing an ABB system.

2. It avoids slack that is often linked to incremental budgeting due to its detailed assessment of the activities and resources needed to support planned sales and production.

3. In ABB the costs of support activities are not seen as fixed costs to be increased by annual increments, but as depending to a large extent on the planned level of activity.

4. It provides a useful basis for monitoring and controlling overhead costs, by drawing management attention to the actual costs of activities and comparing actual costs with what the activities were expected to cost.

Disadvantages of ABB

1. A considerable amount of time and effort might be needed to establish an ABB system, for example to identify the key activities and their cost drivers.

2. ABB might not be appropriate for the organisation and its activities and cost structures.

3. A budget should be prepared on the basis of responsibility centres, with identifiable budget holders made responsible for the performance of their budget centre. 

   A problem with ABB could be to identify clear individual responsibilities for activities.

4. It could be argued that in the short term many overhead costs are not controllable and do not vary directly with changes in the volume of activity for the cost driver. 

   The only cost variances to report would be fixed overhead expenditure variances for each activity.

A rolling budget is sometimes called a continuous budget.

Here, a portion of the budget period is replaced on a regular basis so that the overall budget period remains unchanged.

For example, with a budget period of one year, at the end of each quarter a new quarter could be added to the end of the budget period and the elapsed quarter could be deleted, so that the budget will always be looking one year ahead.

A cash budget is often a rolling budget because of the need to keep tight control of this area of financial management.

A rolling budget is also supported by the availability of cheap and powerful information processing via personal computers and computer networks.

Advantages of rolling budgets

1. 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.

2. 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.

3. 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.

4. Realistic budgets are likely to have a better motivational influence on managers.

5. 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.

Disadvantages of rolling budgets

1. They involve more time, effort and money in budget preparation.

2. Frequent budgeting might have an off-putting effect on managers who doubt the value of preparing one budget after another at regular intervals.

3. 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.