1/28/2016

17
Budgeting
F.~
• A budget is a document that translates plans into
money, that will need to be spent to get planned
activities done (expenditure) and money that will
need to be generated to cover the costs of getting
the work done [income).
• It is an estimate, or informed guess, about what
will be needed in monetary terms to do work.
• This process of financial planning known as.
budgeting.
• The budget is an essential management tool.

Benefits of Budgeting
• Budgets set targets. It helps people to work towards a set target.
• Budget are a measure of how much money is needed to carry out activities.
• Budgets are a form of communication. Employees are aware of performance
expectations with regards to their individual work area.
• Budgets act as a monitoring, coordinating and controlling tool. By doing a variance
analysis the manager can estimate where actual results. are different from the
budgeted results.
• Aid to the planning process by providing a series of quantitative guidelines which
can be followed to achieve organisational objectives.
The budget forces rigorous thinking through the implications of activity planning.
There are times when the realities of the budgeting process forces to rethink
;;iction plans.
Used properly, budgets tell when certain amounts of money wilf be needed to
carry out activities.
The budget enables monitoring income and expenditure and identify any
problems.
• The budget is a basis for financial accountability and transparency. When everyone
can see how much should have been spent and received, they can ask informed
questions about discrepancies.

- To. M.anCL~ FU()cU/ plal])I .

- To f1lUe dl'Te.e.hoV'- / e-wdClnC1' !7) fztVb

g...

_ To IYlOlLlto'i perfu"(n'J"'fl0' cr ae1.leve.. 1

tarf~h
- To allocate
_'T,ffi-L J. (Luo\lf4 0'fl~~"" 'OJ' - To srr(~lY1-une
cleolaho(L.
- "\"rro\o{ f()$."S ~ AIl,H-tA- ~ ffortl>f\,r,VJ. I- Ia~0
- To IMflemenl p 'V>
 1/28/2016
tl .• ,
.
• ~

"./
• •• ..
"f
Limitations of Budgeting
• Budgeting is a time consuming and costly job. The
development of budget includes many repetitive
steps before the budget is finally approved.
• Compared with its costs, budgeting provides little
valuable, reliable and relevant information.
• Budgets are based on assumptions that often
turn out to be inaccurate.
• Budgets also .causegreat. deal of waste and
behavioural problems. People's main goal is to
meet the budgets, so they always try to negotiate
to get lower targets with lower sales and higher
costs, which are well known as padding the
budgets.

Different budgeting techniques

• The two main techniques for budgeting:

.Incremental budgeting
Zero based budgeting

2
 1/28/2016
••

Incremental Budgets.
• Incremental Budgets are budgets in which the figures are based on
those of the actual expenditure for the previous year, with a
percentage added for an inflationary increase for the next year.
• This is an easy method that saves time and preparation costs but it is
the "lazy" way and is often inaccurate.
• .Prevents conflict between departmental managers since a consistent
approach is adopted throughout the organisation.
• The impact of changes can be seen and traced quickly
• This budgeting.technique is only suitable for organisations where each
year. is very simil"arto the previous one in terms of activities. It
assumes that all current activities and costs are still needed, without
examining and justifying them in detail.
• Very few dynamic organisations or projects are so stable that this
budgeting technique really works for them.
• There is no incentive to try and reduce costs and performance targets
are often unchallenging

Example
• A bank will have a sizeable amount in its budget
for staff salaries. In one particular year, staff
salaries were LKR 1.5 bn. When the budget is
being prepared for the next year, the CEO thinks
that he will need to employ two new senior
managers, who will be paid a salary of LKR
500,000 each monthly (before any pay rises) and
also, that he will need to give all staff members a
pay increase of 10%. Assuming that the two new
staff will receive the increased pay levels,
calculate his budget for staff salaries.
I,SOO}ooo,ooo XIO'j. -'J ISO/DOO}000
N (t'-/ Moe. -'2 - 13)100 000
I I\ .4 I SClo octd 0

_-------
••......
~ (I bb2./2.lA?pDOI ~
3
 1/28/2016

Zero Based Budgets

• In zero based budgets, past figures are not used as the starting
point. The budgeting process starts from "scratch" with the
proposed activities for the year.
• The result is a more detailed and accurate budget, but it takes more
time and energy to prepare a budget in this way.
• This technique is essential for new organisations and projects, but it
is also probably the best route to go in a dynamic organisation that
is proactive in taking on new challenges. .
• Every departmental function is reviewed comprehensively, with all
expenditure requiring approval, rather than just the incrementai
expenditure requiring approvaL
• Zero-based budgeting tries to achieve an optimal allocation of
resources to the parts of the business where they are most needed,
by forcing managers to justify every activity in their department.
Until they do this, the budget for their department is zero.

Zero Based Budgets (contd ...)

• A questioning attitude is developed by management,
who are constantly forced to ask themselves questions
such as:
- Is the activity really necessary at all?
- What happens if the activity ceases?
- Is the current level of provision adequate?
- What other ways are there of carrying out the activity?
- How much should the activity cost?
- Do the benefits to be gained from the activity at least
match the costs?

All of these questions are largely answered by breaking

the budgeting process down into three distinct stages.

4
 .,
,
,,,

1/28/2016

STAGES IN ZERO-BASED BUDGETING

• 1. Activities are identified by managers. Managers are then forced
to consider different ways of performing the activities. These
activities are then described in what is called a 'decision package',
which:
- analyses the cost ofthe activity
- states its purpose
- identifies alternative methods of achieving the same purpose"
- establishes performance measures for the activity
~ assesses the. consequence of not performing the activity at all or of
performing it at different levels, 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 ievel of service or support.

While some form of cost-benefit analysis may be useflil at this stage, a

degree of quantitative analysis must also be incorporated.

STAGES IN ZERO-BASED BUDGETING

2. Management will then rank all packages in the

. order of decreasing benefits to the organisation.
This will help management decide what to spend
and where .to spend it. This ranking of the decision
packages happens at numerous levels of the.
organisation. (eg: should the senior managers be
recruited?)

3. Resources are then allocated based on priority.

5
 1/28/2016

Benefits of ZBB
• The benefits afZBS are substantial. They would have to be otherwise no
organisation would ever go to the lengths detailed above in order to implement it.
These benefits are set out below:
• Since ZBB does not assume that last year's allocation of resources is necessarily
appropriate for the current year, all of the activities of the organisation are re-
evaluated annually from a zero base. Most importantly therefore, inefficient and
obsolete activities are removed, and wasteful spending is curbed. This.has got to
be the biggest benefit of zero-based budgeting compared to incremental
budgeting and was the main reason why it was developed in the first place.
• By its nature, it encourages a bottom-up approach to budgeting in order for ZBB 'to
be used in practice. T~is should encourage motivation of employees.
• It challenges the status quo and encourages a questioning attitude among
managers.
• It responds to changes in the business environment from one year to the next .
• Overall, it should resolt in a more efficient allocation of resources .

Drawbacks of ZBB
Departmental managers may nt)t have the necessary skills to construct decision packages. They wHl need
,training for this and training takes time and money
In a large organisation, the number of activities wlJl be so large that the amount of paperwork generated
from zaB will be unmanageable.
Ranking the packages can be difficult, since man'.,. activities cannot be compared on the basis of purely
quantitative measures. QUilJitative factors need to be incorporated but this is difficult. Top level
management may not have the time or knOWledge to rank what could be thousands of packages. This
problem can. be somewhat alleviated by having a hierarchical ranking process, whereby each level of
managers rank the padtages of the managers who report to them.
The process of .identifying decision packages and determining their pur~se. costs and benefits is
massively time consuming and costly. One solution to this problem is to use incremental budgeting every
year and then use ZaB every three to five years, or when major change occurs. This means that an
organisation can benefit from some oftne advantages of ZBB without an annual time and cost implication.
Another option is to use zsa for some departmenls but not for others. Certain costs are essential rather
than discretionary and it could be argued that it Is pointless to carry out ZBa in relation to these. For .
example, electricity costs in a bank are expenses that will have to be paid, irrespective of the budget
amount anocated to them, Incremental budgeting would seem to be more suitable for costs like these, as
with building repair costs.
Since decisions are made at budget time, manager'S 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.
The organisation's MIS might be unable to provide the necessary information.
It could be argued that ZaB is far more suitable for public sector than for private sector organisations. This
is because, firstlv, It is far easier to put activities imc decision packages in organisations which under:take
set definable activities. local government, for example, have set activities inciuding the provision of
housing, schools and local transport. Secondly, it is far more suited to costs that are discretionary in natu~e
or fur support activities. Such costs can be found mostly in not fur profit orsanisations or the public sector,
or in the service dep.aJ1ment of commercial operations.

6
,.'~

1/28/2016

Rolling Budgets
A rolling budget is also known as a continuous budget, a perpetual budget, or a rolling
horizon budget.

Example:
A bank's accounting year ends on each December 31st. Priorto the start of the year 2013, the
bank prepares its annual budget which is detailed by month for January through December
2013. This budget could become it rolling budget if after January 2013 the bank drops the
budget for January 2013 and adds the budget for Januarv 2014. This rolling budget now
covers the one year, or 12-month, period of 1~ February 2013 through 31'" January 2014. At
the end of February 2013, the rolling budget will drop February 2013 and will add FehrLJary
2014, At this point the rolling budget will cover the one year period of 1$1March 2013
through 28[h February 2014.

The ben~fit of a rolling budget is that the bank's management will always have a budget that
looks forward for one full year.

A rolling budget GOulduse 3-month periods or quarters instead of months.

Also. a bank might have a 5-year rolling budget for capital expenditure. In this case 2 full year
will be added to replace the year that has just ended. This 5-year rolling budget meam that
management will always have a S.year planning horizon .

.Activity-Erased Budgeting
• ABB is a method of budgeting in which the activities that incur costs in
every functional area of an organization are recorded and their
relatfanships are defined and analyzed. Activities are then tied to strategic
goals, after which the costs of the activities needed are used to create the
budget. ABB can help firms create more accurate financial forecasts.
• In contrast to cost-based budgeting practices in which a prior period's
budget is simply adjusted to account for inflation or revenue growth, ABB
provides opportunities to align activities with objectives, streamline costs
and improve business practices.
• By looking at the cost structure of an organization via the processes that
are actually being performed, managers can more effectively analyze the
profit potential of a company's products and services. Cost efficiencies can
be found by comparing activities performed in different areas of the
organization and consolidating or rerouting certain functions.

7
 1/28/2016

tBB & ABB Comparison

• ZBB is a method where all expenses have to be justified
for every new period.
• ABB is a budgeting method where all the activities that
invite cost in all functional areas in an organisation are
recorded and the relationship between them analysed.
• In ZBB, all functions in an organisation are analysed for
its needs and costs.
• ZBB can also be termed as a re-evaluationof the
program and expenditures of an organisation.
• ABB aligns all activities with the objectives.
• ABB helps in effective analysis of the profit potential of
an organisation's services and its products.

Line-Item Budgeting
Offers decision~makers a stepo.by-step, approach to budgeting. Bu"dget"makerS ca~ use a line-item
budget to make specific decisions, such as changing funding levels of programs Qeing phased out to
provide money for new programs or making cuts to budgeted expenses because of changes in
organizational policies.

Advantages:
Easy to Make
• Simply list"all expenses, giving each item its own line and specific amount. This is why many
organisations, especially very small businesses, choose line-item"budgeting.lt is Straightforward
and does not require linking budgeting to advanced accounting, such as activity-based costing or
manage'ment practices, such as performance-based budgeting. .
Mlcro-l.evel EXpense Control
Une-item budgets offer advantages for managers seeking to control eXpens~s,at the operational
level.
Flexible Control
Line-item budgeting can give a large organization flexible use of budgetary control, giving flexibility
to some programs and not others based on defined criteria.
Reliance of Past Data
line-item budgeti~g is easy to model after past budgets and other historical'data.

8
..
1/28/20lE

Performance-based budgeting
• Performance budgets use statements of missions, goals and
objectives to explain why the money is being spent. It is a way to
allocate resources to achieve specific objectives based on program
goals and measured results. The entire planning and budgeting
framework is result oriented. There are objectives and activities to
achieve these objectives and these form the foundation of the
overall evaluation.
• Performance budgeting comprises three elements:
the result"{final income)
- the strategy (different ways to achieve the final outcome)
- activity/outputs (what is actuaily done to achieve the final outcome)
• It is possible to understand which activities are cost-effective in
terms of achieving the desired result.
• PBB is a way to allocate resources for achieving certain objectives
• PBB sets a goal, or a set of goals, to which monies are allocated.
• Balanced Scorecard and KPls maybe involved in PBB