Achievers Budgeting Devinda Weerasekara

WHAT IS A BUDGET?

A budget is a quantitative, forward looking, plan of action prepared for a specific time period. It is
expressed in financial terms. Common used budget periods are, monthly, quarterly, semi-annually and
annually. However, Annual Budgets are the most popular.

PURPOSES OF BUDGETS

Budgeting serves a number of purposes such as:

• Planning: A budget is a plan which is prepared for the future. This forces the management to look
into the future and this is vital since it stops the management from ad hoc or poorly coordinated
planning.

• Authorisation: A budget will be a formal authorisation to incur expenditure. A manager may incur
expenses for reasons such as hiring staff, pursuing plans or strategies. However, the spending
should be done within the budget. If the expenses exceed the budget, this will reflect negatively
on the manager.

• Control: A budget will control the expenses of an organisation. After a variance analysis,
corrective action could be taken if needed.

• Communication: A budget will allow the Managers and Subordinates to communicate. A budget
is a communication by the managers to the subordinates regarding the targets which should be
achieved.

• Evaluation (Performance Measurement): Organisation is divided into budget centres and for each
budget centre, there will be a manager who is responsible for the performance of the centre. A
budget will be used to evaluate the performance or the actions of the manager.

• Motivation: A budget is a target for the managers. If a manager can achieve the budget allocated
to the particular budget centre, then the manager will be rewarded. Therefore, managers will be
motivated and will be constantly taking proper actions to achieve the budget.

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LEVELS OF BUDGETING

Strategic Planning

Strategic plans are designed with the entire organization in mind and begin with an organization's
mission. Top-level managers, such as CEOs or presidents, will design and execute strategic plans
to paint a picture of the desired future and long-term goals of the organization and allocate
resource accordingly. Essentially, strategic plans look ahead to where the organization wants to
be in three to five years. Strategic plans, provided by top-level managers, serve as the framework
for lower-level planning.

Tactical Planning

Tactical Plans are medium term and will focus on the next one to two years. This will be prepared
in line with the Strategic Plan. This will look at the department and divisional level and specifies
how to use the resources.

Operational Planning

Operational plans are the plans that are made by frontline, or low-level, managers. All operational
plans are focused on the specific procedures and processes that occur within the lowest levels of
the organization. Managers must plan the routine tasks of the department using a high level of
detail. This is short term Budgeting and will have a plan which is less than one year.

• The aim is that if a manager achieves short term budgetary goals (operational plan) there is
a high chance of meeting the tactical goals and ultimately make the strategic plan a success.

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APPROACHES TO BUDGETING

Different organisations adopt different budgeting techniques. The most commonly used
techniques are:

• Rolling Budgets (Continuous Budgets) -Covered in F2

• Incremental Budgeting -Covered in F2
• Top down Budgeting (Imposed Budgeting)- Covered in F2
• Bottom up Budgeting (Participative Budgeting) - Covered in F2
• Zero Based Budgeting (ZBB) - Covered in F2
• Activity Based Budgeting – New Area of F5

Rolling Budgeting

A budget (Usually Annually) which is constantly updated after each period (Monthly or Quarterly)
when the earliest accounting period has expired.

A rolling budget could be prepared in the following manner:

• Prepare the budget for a period of 4 quarters (E.g.: January to December).

• At the end of the first period (E.g.: 1st Quarter-: 31st March), variance analysis is made of that
period’s results against the budget. The conclusions drawn from this variance analysis are
used to update the budgets for the remaining periods and add a budget for a further three
months.

• This process is repeated at the end of each period (In this case, each quarter).

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• For example, lets take the sales budget:

A rolling budget is suitable if:

• If the business operating in a dynamic environment where forecasting is difficult.

• If the organisation requires tighter control.

Advantages and Disadvantages of Rolling Budgets are:

Advantages Disadvantages

Planning and Controlling will be based on a More Costly and Time consuming compared to
more accurate budget an incremental budget.

Will reduce the element of uncertainty in Employees will spend majority of their time
budget since it will concentrate on the short preparing budgets which is not their main
term. role and this may demotivate them. Also
they will not like to see their targets revised
so many times.

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There is always a budget (A plan) extending If the employees get tired of preparing the
into the future. budgets so often, they might simply add or
deduct a percentage from the previous
budget just for the sake of completion which
exposes it to the risk of becoming an
incremental budget.

Forces the management to re-assess the Increased budgeting work may lead to less
budgets regularly and to produce budgets focus on control of the actual results.
more up-to-date.
Focusing mainly on budgeting will distract
the organisation form key issues and they
might not be able to identify and capitalize
on opportunities or might not foresee threats

Incremental Budgeting

An incremental budget is a budget which is simply prepared by taking the previous year’s
budget and adding a percentage to cover up for inflation and other changes.

This will work in a static business environment where the changes are very minimal. However, in
a dynamic business environment, this technique will definitely not work since a lot can change
since the previous budget.

Incremental Budget = Last Year’s actual results + Inflation

Example: If the 2019 Actual expenses were $ 10 Million and the inflation rate of the country is
10%, then the 2020 expense budget would be as follows:

2020 Expense Budget = 2019 Actual Expenses + Inflation

= $ 10 Mn + ($ 10 Mn x 10%)
= $ 11 Million

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Advantages and Disadvantages of Incremental Budgets are:

Advantages Disadvantages

Quickest and Easiest Budgeting Technique. Carries the previous budget inefficiencies to
the future budgets.

Suitable for organisations in a static business Uneconomic activities may be continued due
environment. to previous practices. (E.g.: producing a
component in-house when it is cheaper to
outsource).

Managers may tend to use up the budget

simply because it’s available, hoping to
obtain a larger budget for the next period.

Top down (Imposed) Budgeting

An imposed budget is a budget allowance which is set without permitting the ultimate budget
holder to have the opportunity to participate in the budgeting process.

In other words, the Top level of an organisation will prepare the budget and impose (force) it on
to the lower level managers to achieve it.

The lower level managers are not consulted when preparing these budgets but they have achieve
it even though it might be an unrealistic budget.

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Advantages and Disadvantages of imposed budgets:

Advantages Disadvantages

Involving managers are more time It may result in dissatisfaction, defensiveness

consuming than the top level simply and low morale among employees, who
imposing it. must implement the budget.

Managers may not have the skills to be
involved in the budgetary process and they
may not be motivated.
The directors have a better overall view of
the organisation can place the resources to
get the maximum utilization.
It is the lower level workers who are closer
to the customers and hence they will be
able to give a more practical input to the
process.
The accountability of the ultimate budget
holder towards the budget will be low since
it was prepared by a third party.

Budgetary slack could be avoided.

The top level is aware about the long term

goals which the lower level managers may
not be aware of to prepare the ideal budget.

When directors prepare the budgets, it is

someone outside the division a fresher
perspective may be incorporated into the
budget.

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Bottom up Budgeting (Participative Budgeting)

A bottom up budget is a system of budgeting in which budget holders have the opportunity to
participate in setting their own budgets. Also called participative budgeting. In other words, the
lower level managers will also get an opportunity to participate in the budgeting process.

Advantages and Disadvantages of participative budgets:

Advantages Disadvantages

Increased motivation due to the ownership of Director may lose control.

budgets.

The operational level workers are closer to the Dysfunctional Behaviour: The budgets will reflect
customer and hence a more practical input could divisional concerns, but it may not be in line with
be obtained. the overall corporate objectives.

Increases the manager’s understanding and Bad decisions from inexperienced lower level
commitment because it is his or her own budget. managers.

Directors could concentrate on strategy. Budgetary slack may arise.

Significant time will be consumed.

May not reflect long term objectives of the

organization since the lower levels are more
focused on short to medium term.

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Budgetary Slack:

Budget slack is simply an employee purposely understating a revenue budget or overstating an

expense budget just to ensure that the targets are met easily, and the employee obtains a good
bonus. This occurs when the employees are given the chance to prepare their own budgets.

Zero Based Budgeting

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'

It is suitable for:

• allocating resources in areas were spend is discretionary (optional). For example, research
and development, advertising and training.
• public sector organisations such as local authorities.

Implementation of ZBB:

There are 4 key steps in implementing ZBB in an organization:

1. List down all activities planned across all departments for the next financial year

Example: Marketing department may have the following 3 activities planned for the next
year:
I. TV Advertisement
II. Newspaper Advertisement
III. Sponsorship

2. Perform a cost benefit analysis for all activities

Example: Cost benefit analysis for TV Advertisement:

Cost of the TV advertisement - ($ 15,000)

Benefit of the TV Advertisement
(Increase in Profit due to the TV advertisement) - $ 50,000
Net Benefit / Cost Benefit - $ 35,000

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3. Rank all activities based on the cost benefit. Rank 1 will be the activity with the highest cost
benefit.

4. Allocate resources based on the rank. First allocation will be done for the rank 1 activity.

Advantages and Disadvantages of ZBB are:

Activity Based Budgeting (ABB)

ACCA Official Terminology describes activity-based budgeting (ABB) as a method of budgeting
based on an activity framework, using cost driver data in the budget setting and variance
feedback processes.

The most basic form of ABB uses cost drivers (identified through activity-based costing, ABC) to
help derive budgets. As its name suggests, ABB focuses on activities rather than functions
(departments).

In simple terms, ABB follows four stages:

1. Identify activities and their cost drivers
2. Calculate the cost driver rate (cost per unit of activity).
3. Forecast the number of units of cost driver for the required activity level
4. Calculate the budget (Cost drive rate x number of units of cost driver)

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The following simple example uses a sales order processing cost scenario, where the cost driver
is number of sales orders.

• Activity is sales order processing and the cost driver is the number of sales orders
• Calculate the forecast cost of processing a single sales order using ABC. Let’s say this is
$5 per sales order
• Forecast the number of sales orders for the budget period. Assume it is calculated to be
40,000 sales orders.
• Finally, calculate the total sales order processing cost budget -: 40,000 x $5 = $200,000

Flexed Budgets
A flexed budget is a budget that is prepared for the actual activity level. The budget prepared at
the start of the year is known as the “fixed budget”.

However, the budgeted activity level and the actual activity levels are different in most
situations. Hence, we cannot do a variance analysis, since we cannot compare costs and
revenues at different activity levels.

As a result, we need to prepare the budget at the actual activity level and then compare with
the actual results. The budget prepared at the actual activity level is known as the “Flexed
Budget”.

For variance analysis, it is always the flexed budget and the actuals that should be compared.

Example:

Raw Material Budget - 1000 Kg @ a total cost of $ 20,000

Actual Raw Material Purchases – 2500 Kg @ a total cost of $ 46,000
Calculate:
1. Flexed budget for 2500 Kg of Raw Material Purchases
2. Material Price Variance

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What is Budgetary Control ?

It is a system through which the organizations tend t monitor and control whether the set
budgets are achieved and to take corrective actions.

Types of Budgetary Control

There are 2 main types of budgetary control:

• Feed-back Control System

• Feed-forward Control System

Feed-back Control System

The aim of this control system is to take corrective actions for the problems that have already
occurred.
The budget is set at the start of the year and the actual results are compared at the end of the
year (nothing is done in the year to monitor the budget achievement) and a variance analysis is
performed. Based on the findings and the reasons for the variance, corrective action will be
taken for the next year.
However, the current year is already lost, and we are reacting to the variance in the current
year to take actions for the next year.
Therefore, a feedback control system is known as a Reactive Control System since it waits for
the problem to occur and then react to it.
Example:

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Feed-forward Control System

The aim of this system is to anticipate problems and take actions in order to prevent the
problems from occurring.
The budget is set at the start of the year and after few months, let’s say 3 months, a forecast is
made using the first 3 months actual results. The forecast will indicate what the actual results
would be at the end of the year. This forecast is then compared with the budget to calculate a
forecasted variance. The reasons for the variance will then be used to take actions for the
current year.
Through this method we ensure that the current year is not lost, and the targets are achieved.
Since the Feed-forward control system anticipates problems and prevents them from occurring,
it is known as a Proactive Control System.

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Positive Feedback
In Feed-back and Feed-forward control, if the variance /forecasted variance is favourable, then
it is known as positive feedback since it indicates that we will be achieving the budget.
Negative Feedback
In Feed-back and Feed-forward control, if the variance /forecasted variance is adverse, then it is
known as negative feedback since it indicates that we will not be achieving the budget.
Single loop Feedback
If the corrective action taken is to improve the processes, efficiency and ways of working, it is
known as single loop feedback.
Double loop Feedback
If the corrective action taken is to change the budget, it is known as double loop feedback.

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