BEDER INTERNATIONAL έΪ˰˰ΑΔ˰˰ό˰˰ϣΎ˰˰Ο

UNIVERSITY
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JAAMACADDA BEDER EE CAALAMIGA AH

Project Finance and Budgeting

Chapter 4 : Approaches of
Budgeting
 Chapter Outline
After reading this chapter, the students will be able to
understand:
 Approaches to budgeting
 Incremental budgeting
 Advantages and disadvantages
 Activity based budgeting
 Advantages and disadvantages
 Zero based budgeting
 Advantages and disadvantages
 Introduction
A budget is a tool for both planning & control. At the beginning of
the period, the budget is a plan or standard; at the end of the
period, it serves as a control device to help management measure
the firm’s performance against the plan so that future
performance may be improved.
There are four common methods of budgets that companies use:
(1) incremental, (2) activity-based, (3) zero-based, & (4) based
budgeting. These four budgeting methods each have their own
advantages & challenges, which will be discussed in more detail in
this chapter.
Setting up a budget can be challenging, & choosing the right
budgeting method that best fits your project model & needs. In
this chapter, we will shed light on the most common approaches
to budgeting, as well as their & and cons. 
 Approaches To Budgeting
 Incremental Budgeting (IB)
 Zero-base Budgeting (ZBB)
 Activity Based Budgeting (ABB)
 Base Budgeting

A.Incremental Budgeting: In Incremental Budgeting

last year’s budget is used as a starting point for the
new budget, and a number of increases are ‘pre-
programmed’.  These include inflationary increases,
salary increases, and overall market growth increases.
B. Zero based budgeting: In ZBB the budget for any activity
at the start of each year is set at zero.  All expenditure must
be justified on a cost/benefit basis, including justification of
continuing existence.
C. Base Budgeting: In BB, Phase 1 of the budget is designed
with ‘just enough’ resources to run the organization as a
going concern.  Any incremental spending above this level
must be justified on a cost/benefit basis.
D. Activity Based Budgeting: In ABB, the budget recognizes
that it is activities which generate cost in a project, & the
desire is to control these cost drivers.  For each identifiable
activity, the cost of a unit is measured, the demand is
measured, a budgeted cost is set for each unit of activity, &
the budget is designed around activity terms.
What is Incremental Budgeting (IB)?
• Incremental budgeting is a type of a budgeting process
that is based on the idea that a new budget can best be
developed by making only some marginal changes to the
current budget. In other words, with IB, the current budget
is used as a base to which incremental assumptions are
added or subtracted from the base amounts to determine
new budget amounts.
Among all budgeting methods, IB is commonly considered as
the most conservative approach.
Note that there is no standard formula to determine the
applicable marginal changes in the budgeting process. The
marginal changes are typically determined using certain
assumptions that are based on previous budgeting & expenses.
 Advantages of Incremental Budgeting (IB)

Incremental budgeting can be appealing to organizations

for a number of reasons, including:
• Simplicity
Incremental budgeting is the easiest budgeting approach.
Since it uses the budget for the current period to project
the future budget, it does not require complex calculations.
Also, only a few assumptions are required in the budgeting
method. Finally, the method’s simplicity allows the
organization’s management to save time on the budgeting
process.
• Funding stability
IB may also help ensure that funding remains stable over
time, as expenses are relatively easy to project. This can be
helpful for organizations with projects that require funding for
multiple years. Incremental Budgeting favors the programs or
projects that require funding for multiple years.
• Consistency and operational stability
The dependence on the figures from the budgets of previous
periods ensures that the budgets remain fairly consistent and
relatively stable over time. This approach makes sure that the
departments operate on a consistent basis. Also, it leads to
fewer conflicts if all the departments are treated similarly.
• Reduces internal rivalry
IB generally allocates equal incremental changes to the budget
from one year to the next. Thus, departments within a
company are not forced into a position of competing with each
other to obtain a larger portion of the budget.
• Easy to see the impact of change
Budgets are mostly the same year after year under this
approach. But, if mngt makes any change made to it, one can
easily identify it by comparing with earlier budgets.
• Easy to implement
Being easy to implement is a major reason why businesses go
for this approach. Also, it does not require a lot of detailed
analysis like other budgeting techniques.
 Disadvantages of Incremental Budgeting
Despite its simplicity and consistency, IB is frequently
criticized for a number of underlying flaws. The primary
potential disadvantages of such a budgeting method are as
follows:
• Leads to extra spending
This is the biggest disadvantage of this approach. It is a
known fact that each department tries to get as much as
funds it can to fund its operations. So, if incremental
budgeting is in use, the department will try to spend as
much money as they possibly can to ensure that they get
a similar amount for the next budget.
• Hampers potential growth
As the budget allocates funds in a similar way year after
year, it often gets difficult to get funds for the new
activities. This leads to a conservative business
environment that kills innovation & risk-taking.
• Waste of resources
If the previous budget allocates a certain sum to a
specific project unit. Then, the new budget will also
allot funds to the same unit even if the unit doesn’t need
it, or needs a lesser amount.
• Don’t consider changes
This approach assumes that everything stays the same as
last year with minimum changes. Thus, it fails to take into
account the changing circumstances.
• Lacks an incentive for a comprehensive review
The stability of incremental budgets does not provide
any incentives to the company’s management for
reviewing its budgets with a view to realizing savings in
expenditures. The lack of a review process makes budgets
vulnerable to waste, inadequate assumptions, and
mistakes.
• Based on unreal assumptions
This budgeting method assumes that there is no need to
analyze the objectives and activities of the department.
Also, it assumes no significant change in policy and
financing approach as well.

Overall, it can be said that though incremental budgeting

is easy to implement, it has the potential to destroy the
business in the long-term. To avoid such a fate, a business
must carry a in-depth analysis of its income, expenses
(both current and future), and make the budget
accordingly.
 What is Activity Based Budgeting (ABB)?

Activity-Based Budgeting is a process of creating a

blueprint or financial plan in advance which will act as a
yardstick by addressing individual activities which are to
be carried out given the limited amount of resources in an
organization using research tools & allocating the
resources accordingly as per their priority in form of a
budget specifying expected costs that are required to be
spent.
Activity-based budgeting (ABB) is a budgeting method
where activities are thoroughly analyzed to predict costs.
ABB does not take historical costs into account when
creating a budget.
Advantages of Activity Based Budgeting (ABB)
• Evaluation
Activity based budgeting method evaluates each & every
cost driver. It takes into consideration all the steps involved
in an activity. The irrelevant activities are eliminated & only
the necessary activities form a part of the project.
• Competitive edge
Activity based budgeting system eliminates all sorts of
unnecessary activities, which helps the business to save its
costs. The saved cost results in the production of goods &
services at lower cost than that of competitors. It also helps
the organization to gain a competitive edge in the market.
• Business as a unit
This budgeting technique helps in viewing the business as a
single unit & not in the form of departments. The managers
or the top mngt prepare the budget for the business unit as
a whole & not keeping in mind any single department as
done in the case of other methods of budgeting.
• Elimination of bottlenecks
Budgets under ABB are prepared after deep research &
analysis. This study removes all the unnecessary activities of
the business. By doing so, the business eliminates all sorts of
bottlenecks associated with an activity & business functions
are carried out more smoothly.
• Improves relationship
Activity based budgeting system helps in improving the
relationship between the organization and its customers.
The main aim of this budgeting method is to eliminate
unnecessary activities and serve the customers with the
best quality at best price.
This enforces (indirectly) the employees of the company
to serve the customers in the best way possible and
ensure customer satisfaction. In turn, the relationship
between the organization and the customers improves.
 Disadvantages of Activity Based Budgeting
ABB offers many advantages. However, like every process,
this too has its disadvantages as listed below:
• Requires understanding
ABB requires a deep understanding of various functional
areas of the business. If the manager preparing the budget
is incapable of understanding & evaluating the areas of
business, it would lead to inaccurate budget preparation.
• Complex
ABB system is complex in nature. It requires research and
analysis of various factors. This budgeting method comprises
of estimation of demand & based on that, it does the
estimation of resources to be employed in various activities.
• Resource consumption
The process of budgeting in this method consumes a lot of
resources of an organization. It needs to employ top
officials for conducting numerous analyses. It is a very
time-consuming task too. If these resources are employed
in other operational activities, they can give better returns.
• Short term
Activity-based budgeting focuses on short-term goals of
the business. It does not take into account the long-term
scenario of the business. Focusing more on short-term
goals rather than long-term goals can prove to be very bad
for the organization.
• Cost involved
Implementation of activity-based budgeting requires
trained employees. An employee, who is not trained
enough, cannot handle the budgeting exercise
effectively. So business needs to incur extra costs to
train its employees. Moreover, the process requires the
involvement of top management, so proves to be costly
too.
• What is zero-based budgeting (ZBB)?
Zero-based budgeting (ZBB) is an approach to making
a budget from scratch. The budget is not based on
previous budgets. Instead, the budget starts at zero.
• With ZBB, you need to justify every expense before
adding it to the official budget. The goal of ZBB is to
reduce spending by looking at where costs can be cut.
ZBB is a methodology that helps align company spending
with strategic goals. Its approach requires organizations to
build their annual budget from zero each year to help
verify that all components of the annual budget are cost-
effective, relevant, & drive improved savings.
 Advantages of Zero-Based Budgeting (ZBB)

• Efficiency
ZBB helps a business in the allocation of resources efficiently
(department-wise) as it does not look at the previous budget
numbers, instead looks at the actual numbers.
• Accuracy
Against the traditional budgeting method that involves mere
some arbitrary changes to the earlier budget, this budgeting
approach makes all departments relook every item of the
cash flow & compute their operation costs. This methodology
helps in cost reduction to a certain extent as it gives a true
picture of costs against the desired performance.
• Budget inflation
As mentioned above every expense is to be justified. ZBB
compensates the weakness of incremental budgeting of
budget inflation.
• Coordination and Communication
ZBB provides better coordination & communication within
the department & motivates employees by involving them in
decision-making.
• Reduction in redundant activities
This approach leads to identify optimum opportunities &
more cost-efficient ways of doing things by eliminating all
the redundant or unproductive activities.
Disadvantages of Zero-Based Budgeting
• High Manpower Turnover
The foundation of zero-based budgeting itself is a zero.
Budget under this concept is planned & prepared from the
scratch & require the involvement of a large number of
employees. Many departments may not have adequate
human resource & time for the same.
• Time-Consuming
This Zero-based budgeting approach is a highly time-
intensive for a company to do annually as against
incremental budgeting approach, which is a far easier
method.
• Lack of Expertise
Providing an explanation for every line item and every
cost is a problematic task and requires training for the
managers.

• Zero-based budgeting targets at presenting true

expenses to be incurred by a department. Although
this budgeting method is time-consuming, this is a
more appropriate way of budgeting. This includes all-
inclusive analysis of the budget proposal and if the
managers make irrelevant variations so as to achieve
what they want, they are probably exposed.
 Conclusion

• A company’s annual financial plan is called a

budget. In short words; a budget is a set of
pro-forma statements about the company’s
finances and operations.
• Before a company or other organizations can
develop operating budgets, management must
decide what planning approaches to budgeting
will be used for the various revenue and
expenditure activities and organizational units.