Budgeting methods

In the last article I discussed two approaches to budgeting. I looked at the top down approach or imposed budgeting approach. I then looked at the bottom up approach which is called the participatory budgeting approach. Both approaches have strengths and weaknesses which should be considered when choosing the approach to use.

In this article I will be discussing three methods of budgeting. The major methods which companies adopt are incremental budgeting, zero based budgeting and activity based budgeting.

Incremental budgeting is where one uses last year’s actual figures to budget. The method takes last year’s actual figures and adds a percentage, which could be an inflation rate, to obtain the current year’s budget. Incremental budgeting is the most commonly used method of budgeting because it is simple and easy to understand.  It is appropriate to use this method if you are operating in a stable environment and if the primary cost drivers do not change from year to year.

There are shortcomings in using this method. Using this method will likely perpetuate inefficiencies in the system. Management will not be motivated to spend time looking at how costs can be cut since they have to use a recommended percentage increase without scrutinising the processes for inefficiencies.

During an economy boom the problem might not be so serious because revenues will be enough to cover costs but during an economic downturn these inefficiencies will begin to impact on the performance of business negatively to an extent where management is forced to look for areas to cut costs. In most cases cost cutting will impact employees through retrenchment. It is advisable that management identify inefficiencies within the system before applying the percentage increase.

Incremental budgeting is also likely to result in budgetary slack. A manager might overstate the size of the budget when applying the percentage increase knowing well that the costs will be lower than budgeted for so that it appears that the manager and his team are always under budget on expenses. The budgetary slack can be identified if top management interrogate previous costs for slack. Any slack that is identified should be adjusted before applying a blanket percentage increase.

When applying a prescribed percentage increase in budgeting the shortcoming is that this method ignores external influences on costs. Not all costs increase by the same percentage. Some costs will increase by a higher percentage due to certain specific external factors that impact only on particular costs. For instance wages might not increase by the inflation rate because of negotiations agreed with trade unions. The assumption that every cost will increase by the same percentage is therefore wrong. Each cost has different inflation rates and this should be considered in coming up with a budget. These issues should be considered before applying the blanket rate of increase.

The second method of budgeting is called activity based budgeting (ABB). This method involves defining the key activities within an organisation and then using these activites to decide how much resources should be allocated for each activity. The overhead costs are then budgeted based on these activities. This method is based on the activity based costing system where a business costs products allocating overheads based on the activities and the cost drivers of those activities.

Budgeting for direct costs such as direct materials and direct labour is the same as the traditional incremental method. The difference comes in how the overhead costs are treated and absorbed into product costs. Using the ABB helps in focussing on those activities which drive costs and so the objective will be to plan and control the drivers of costs so that costs will be better managed.

This method is ideal where overheads make up a bigger portion of the costs. Every activity that does not add value will not be considered in budgeting. The challenge with this method is that it needs time in identifying activities. The company should have a good accounting system to record transactions and should already be using activity based costing system. This method is therefore expensive to use although it is very accurate in costing activities.

The third method is the zero-based budgeting (ZBB) method. This assumes that all department budgets are zero right from the beginning and must therefore start from scratch.  Managers are required to justify every single expense. Each cost element must be specifically justified as if the activities budgeted for were being undertaken for the first time.

No expenditure is automatically approved even if it had been incurred in the previous year. This method of budgeting is very strict on approval of expenditure and aims to avoid any expenditure that is not considered absolutely essential for the company’s successful operation. Zero-based budgeting is good to use when there is an urgent need for cost containment, for instance, in a situation where the company is going through a financial restructuring or because of a major economic downturn that requires it to reduce costs dramatically.

It is also best suited for addressing discretionary costs such as marketing, training or travel. ZBB is also appropriate to use in public sector organisations.

The advantages of using this method are: Most inefficient operations can be identified and therefore discontinued resulting in resources being allocated efficiently and economically. Staff will be motivated to implement the budget because they are involved in preparing the  budget and own the budget.

The budget preparation process will enhance their understanding of the cost behaviour patterns of the organisation which will make it easier to control costs. The last advantage is that ZBB responds to changes in the economic environment since every expenditure should be justified in line with what is happening in the environment.  In an unstable environments it’s better to use ZBB.

The shortcomings of ZBB are that: It emphasises short-term benefits to the detriment of long-term goals; the business will be focussing  on controlling immediate costs. The budgeting process can also be too rigid and the organisation may not be able to react to unforeseen opportunities or threats. Management might not have the skills required in preparing budgets under ZBB and therefore to use this method will require a lot of training for staff that will be involved in budgeting. The budgeting process requires a lot of time and so managers may feel demotivated due to the large amount of time spent.

The choice of which method to use will depend on nature of  the environment, the performance of the organisation, whether costs are out of control, and whether the business is using activity based costing system if a company that wants to use ABB.

The budgets prepared using the above methods can either be fixed or flexible. A fixed budget is designed to remain unchanged irrespective of the level of activity actually attained. It is prepared on the basis of a standard or fixed level of activity and the assumption is that there will be no change in the level of activity. It is more useful for a short period of time when the level of activity is not expected to change. A fixed budget therefore has limited application in controlling cost.

Another type of budget is the flexible budget which is designed to change with the level of activity actually attained. Under flexible budget, the budgeted figures can be changed according to the level of activity which makes it easier to control costs since budgeted costs will be compared with actual costs at the same level. A flexible budget has the advantage that it recognizes the behaviour of costs into variable, semi variable and fixed and compares like with like.

Stewart Jakarasi is a business and financial strategist and a lecturer in business strategy, advanced performance management and entrepreneurship. For assistance in implementing some of the concepts discussed in these articles please contact him on the following contacts: sjakarasi@gmail.com, call on +266 58881062 or WhatsApp +266 62110062.