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BUDGETING APPROACHES
STUDY UNIT 5 BUDGETING APPROACHES SUNJAY LUTCHMAN

Incremental Budgeting
Traditional form of Budgeting Costs and Allocations of monies tend to be on the basis of what happened in previous years Adjustment (increments) are made on the basis of changes (e.g. inflation, increases in productivity, workforce etc.) that happen from year to year. Often used for discretionary budgets (i.e. where budget holder is responsible for allocating a sum of money within a department) No clear relationship between the input or output (e.g. the raw materials required or the level of sales produced)

Incremental Budgeting
Budget allocations are increased by a certain percentage of current years allocation.
Item ($' 000) Materials Labour Petrol Travel Total Expenditure Year 1 Budget Actual 40 20 20 5 85 Year 2 Budget Actual 44 22 22 5.5 93.5 Year 3 Budget Actual 48.4 24.2 24.2 6.05 102.85

Materials in Year 2 = 40 x 1.10 (assume inflation is 10%) Materials in Year 3 = 44 x 1.10 (assume inflation is 10%)

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Comparing with Previous Data


Budget allocations are adjusted by comparing ACTUAL expenditure of current year
Item ($' 000) Materials Labour Petrol Travel Total Expenditure Budget 40 25 10 5 80 Year 1 Actual 20 24 18 5 67 Variance 20 1 -8 0 13 Year 2 Budget Actual 22 28 20 5.5 75.5 Year 3 Budget Actual

Materials in Year 1 was under spent and hence the allocation towards Materials in Year 2 budget was decreased (in comparison to Year 1) Petrol in Year 1 badly exceeding the budget and hence in Year 2 the allocation towards Petrol was increased significantly

Variance Analysis
Used to analyse performance and promote management action Variance = difference between the Budgeted amount and the actual amount; this can be adverse or favourable. Variances might cover: Sales Volume, Pricing, Direct Materials Usage, Direct Materials Price, Direct Labour Efficiency, Direct Labour rate, Fixed Overheads They can be calculated using absorption costing or marginal costing Limitations include out-of-date standards; inappropriate absorption of fixed overheads into cost units; and focus on price at expense of other more important issues.

Zero-Base Budgeting (ZBB)


Draws on the philosophy that ALL spending needs to be justified. All budgets are allocated a zero base, and will be increased from this only if a good case can be made out for the money Senior management will be using the criterion of value for money to allocate scarce resources. ZBB encourages managers to adopt a questioning approach; this leads to more strategic thinking and allocation of resources to enable this strategy to happen Clear links required between input/output and the resourcing

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Zero Based Budgeting


Budget allocations in any year are NOT LINKED to previous year(s).
Item ($' 000) Materials Labour Petrol Travel Total Expenditure Budget 40 25 10 5 80 Year 1 Actual 20 24 18 5 67 Variance 20 1 -8 0 13 Year 2 Budget Actual ? ? ? ? ? Year 3 Budget Actual

The budget in Year 2 will start from a zero base, that is there will be no link to the previous years allocation or actuals. The budget allocations will be determined from strategic planning process.

Activity-Based Budgeting
Applies the philosophy of Activity-Based Costing to the Budget process, recognising that activities drive costs If cost-driving activities can be identified, then the cost of the output can be achieved more accurately) Central feature: budget holders (those who are responsible for meeting a particular budget) have control over the events that affect performance in their area. ABB tries to generate budgets in such a way that the manager who has control over the cost drivers is accountable for those costs. Typical problems: increased levels of activity generated from outside the managers control, e.g. Manufacturing Budget thrown into disarray by a new sales contract

Spot Quiz
What are the advantages and disadvantages of zerobased budgeting? How might any disadvantages be overcome?

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Solution

Advantages Little Wastage of Resources Strategic use of resources, enable plans to be fulfilled more easily

Disadvantages Time Consuming Managers can often feel threatened by ZBB

The disadvantages can be countered by using the approach selectively, for example on every third year, or on particular budgets which tend to require strategic input, e.g. training, advertising, research & development.