Chapter 8

Budgeting

Outcome

By the end of this session you should be able to:

 explain why organisations use budgeting and how budgetary systems fit within
the performance hierarchy

 describe the factors which influence behaviour at work and the issues
surrounding setting the difficulty level for a budget

 explain the benefits and difficulties of the participation of employees in the

negotiation of targets

 explain and evaluate ‘top down’ and ‘bottom up’ budgetary systems; ‘rolling’,
‘activity-based’, 'incremental' and 'zero-based' budgetary systems.

 explain and evaluate ‘feed-forward’ budgetary control

 describe the information used in various budgetary systems and the sources of
the information needed

 explain the difficulties of changing a budgetary system and type of budget used,
and how budget systems can deal with uncertainty in the environment

 explain the major benefits and dangers in using spreadsheets in budgeting

and answer questions relating to these areas.

The underpinning detail for this Chapter in your Integrated Workbook can
be found in Chapter 8 of your Study Text

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Overview

Hopwood
Purposes Beyond
Budgeting

Behavioural BUDGETING
aspects

Budgets and Spreadsheets

performance
management

The Approaches to
performance
budgeting
hierarchy

Budgeting
Incremental Rolling Feedback vs.
and
vs. ZBB budgets feedforward
participation

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Purposes of budgets

A budget is a quantitative plan prepared for a specific time period. It is

normally expressed in financial terms and prepared for one year.

Purposes:

 Planning – forces organisation to look into the future and plan ahead
 Responsibility – should motivate managers and result in better targets
 Integration – of all parts of the organisation/levels of staff towards common
goals

 Motivation – manager’s rewards based on achievement of budgetary targets

 Evaluation – of performance by comparing actual to budgeted performance

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Budgets and performance

management
Budgets contribute to performance management by providing benchmarks against
which to compare actual results (through variance analysis), and develop corrective
measures. They take many forms and serve many functions, but most provide the
basis for:

Detailed
sales targets

Capital
Staffing plans
expenditure

Cash investment
Production
and borrowing

It is an essential facet of the planning and control process. Without a budget, an

organisation will be highly inefficient and ineffective.

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 Budgeting

The performance hierarchy

Firms have a planning hierarchy:

Strategic
planning

Tactical planning

Operational planning

 Strategic planning is long term, looks at the whole organisation and defines
resource requirements. For example, to develop new products in response to
changing customer needs.

 Tactical planning is medium term, looks at the department/divisional level and

specifies how to use resources. For example, to train staff to deal with the
challenges that this new product presents.

 Operational planning is very short term, very detailed and is mainly concerned
with control. Most budgeting activities fall within operational planning and
control. For example, a budget is set for the new product to include advertising
expenditure, sales forecasts, labour and material expenditure etc.

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The aim is that if a manager achieves short-term budgetary targets

(operational plans) then there is more chance of meeting tactical goals
and ultimately success for strategic plans. The achievement of
budgetary plans will impact on the eventual achievement of the tactical
and strategic plans. However, budgets should also be flexible in order
to meet the changing needs of the business.

Illustrations and further practice

Now try TYU 1 ‘Evaluation of managers’ on Chapter 8.

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 Budgeting

Behavioural aspects of budgeting

Individuals react to the demands of budgeting and budgetary control in different ways
and their behaviour can damage the budgeting process. Behavioural problems are
often linked to management styles, and include dysfunctional behaviour and budget
slack.

4.1 Management styles (Hopwood)

Budget constrained style  Job related pressure

 Manager evaluated on ability to  May result in short-term decision

achieve budget in the short term making at the expense of long-term
goals
 Manager will be criticised for poor
results. For example, if spending  Can result in manipulation of data
exceeds the limit set

Profit conscious style  Less job related pressure

 Manager evaluated on ability to  Better working relations with

reduce costs and increase profits colleagues
in the long term
 Less manipulation of data

Non accounting style  Similar to profit conscious style but

there is less concern for accounting
 Manager evaluated mainly on information
non-accounting performance
indicators such as quality and  Requires significant and stringent
customer satisfaction monitoring of performance against
budget

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Setting the difficulty level of a budget

Expectations budget Aspirations budget

 A budget set at current  A budget set at a level which

achievable levels. exceeds the level currently
achieved.
 Unlikely to motivate managers to
improve but may give more  This may motivate managers to
accurate forecasts for resource improve if it is seen as
planning, control and attainable, but may also result in
performance evaluation. an adverse variance if it is too
difficult to achieve.

Illustrations and further practice

Now try TYUs 2 and 3.

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 Budgeting

Approaches to budgeting

6.1 Budgeting and participation

Top down Bottom-up

budgeting budgeting
(non-participative) (Participative)
imposed

Imposed on budget holder by senior Divisional managers set the budget

managers

 Avoids dysfunctional behaviour  More realistic budgets

and budgetary slack
 Improved motivation
 Quick
 Improved divisional managers’
 Senior managers retain control understanding

 Senior managers understand  Frees up senior managers’ time

needs of whole organisation

Illustrations and further practice

Now TYU 4 from Chapter 8.

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6.2 Incremental budgets, zero-based budgets (ZBB) and rolling budgets

Type of budget Suitability Advantages

Incremental –  Stable business  Quick, low cost and

starts with the easy
previous period’s  Good cost control
budget or actual  Managers not
results and adjusts  Limited discretionary demotivated by targets
these by an costs changing regularly
incremental
amount to cover  Fine if historic figures
inflation or other accurate
expected changes

ZBB – each  Fast moving  Inefficient/obsolete

element of the business operations identified
budget is justified and removed
as if the activity to  Historic figures
which the budget inaccurate  Better resource
relates is being allocation
undertaken for the  High discretionary
first time costs  Involvement of
managers improves
ZBB stages:  Public sector knowledge and
organisations motivation
(1) Managers identify
activities that can be  Responds to changes
individually evaluated in the business
environment
(2) The costs and
benefits of each
activity are included
in a decision package

(3) The activities are

ranked

(4) Resources allocated

to various packages

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 Budgeting

Type of budget Suitability Advantages

Rolling – the  Fast moving  Budgeting and control

budget is kept organisation should be more
continuously up to accurate
date by adding  New business
another  Managers take
accounting period  Any organisation that budgeting process
(e.g. month/ needs cost control more seriously
quarter) when the
earliest accounting
period has expired

Illustrations and further practice

Now TYU 4, 5, 6 and 7 from Chapter 8 as well as Illustration 1 ‘Rolling budgets’.

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6.3 Activity based budgeting (ABB)

Activity based costing

Let’s begin by recapping our costing knowledge from Paper F5.

Absorption costing (AC) Activity based costing (ABC)

Aim: to calculate the full production Aim: as per AC, i.e. to calculate the
cost per unit full production cost per unit
Aim: to calculate the full production cost
Assumes production overheads are Recognises the diversity and
per unit
driven by the level of activity complexity of modern production
meaning that not all production
overheads are driven by level of
activity

Steps:

Group production overheads into activities (cost pools), according to how

1
they are driven

2 Identify cost drivers for each activity

3 Calculate an overhead absorption rate (OAR) for each activity

4 Absorb activity costs into products

5 Calculate the full production cost/unit and profit/(loss) (if required)

Illustrations and further practice

Now try TYU question 8 from Chapter 8 ‘Preparing an ABB’.

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Advantages Disadvantages

 An understanding of what drives  Cost and time involved
costs should improve cost control
 Limited benefit if production
 More accurate cost per unit overheads are minimal or
resulting in better: mainly driven by level of
production
– pricing
 Difficult to identify cost pools
– cost control and drivers

– decision making

Illustrations and further practice

Now try TYU question 9 from Chapter 8.

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 Budgeting

Changing a budgetary system

A change in the budgetary system could bring about improved planning, control and
decision making.

However, before a change is made the following issues should be considered:

 Are suitably trained staff available to implement the change successfully?

 Will changing the system take up management time which should be used to
focus on strategy?

 All staff involved in the budgetary process will need to be trained in the new
system and understand the procedure to be followed in changing to the new
approach. A lack of participation and understanding builds resistance to
change.

 All costs of the systems change, e.g. new system costs, training costs, should
be evaluated against the perceived benefits. Benefits may be difficult to quantify
and therefore a rigorous investment appraisal of the project may be difficult to
prepare.

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Spreadsheets

A spreadsheet is a computer package which stores data in a matrix

format where the intersection of each row and column is referred to as a
cell. They are commonly used to assist in the budgeting process.

Advantages of spreadsheets

 Large enough to include a large volume of information.

 Formulae and look up tables can be used so that if any figure is amended, all
the figures will be immediately recalculated. This is very useful for carrying out
sensitivity analysis.

 The results can be printed out or distributed to other users electronically quickly
and easily.

 Most programs can also represent the results graphically e.g. balances can be
shown in a bar chart.

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 Budgeting

Disadvantages of spreadsheets:

 Spreadsheets for a particular budgeting application will take time to develop.

The benefit of the spreadsheet must be greater than the cost of developing and
maintaining it.

 Data can be accidentally changed (or deleted) without the user being aware of
this occurring.

 Errors in design, particularly in the use of formulae, can produce invalid output.
Due to the complexity of the model, these design errors may be difficult to
locate.

 Data used will be subject to a high degree of uncertainty. This may be forgotten
and the data used to produce, what is considered to be, an 'accurate' report.

 Security issues, such as the risk unauthorised access (e.g. hacking) or a loss of
data (e.g. due to fire or theft).

 Version control issues can arise.

 Educating staff to use spreadsheets/models and which areas/cells to use as

inputs can be time consuming.

Illustrations and further practice

Now try Illustration 4 ‘Using spreadsheets in budgeting’.

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Beyond Budgeting

Beyond Budgeting is the idea that companies need to move beyond

budgeting because of the inherent flaws in budgeting, especially when
used to set incentive contracts. It is argued that a range of techniques,
such as rolling forecasts and market-related targets, can take the place
of traditional budgets.'

9.1 Beyond Budgeting – 6 principles

A BB implementation should incorporate the following six main principles:

 An organisation structure with clear principles and boundaries; a manager

should have no doubts over what he/she is responsible for and what he/she has
authority over; the concept of the internal market for business units may be
relevant here.

 Managers should be given goals and targets which are based on relative
success and linked to shareholder value; such targets may be based on key
performance indicators and benchmarks following the balanced scorecard
principle.

 Managers should be given a high degree of freedom to make decisions; this

freedom is consistent with the total quality management and business process
reengineering concepts; a BB organisation.

 Responsibility for decisions that generate value should be placed with ‘front line
teams’; again, this is consistent with TQM and BPR concepts.

 Front line teams should be made responsible for relationships with customers,
associate businesses and suppliers; direct communication between all the
parties involved should be facilitated; this is consistent with the SCM concept.

 Information support systems should be transparent and ethical; an activity

based accounting system which reports on the activities for which managers
and teams are responsible is likely to be of use in this regard.

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You should now be able to answer test your understanding questions 1 to 14

from Chapter 8 of the Study Text.

You will be able to answer questions 96 to 109 from the Exam Practice Kit;
partly answer questions 213 to 215 and 258 to 261.

For further reading, visit Chapter 8 from the Study Text and read the F5 article
on ‘Comparing Budgeting Techniques’ at www.accaglobal.com

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