Budgeting

by Rosemarie Kelly, PhD, FCA, MBS, Dip Acc, Examiner, F2 Management Accounting, January 2019.

This short article provides an overview of some of the key aspects of budgeting. First, it describes a budget and
how it fits in an organisation’s strategic planning process. Next, it outlines the purposes of budgeting, why budgets
are prepared. This is followed by a brief summary of budget preparation and the types of budgets that are
produced. The distinction between fixed and flexible budgets is then presented and two common forms of
budgeting, incremental and zero based are described. Finally, some behavioural issues arising from the
budgeting process are outlined.

Budgets and the strategic planning process

An organisation develops its strategic or long term objectives and identifies, evaluates and selects suitable
courses of action to achieve those objectives. An annual budget is an integrated part of the strategic (long term)
planning process as it represents one such course of action. A budget is a detailed plan of action prepared for a
specific period of time, usually twelve months.

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 (Source: Drury, 2015)

Purposes of budgets – why prepare budgets? (Figure 1)

To aid the planning of operations by forcing managers to consider how conditions might change and what steps
should be taken now.

To co-ordinate the activities of the organisation by compelling managers to examine relationships between their
own operations and those of other departments.

To communicate plans to various responsibility centre managers so that everyone in the organisation has a clear
understanding of the part they are expected to play in achieving the annual budget.

To motivate managers to strive to achieve the budget goals by focusing on participation and providing a
challenging target.

To control activities by comparison of actual with budget (this is attention directing/management by exception).

To evaluate the performance of managers by providing a means of informing managers of how well they are
performing in meeting targets they have previously set.
(Drury, 2015)

Plan

Evaluate Co-ordinate

Purposes of
Budgeting
Control Communicate

Motivate

Figure 1: The purposes of budgeting

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Preparation of budgets
In many organisations, detailed monthly budgets are prepared once a year. Prior to the budgeting process, a
budget manual may be prepared by the accountant describing the objectives and procedures involved in
developing the overall budget for the organisation. A budget committee is established comprising top executives
from all functions of the business who receive and approve individual budgets from departmental managers. The
management accountant, with the assistance of accounting staff, co-ordinates these individual budgets into an
overall budget for the organisation.

Typical budgets produced

Organisations may produce functional budgets and cash budgets.

Functional budgets relate to the activities of the organisation and provide details of expected sales, materials and
labour costs, anticipated production costs and non-manufacturing overhead expenses (see Figure 2).

Functional budgets comprise:

 Sales budget (in units and € value)

 Production budget (in units only)
 Direct materials usage budget (in units only)
 Direct materials purchases budget (in units and € value)
 Direct labour budget (in hours and € value)
 Production overhead budget (in € value)
 Selling and administration expenses budget (in € value)
 Master budget = budgeted income statement (profit & loss account) and statement of financial position
(balance sheet) (in € value)

Cash budgets are prepared in monetary terms and focus on cash receipts and payments including income
received from customers and payments to suppliers for goods and for other expenses.

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 Sales budget

Production budget
(in UNITS)

Production
Direct materials Direct labour
usage budget overhead
budget budget
(in UNITS)

Direct materials Selling &

purchases administration
budget expenses budget

Master Budgets
Figure 2: Preparation of functional budgets
Income statement & Statement of financial position

Fixed and flexible budgets

In budgeting a distinction is made between two forms of budget, a fixed budget and a flexible (or flexed) budget.

A fixed budget, once developed and agreed, is not changed or altered if actual activity differs from budgeted
activity.

A flexible budget is ‘ a budget which, by recognising the difference in behaviour between fixed and variable costs
in relation to fluctuations in output, turnover, or other variable factors such as number of employees, is designed
to change appropriately with such fluctuations’ (Griffith College Manual).

A flexible budget is prepared based on actual activity and shows what the budgeted costs and revenues would
have been if the budget had been based on actual activity achieved. A flexible budget thus allows comparison of
actual and budgeted costs and revenues based on the same activity level. It is much more useful than a fixed
budget as it allows more meaningful variances to be calculated.

Incremental budgeting

Incremental budgeting starts with the budget from the previous period and adds or subtracts an incremental
amount to cover inflation and other known expenses. It is suitable for stable businesses, where costs are not
expected to change significantly and where there is good cost control and limited discretionary expenses.

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 Advantages/benefits of incremental budgeting Disadvantages/drawbacks of incremental
budgeting
Quick and easy method of budgeting Carries forward previous problems and
inefficiencies to the next budgeting period
Only the increment (extra amount) needs to be Uneconomic activities may be continued
justified in organisations that have stable and
historic figures
Managers may spend unnecessarily to use up their
budgeted expenditure to ensure that they will get
the same or a larger budget next year

Zero based budgeting (ZBB)

Zero based budgeting (ZBB) emerged in the late 1960s as a response to incremental budgeting. With ZBB, all
budgets start at zero and activities/costs are only allowed if they are justified under investigation. All requests for
resources must be presented and they are evaluated on the basis of cost-benefit – i.e. where is the value in the
spend? ZBB is best suited to discretionary spending where there is no clearly defined input-output relationship
(e.g. marketing, research & development, training, etc.) or public sector organisations such as local councils.

Advantages/benefits of ZBB Disadvantages/drawbacks of ZBB

Should reduce inefficiencies as past waste is not Expensive and time consuming process
carried into the next year
Cost-benefit analysis approach – promotes focus In a highly pressured environment it may become
on organisational activities and costs overly competitive
Questions are asked, rather than just accepting Can give rise to a short-term focus to the detriment
figures of long term goals
Inefficient or obsolete operations can be identified Managers may feel demotivated due to the large
and discontinued amount of time spent on the budgeting process
ZBB leads to increased staff involvement as more Budgeting process may become too rigid and
information and work is required to complete the unable to react to unforeseen opportunities or
budget threats
Resources should be allocated efficiently and The necessary management skills to apply ZBB
economically may be absent
ZBB responds to changes in the business
environment

Behavioural issues arising from the budgeting process

Earlier in the article the purposes of budgeting were outlined. Three of these purposes specifically relate to
behaviour, control, evaluation and motivation. Budgets facilitate control over costs by highlighting any differences
arising between actual costs and budgeted costs. Budgets are used to evaluate managerial performance and also
to motivate staff to perform better. Consequently it is important to address these three aspects when developing
budgets otherwise behavioural problems may arise. Examples of potential problems/issues that may arise and
how they may be avoided are noted below.

Control

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• Budgets facilitate comparison of planned outcomes with actual results allowing the organisation to improve
sales performance, monitor capital expenditure projects, forecast cash flows and control expenditure levels. In
terms of behavioural consequences, it is important that managers understand the budgeting process when
the organisation is trying to reduce and control its expenditures. Better understanding of the budgeting
process should promote a more questioning approach towards potential costs and discourage inefficiencies
from being carried forward from one year to the next.

Evaluation

• If managers are being evaluated and possibly remunerated based on budgeted outcomes, these outcomes
must be within managerial control i.e. controllable by the manager rather than by head office for example. If
the manager has limited or no control over budgeted outcomes he/she may consider any evaluation based on
these outcomes as unfair and become less motivated to improve performance.

Motivation

• If managers are not involved in developing the overall budget for the organisation they will be less committed
and motivated to achieve the desired results. However, sometimes when managers are involved in the
budgeting process they may attempt to secure easier, less challenging targets. Managers may include some
‘budgetary slack’, which means that budgeted costs may be overstated and budgeted revenues may be
understated.

Author: Rosemarie Kelly, Examiner F2 Management Accounting.

Bibliography

Drury, C. (2015) Cost and Management Accounting: An Introduction. 8th Edition. London: Cengage Learning
EMEA.

Griffith College. Institute of Certified Public Accountants Formation II Management Accounting Manual.

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