Chapter 5- Budgeting and Control
Sources – Kaplan Publishing study materials and ACCA Study Hub
Purposes of budgeting
• A budget is a quantitative plan prepared for a specific time period. It is
normally expressed in financial terms and prepared for one year.
• Budgeting serves a number of purposes:
● Planning
● Control
● Communication
● Co-ordination
● Evaluation
● Motivation
● Authorisation
● Delegation.
Methods of budgeting
Participation in budget setting
• A top-down (or non-participative) budget is one that is imposed on the budget holder by senior
management.
Participation in budget setting
• A bottom-up (or participative) budget involves the divisional managers of an organisation having the
opportunity to participate in the setting of the budgets.
Incremental budgets
• An incremental budget starts with the previous period's budget or
actual results, and adds (or subtracts) an incremental amount to
cover inflation and other known changes.
• Suitability
●It is suitable for stable businesses, where costs are not expected
to change significantly.
●There should be good cost control.
●There should be limited discretionary costs.
Test your understanding no 1
Zero based budgets
• Zerobased budgeting (ZBB) is a method of budgeting that
requires each cost element to be specifically justified, as
though the activities to which the budget relates were
being undertaken for the first time. Without approval, the
budget allowance is zero.
• Suitability
●Fast moving businesses/industries
●Discretionary costs such as research and development
(R&D).
●Public sector organisations such as local authorities.
ZBB process
There are four distinct stages in the implementation of ZBB:
(1) Managers should specify for their responsibility centres those activities that can be
individually evaluated.
(2) Each of the individual activities is then described in a decision package. The decision
package should state the costs and revenues expected from the given activity. It should be
drawn up in such a way that the package can be evaluated and ranked against other packages.
(3) Each decision package is evaluated and ranked usually using cost/benefit analysis.
(4) The resources are then allocated to the various packages.
Rolling budgets
A rolling budget is one that is kept continuously up to date by adding
another accounting period (e.g. month or quarter) when the earliest
accounting period has expired
Suitability
1. Accurate forecasts cannot be made, e.g. in a dynamic business
environment or in a new business.
2. For any area of business that needs tight control.
Test your understanding 2
Activity-based costing (ABC)
Aim: the aim of ABC is to calculate the full production cost per unit. It is an alternative to
absorption costing in a modern business environment.
Test your understanding 4
Steps in ABC
Step 1: Group production overheads into activities (cost pools), according to how they
are driven.
Step 2: Identify cost drivers for each activity, i.e. what causes the activity costs to be
incurred.
Step 3: Calculate an overhead absorption rate (OAR) for each activity.
Step 4: Absorb the activity costs into the product.
Step 5: Calculate the full production cost and/or the profit or loss.
Activity based management (ABM)
• Activity based management (ABM) is the use of ABC information for management
purposes to improve operational and strategic decisions.
• Performance should improve as a result.
● By identifying the underlying drivers of activities, ABM provides an understanding of
the resource implications of various courses of action and therefore ensures that
unfeasible courses of action are not taken.
● It can assist in re-pricing or eliminating unprofitable products.
● It may eliminate the need to carry out certain activities which do not add value to the
customer.
● It may identify ways to produce a product more efficiently by understanding what
drives the costs.
● It may identify design improvements.
● It can assist in improving relationships with customers and suppliers.
● Can be used to decide which products to develop and which strategies to pursue.
Two types of ABM
Activity-based budgeting (ABB)
• Activity-based budgeting (ABB) uses the principles of ABC to estimate the firm's
future demand for resources and hence can help the firm to acquire these
resources more efficiently.
Illustration Number 2
• Steps in ABB
● Step 1: Estimate the production and sales volumes of individual products or
customers.
● Step 2: Estimate the demand for organisational activities.
● Step 3: Determine the resources that are required to perform organisational
activities.
● Step 4: Estimate for each resource the quantity that must be supplied to
meet the demand.
● Step 5: Take action to adjust the capacity of resources to match the projected
supply.
Budget evaluation and control
Fixed and flexible budgeting
• A fixedbudget is a budget prepared at a single level of
activity.
• A flexiblebudget is a budget prepared with the cost
behaviour of all cost elements known and classified as either
fixed or variable. The budget may be prepared at a number
of activity levels and can be 'flexed' or changed to the actual
level of activity for budgetary control purposes.
• Test your understanding 6 and 7
Variances
• In PM you learnt that variance analysis was a key element of management
control:
● Targets and standards are set reflecting what should happen.
● Actual performance is then measured.
● Actual results are then compared with the (flexed) standards, using variance
analysis.
● "Significant" variances can then be investigated and appropriate action
taken.
• This process thus facilitates "management by exception".
A quick reminder of some of the different
types of budget variance
Planning and operating variances
• The variances calculated can be further divided into planning and operational
elements if at the end of the period, with the benefit of hindsight, it is known
that the original budget was unrealistic and therefore a decision is taken to
amend the budget
● The planning variance is the difference between the original standard and
the revised one. Planning variances are thus those which arise due to
inaccurate forecasts or standards in the original budget setting.
● Operational variances are then the remainder due to the decisions of
operational managers. An operational variance is the difference between this
revised standard and actual performance.
Non-budgetary methods for
organisational control
Weaknesses and limitations of traditional approaches to budgeting
• Costly and time consuming
• Focus is on short-term results
• Insufficient external focus
• Top-down approach to strategy and decision-making
• Change is the new norm
Reasons to replace traditional
budgeting
• Budgeting prevents rapid response
• Budgeting is too detailed and expensive
• Budgeting is out-of-date within a few months
• Budgeting is not aligned with the competitive environment
• Budgeting is divorced from strategy
• Budgeting stifles initiative and innovation
• Budgeting protects non-value adding costs
• Budgeting reinforces command and control
• Budgeting demotivates people
• Budgeting encourages unethical behaviour and increases reputational risk
Beyond Budgeting
• Beyond budgeting (BB) is the generic term given to the body of practices intended to
replace traditional budgeting as a management model.
• The core concept is the need to move from a business model based on centralised
organisational hierarchies and control to organisations based on empowerment and
adaption. A range of techniques, such as rolling forecasts and market related targets, can
take the place of traditional budgeting
Advantages and Disadvantages
Forecasting