Budgetary Systems and Types of Budget: Purposes, Process and Approaches

Every year, in the last quarter, a manufacturing company in Ikeja holds a series of meetings that few managers enjoy. The sales director defends a revenue target, the production manager argues about capacity, the finance team asks everyone to cut ten per cent, and the board eventually approves a set of numbers that will be used to judge performance for the next twelve months.

The budget is the most widely used tool in management accounting, and also the most criticised.

Before the later topics deal with how budgets are prepared and how they are flexed, this topic explains what a budget is, what it is for, how the budgeting process runs, why the principal budget factor comes first, and the main budgetary systems: top-down and bottom-up budgeting, incremental and zero-based budgeting, periodic and rolling budgets, and feed-forward control.

It builds on the earlier topic on the value of perfect and imperfect information, which closed the study of decisions under risk. The next topic covers preparing fixed and flexed budgets.

What a budget is and how it is produced

Planning framework and the nature of a budget

An entity plans over several horizons. Strategic planning concerns long-term objectives. Tactical planning covers the next year or two. Operational planning covers day-to-day and week-to-week activity. A budget is the medium-term plan, expressed in financial terms and covering all the activities of the entity.

It is normally prepared for a year, which is subdivided into control periods of a month or a quarter, so that actual results can be compared with the plan at short intervals.

Purposes of budgeting

• Planning: to convert long-term strategic plans into detailed annual plans linked to the objectives.
• Coordination: to make the parts of the organisation work towards the same goals (goal congruence).
• Communication: to tell managers and staff what is expected of them.
• Motivation: by setting targets and, possibly, by linking bonuses to them.
• Authorisation: expenditure not in the budget normally needs special approval.
• Responsibility: a named manager is accountable for each part.
• Benchmark and control: actual results are compared with the budget, and significant variances are investigated.

The budgeting process

Preparing the annual budget is a large task in a medium or large company, which may take several months. A budget committee, made up of senior managers from the main areas of the business, supervises the process, coordinates the functional budgets, and requires changes where the drafts are unrealistic or inconsistent.

A budget manual guides everyone involved: it sets out the objectives of the budget, the procedures and timetable, the detail required in each functional budget, who is responsible for preparing each, and how the budget is approved.

Functional budgets are budgets for one aspect of the business: sales, production, materials usage and purchasing, labour, and expenditure budgets for each overhead centre. The master budget is the final approved budget, presented as a budgeted profit or loss account, a budgeted statement of financial position and a cash budget.

The principal budget factor

The principal budget factor (key or limiting budget factor) sets the limit to the volume and scale of operations. It is normally sales demand: there is no point producing more than can be sold, unless the company decides to build inventory. The first budget prepared is the budget for this factor, and all the others are prepared within its limits, so that they are consistent with each other.

If something else is the limit, such as a shortage of machine time or skilled labour, that resource budget comes first. In a government department, the principal budget factor is often the expenditure limit for the year.

Stages in the process

1. Give budget guidelines to the managers concerned.
2. Identify the principal budget factor.
3. Prepare the budget for the principal budget factor, usually the sales budget.
4. Prepare the other functional budgets in sequence: inventory, production, materials, labour, overheads.
5. Submit the functional budgets to the budget committee for review and coordination.
6. Prepare the master budget.
7. Submit it to the board for approval.
8. Communicate the approved budgets to the responsible managers.
9. Monitor actual results against the budget and investigate significant variances (budgetary control).

Budgetary systems

Top-down and bottom-up budgeting

In top-down budgeting the board or budget committee sets the targets for the year, for example growth of 5% in sales and 8% in profit, and each division prepares a budget consistent with them. It suits a centralised organisation and keeps the budget in line with strategy. But managers may feel that targets are imposed, may lack commitment, and the people who know most about operations are not heard.

In bottom-up (participative) budgeting, budgets begin at the lowest level, are combined at each level above, and are finally agreed by the board. Managers have more input, the budgets use local knowledge and commitment is likely to be stronger; but the process takes longer, managers may build in slack by understating revenue or overstating costs. The combined budget may not match the strategy, which calls for repeated redrafting.

Periodic and rolling budgets

A periodic budget is fixed for a period, usually the year, and is not revised. It assumes that the year is reasonably predictable. When events are unpredictable, for example with very high or very variable inflation, a rolling budget that is updated at intervals is more useful: this is developed in the later topic on rolling, activity based, functional and master budgets.

Incremental budgeting

The budget starts from current spending, adds an allowance for inflation and for any extra activity, and so is simple and quick.

For example, last year’s labour cost of ₦4.8 million, with 3% more staff and a pay rise of 8%, gives ₦4.8m × 1.03 × 1.08 = ₦5.34m. Its serious weakness is that it carries forward any waste and rewards managers for spending up to the limit, since a lower spend might lead to a lower budget next year. It encourages budget slack and does not ask whether activities are still worthwhile.

Zero-based budgeting (ZBB)

ZBB prepares the budget “from the ground up”, as if for the first time, so that every activity must be justified. The approach is to identify the minimum level of operations that a department must perform and budget for it, and then treat each additional activity as an optional decision package: a programme of activities with a stated purpose, cost, expected benefit and measurable performance objectives.

Packages are ranked by net expected benefit, and are included from the top of the list until the spending limit is reached.

• Advantages. Every activity is reviewed and only worthwhile ones are included; waste and inefficiency are found; managers are made to question why things are done; it gives a priority list when cuts are needed; and it encourages involvement.
• Disadvantages. It is slow and costly, particularly every year; managers need to understand relevant costing; ranking involves value judgements because benefits are often guesses; managers may see it as a threat to their allowances; and disputes arise between departments over rankings. A company may use ZBB every three years or so, with incremental budgets between. It also needs a reward system that does not punish managers for lower budgets, and performance monitoring against the package objectives.

Feed-forward control and changing a system

Normal budgetary control uses feedback: actual results are compared with budget. With feed-forward control the comparison is between a revised, up-to-date forecast and the original budget or target, so that corrective action can be taken before the results occur. It is valuable when the environment changes, but depends on reliable forecasts.

Changing the budgetary system is itself difficult: managers may resist, suspect the motives, need training, and meet practical problems (for example in costing decision packages), so the benefits must exceed the cost of change.

Layouts for the functional budgets and for incremental and zero-based budgets

1. Production units = sales + closing finished goods − opening finished goods.
2. Materials usage = production × usage per unit. Purchases = usage + closing materials − opening materials; × price.
3. Labour hours = production × hours per unit; × rate.
4. Incremental budget = current cost × (1 + change in activity) × (1 + price change).
5. ZBB: basic package; incremental packages ranked by net benefit; include down the list while the limit allows.

Money is in naira and each answer is rounded once, at the end.

Worked examples

1. Production.
   12,000 + 2,500 − 1,500 = 13,000 units.
2. Material usage.
   13,000 × 3 = 39,000 kg.
   Purchases. 39,000 + 6,000 − 4,000 = 41,000 kg, costing 41,000 × 200 = ₦8,200,000.
3. Labour.
   13,000 × 2 = 26,000 hours × 350 = ₦9,100,000.
4. Note. If material were the principal budget factor, with, say, only 30,000 kg obtainable, the materials budget would come first and production and sales would be limited to 10,000 units.

1. Incremental salaries.
   4.8 × 1.03 × 1.08 = ₦5.34m.
2. Net benefits. B 0.9; E 0.8; C 0.1; D (0.1). Rank: B, E, C, D.
3. Build the budget. Basic 0.9; add B 0.6 = 1.5; add E 0.4 = 1.9; add C 0.5 = 2.4, which reaches the limit; D is rejected because its cost exceeds its benefit and the limit is reached. Total ₦2.4m.
4. If the limit were ₦2.0m, C would also be dropped: basic, B and E total ₦1.9m.

Expect variants: functional budgets with a limiting resource, a requirement to explain bottom-up and top-down systems, or a discussion of why budgets fail to motivate.

Common mistakes

• Starting with the wrong budget. The principal budget factor comes first.
• Production = sales without adjusting for finished stock.
• Purchases = usage without adjusting for material stock.
• Mixing top-down with bottom-up. Say who sets the targets.
• Thinking ZBB always starts a department at nothing. It starts with a minimum level that must be justified.
• Listing purposes without explaining them.

Quick revision

• Budget = formal plan in money for a period; purposes: plan, coordinate, communicate, motivate, authorise, responsibility, control.
• Budget committee, manual, principal budget factor first, functional budgets, master budget.
• Top-down (imposed) v bottom-up (participative); incremental v zero-based; feed-forward v feedback.

How the marks are earned

• Explain each purpose or system with a reason.
• Calculate the chain of budgets in order.
• Evaluate advantages and disadvantages for the case.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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