Budgets

Beyond budgeting is an approach to budgeting that tries to resolve the
weaknesses and limitations of traditional approaches.

In particular, many organisations complain that budgets
do not fully prepare an organisation for potential changes in its environment and
are too often based on assumptions that things won’t change and that last
year’s assumptions will continue to be valid

A key aspect of budgetary control is responsibility accounting – that is,
making managers account for the costs (and/or revenues) for which they have
responsibility. However, this will only work effectively if managers are appraised
only on the costs which they can control. The success of responsibility
accounting relies on the ability of the organisation to correctly identify the costs
that a manager can control.
Controllable costs are costs which can be influenced by the budget holder and
are generally considered to be those which are:
• variable or
• directly attributable fixed costs.
Uncontrollable costs are costs that cannot be influenced (i.e. their value can
neither be increased nor decreased) by management action.
Most variable costs within a department are thought to be controllable in the
short term because managers can influence the efficiency with which resources
are used, even if they cannot do anything to raise or lower price levels. So costs
such as direct labour costs and material costs in a manager's department are
said to be controllable by that manager.
Many fixed costs are uncontrollable (or committed) in the short term (such as
insurance etc.) and these are not normally treated as controllable costs. But
some fixed costs are directly attributable to a department in that, although they
are fixed (in the short term) within the relevant range of output, a drastic
reduction in the departments’ output, or closure of the division entirely, would
reduce or remove these costs. This might include costs such as supervisors'
salaries, department rent etc.
A useful distinction can be made between committed fixed costs, which are
costs that are uncontrollable in the short term, but are controllable over the
longer term; and discretionary fixed costs, which are costs treated as fixed
cost items that can nevertheless be controlled in the short term, because
spending is subject to management discretion. Examples of discretionary fixed
costs are advertising expenditure, and executive travel and subsistence costs,
and these would normally be included as directly attributable fixed costs

Beyond budgeting is: ‘An idea that companies need to move beyond
budgeting because of the inherent flaws in budgeting especially when
used to set contracts. It is argued that a range of techniques, such as
rolling forecasts and market related targets, can take the place of
traditional budgeting

A budget is a quantitative or financial plan relating to the future. It can be for the
company as a whole or for departments or functions or products or for
resources such as cash, materials, labour, etc. It is usually for one year or less

Co-ordination
Responsibility
Utilisation
Motivation
Planning
Evaluation
Telling/communnication

• budgets ensure that the
organisation’s actions are
matched to the organisation’s
goals and that these goals
are communicated
throughout the organisation
• creating a budget forces
management to consider the
future and how the business’
environment (both internally
and externally) might change
• it means that organisations
are better placed to cope with
change and can act as an
early warning system for
problems
• budgets force management
to consider the cost and
profitability of products,
departments, functions etc
• this in turn can force
management to consider the
value added by these
products, departments or
functions
• budgets improve decisions
on resource and cash
allocation, financing and
investment
• having budgets facilitates
performance evaluation in
areas such as the use of
variance analysis

• budgets can encourage managers
to spend what is in the budget,
even if it is not necessary, to guard
against reductions to next year's
budget.
• preparing budgets can be time
consuming for staff and
management and may distract from
the business’ core operations
• predicting future changes is very
subjective and relies on the ability
of the preparer of the budget to
make these predictions as
accurately as possible
• budgets can create conflicts and
barriers between budget holders
rather than knowledge sharing and
coordination
• the use of budgets can encourage
short-termism where, for example,
discretionary expenditure such as
staff training is reduced in order to
meet budget targets
• budgets focus on financial
outcomes rather than broader
measures of success such as
customer satisfaction, quality etc
• using budgets can deter innovation
and enterprise as staff become
focused on meeting the targets
rather than exceeding them or
responding to changing market
needs

A master budget for the entire organisation brings together the departmental or
activity budgets for all the departments or responsibility centres within the
organisation.
The structure of a budget depends on the nature of the organisation and its
operations. In a manufacturing organisation, the budgeting process will probably
consist of preparing several functional budgets, beginning with a sales
budget. All budgets will be prepared for the same budget period

Budgets are based on assumptions about the future. Each and every one of
these assumptions could be wrong. It will therefore be important to test what
might happen to a budget if the assumptions change.
There are various approaches to this issue and one of the most widely used is
‘sensitivity analysis’.
Sensitivity analysis
A sensitivity analysis exercise involves revising the budget on the basis of a
series of varied assumptions. One assumption can be changed at a time to
determine the impact on the budget overall. For example, if sales quantities
were to be changed, the impact on profits, cash flow etc. could be observed.
When changing more than one variable at a time, computer spreadsheets are
almost essential to organisations, as they allow managers to change their
original specifications to present alternative versions of the future. This
simplifies and speeds up the process

Stress testing a budget involves a more substantial examination of how a
budget would cope under pressure from difficult conditions. It is more complex
than simply changing one assumption, which is what we saw in sensitivity
analysis.
A stress test examines how a budget would perform or function under
severe or unexpected pressure.

Stress testing is a management accounting exercise which enables you to see the effect of a "stressful" event on a budget or forecasted figures. Stressful events must be unusual and fundamental the the business.

• sudden changes in the economy (such as a recession or boom)
• cybersecurity attacks
• the loss of a major customer
• foreign exchange rate risk
• advancements in technology, rendering products obsolete or
uncompetitive
• changes in customer or consumer tastes
• a workforce strike/ industrial action

Stress testing allows risks to be quantified.
Many businesses might be able to state that sales will fall if the economy
were to move into a recession but a company who has stress tested its
budgets for such an event would be able to say not only by how much
sales would fall, but also to explain the impact on profits and cash as
well as the company’s plans to minimise the impact and adjust its
strategies.
Helps create and identify warning signs/triggers for stress events.

Considering events prior to the budget launch will allow the company to
more quickly and effectively react to the warning signs as and when they
arise.
Stress testing and software.
Stress tests are usually computer-generated simulation models that test
hypothetical scenarios.

• They reduce uncertainty in
budgeting
• They can be used for cash
management
• They force managers to look
ahead continuously
• When conditions are subject to
change, comparing actual results
with a rolling budget is more
realistic than comparing actual
results with a fixed annual
budget.

• Preparing new budgets regularly
is time-consuming
• It can be difficult to communicate
frequent budget changes

• Simple, low-cost budgeting system
• Quick to administer
• Suitable in stable environments
• Most practical for certain items of cost, such as telephone expenses
(where next year’s budget can reliably be based on the current year’s
cost)

• Backward looking in nature, since next year’s budget is based on what
has happened in the past. Therefore, unsuited to changing environments
• Assumes that all current activities should be continued at the current
level of operations and with the same allocation of resources; hence
building on previous inefficiencies and not looking to reduce waste
• Encourages over-spending; managers know that if they fail to spend their
budget, it is likely to be reduced next period. They therefore try to spend
the whole budget, regardless of whether or not the expenditure is
justified
• Targets are often unchallenging, based on past performance. This
method does not encourage managers to look for ways of improving the
business
• Consideration is not given to the justification for each activity. They will
be undertaken merely because they were undertaken the previous year

A method of budgeting whereby all activities are re-evaluated each time a
budget is formulated. Each functional budget starts with the assumptions that
the function does not exist, and is at zero cost. Increments of costs are
compared with increments of benefits, culminating in the planned maximum
benefit for a given budgeted cost.'
Zero-based budgeting (ZBB) is a radical alternative to incremental budgeting. In
ZBB, all activities and costs are budgeted from scratch (a zero base). For every
activity, managers look at its costs and its purpose, and consider whether there
are alternative ways of doing it. Inessential activities and costs are identified
and eliminated, by removing them from next year’s budget.
It is suitable for:
• allocating resources in areas where spend is discretionary, for example
research and development, advertising and training.
• public sector organisations, such as local authorities.
• new functions (such as a new department or service) in an organisation.

All activities are subjected to the most basic scrutiny, and answers
sought to such fundamental question as:
(a) Should the activity be undertaken at all?
(b) If the company undertakes the activity, how much should be done
and how well should it be done (e.g. should an economy or a
deluxe service level be provided)?
(c) How should the activity be performed – in-house or subcontracted?
(d) How much would the various alternative levels of service and
provision cost?

1 Determine the activities that are to be used as the object of
decision packages. There are two types of decision package:
(i) Mutually exclusive packages, which contain different
methods of meeting the same objective.
(ii) Incremental packages, which divide the activity into a
number of different levels of service or support needed to
carry out the activity. The base package describes the
minimum level of service or support, whilst the incremental
packages reflect increasing levels of service or support.

2 Request the managers identified in (1) above to prepare a number
of alternative decision packages for those individual activities for
which they are responsible. (At least three packages are normally
requested: one that sets out what could be delivered with funding
maintained at the current level; one for a reduced level of funding,
e.g. 80% of the current level; and one for an enhanced level of
funding, e.g. 120% of the current level). The decision package
should state the costs and revenues expected from the given
activity.
3 Rank the decision packages in order of their contribution towards
the organisation’s objectives.
4 Fund the decision packages according to the ranking established
under (3) above until the available funds are exhausted

• It creates an organisational environment where change is accepted,
enabling organisations to be more responsive to changes in the business
environment
• It promotes a better focus on organisational goals; it moves budgeting
away from number-crunching, towards analysis and decision-making
• It forces managers to examine activities, identifying inefficient or obsolete
operations and wasteful spending (which can then be eliminated).
• It establishes a measure of performance for each decision package. This
measure can be used to monitor actual performance and compare actual
with budget.
• It involves managers in the budgeting process. Unlike incremental
budgeting, it is not a desk-bound exercise driven by the accounting
department. Preparation of the decision packages will normally require the
involvement of many employees, and thus provides an opportunity for their
view to be considered. This involvement may produce useful ideas, and
promote job satisfaction among the wider staff.
• It is forward looking, focussing on the future rather than the past

• It is a time-consuming exercise, and therefore costly. It is unlikely that an
organisation will have the time or funds to carry out a ZBB exercise every
year.
• There is a temptation to concentrate on short-term cost savings (such as
staff training or R&D) at the expense of longer-term benefits (encouraging
short-termism).
• It might require budgeting skills from management that the management
team does not possess. Training in new skills requires time and money.
• The budgeting process may become too rigid and the organisation may
not be able to react to unforeseen opportunities or threats.
• The ranking process can be difficult, since widely-differing activities cannot
be compared on quantitative measures alone. For example, it might be
difficult to rank proposals for spending on better service quality,
improvements in safety in the work place or more spending on new
product development.
• It is less useful when budgeting for standard costs, where costs and
efficiency levels should already be well-controlled

As its name should suggest, activity-based budgeting (ABB) takes a
similar approach to activity-based costing. ABB is defined as: 'a method
of budgeting based on an activity framework and utilising cost driver data
in the budget-setting and variance feedback processes' (CIMA Official
Terminology).
Whereas ZBB is based on budgets (decision packages) prepared by
responsibility centre managers, ABB is based on budgeting for activities.
In its simplest form, ABB is simply about using costs determined via ABC to
prepare budgets for each activity. The basic approach of ABB is to budget the
costs for each cost pool or activity as follows:
1 The cost driver for each activity is identified. A forecast is made of the
number of units of the cost driver that will occur in the budget period.
2 Given the estimate of the activity level for the cost driver, the activity cost
is estimated. Where appropriate, a cost per unit of activity, known as the
cost driver rate, is calculated.
(There will also be some general overhead costs that are not activity-related,
such as factory rental costs and the salary cost of the factory manager. General
overhead costs are budgeted separately.)

• It draws attention to the costs of ‘overhead activities’. This can be
important where overhead costs are a large proportion of total operating
costs.
• It recognises that is it activities which drive costs. If managers can control
the causes (drivers) or costs, then costs should be better managed and
controlled.
• It can provide useful information for a total quality management (TQM)
programme, by relating the cost of an activity to the level of service
provided (for example, stores requisitions processed) – Do the user
departments feel they are getting a cost-effective service?

• It is an expensive system to implement. New information systems are
required and managers need to be trained in its use.
• It will also rely on the use of activity based costing (ABC) as the standard
costing system.

• The use of rolling budgets, produced on a quarterly or monthly basis, as
an alternative to annual budgeting. These are flexible, do not rely on
obsolete figures and should result in more timely allocation of resources. It
also means that budgets are quickly adjusted for changes in the
organisation’s environment.
• A wider range of performance measures are assessed such as customer
satisfaction, production times, innovation, staff utilisation etc.
• Targets are often set based on ‘benchmarks’ observed externally. For
example, if Amazon can offer guaranteed next day delivery on products
then this may become the benchmark for an organisation’s own
distribution department.
• There is a greater focus on determining and explaining what might happen
in the future (for example, how might product design be changed to reduce
material usage) rather than on what has happened in the past (for
example, examining why a material usage variance has occurred).
• Innovation is encouraged and rewarded.
• Budgets are set at a local level rather than being prepared centrally based
on organisational goals and then having these provided to local managers
who might actually understand the local environment better

• Planning is continuous and the organisation is more likely to be proactive
rather than reactive to changes in its environment.
• Targets become more challenging and more market focused. They
stretch staff and encourage staff to find better ways to do things. They
also make the organisation more customer focused.
• The organisation becomes more innovative and continuously improves.
• Managers are more involved in the decision making process which
provides better information for decisions as well as providing better
motivation for managers.
• Managers can take decisions much more quickly.
• It creates information systems which provide fast and open information
throughout the organisation

• Planning, coordination and performance evaluation become more
complicated. This has the added impact that reward systems also
become more complex.
• If benchmarks and targets are seen as being unachievable then effort to
achieve them is reduced rather than improved.
• Organisational goals are less clear and are not communicated
throughout the organisation. This means that many key stakeholders
such as providers of finance and shareholders lose out as the
organisation focuses more on customers and innovation.
• Organisations who move to a beyond budgeting structure can often face
a lot of resistance from staff and managers where traditional budgets
may be very deeply ingrained in the organisation’s culture. Is staff fail to
fully embrace the new systems and targets then the system is set to fail.
• It may be very difficult or impractical for organisations to adopt the culture
of decentralisation on which successful BB depends.
• The need for more up-to-date and accurate information requires costly
investment