Budgeting
Budgeting is the process of creating a detailed financial plan for a specific period, outlining expected
revenues, costs, and expenses.
Budgeting is an essential tool for planning, controlling and performance management in an organization’s
financial and operational activities.
Purpose of Budgeting and Forecasting:
To allocate resources efficiently.
To provide a roadmap for achieving financial and operational goals.
To facilitate performance monitoring and control.
Types of Budgets and budgeting techniques
Fixed budget
A fixed budget is a financial expression of a plan of action based upon a single activity level.
Flexible budgeting
A flexible budget is a summary of revenues and costs across a range of different activity levels. So instead
of looking at only one activity level various activity levels are considered.
Flexed budgeting
A flexed budget can be created at the end of the budget period based on the actual activity level.
Example
Corfe Co is a business which manufactures computer laptop batteries and it has developed a new battery
which has a longer usage time than batteries currently available in laptops. The selling price of the battery
is forecast to be $45. The maximum production capacity of Corfe Co is 262,500 units. The company’s
management accountant is currently preparing an annual flexible budget and has collected the following
information so far:
Production (units) 185,000 200,000 225,000
Material costs 740,000 800,000 900,000
Labor costs 1,017,500 1,100,000 1,237,500
Fixed costs 750,000 750,000 750,000
In addition to the above costs, the management accountant estimates that for each increment of 50,000
units produced, one supervisor will need to be employed. A supervisor’s annual salary is $35,000.
Assuming the budgeted figures are correct, what would the flexed total production cost be if
production is 80% of maximum capacity?
Solution
An 80% activity level is 210,000 units.
Material and labor are both variable costs. Material is $4 per unit and labor is $5.50 per unit, so total
variable cost per unit is $9.50
Total variable costs = $9.50 x 210,000 units = $1,995,000
Fixed costs = $750,000
Supervision = $175,000 as five supervisors are required for a production level of 210,000 units.
Total annual budgeted cost allowance = $1,995,000 + $ 750,000 + $ 175,000 = $2,920,000
Rolling budget
Traditionally, budgets are prepared on an annual basis. After the annual budget is approved, it is usually
‘set in stone’ and not updated during this period. This approach can be useful for controlling a business in
a stable, mature industry. However, as many organizations face more volatility and uncertainty, this
arbitrary, one-year budget cycle may be too long and unpredictable for forecasts and targets to be
meaningful. A lot can happen in one year – competitors can launch new products, consumer demand can
change, and costs can fluctuate. This can render the annual budget obsolete.
A solution to this problem is the rolling budget approach. This means that the budget will be updated
more frequently than annually – either quarterly or even monthly – and a new budget period will be added
to replace the expired period. Using this approach, the budget will always extend one year into the future
and will be continuously updated.
Activity-based budgeting
The rise of e-commerce, globalization, and shorter product life-cycles are some of the factors increasing
competitive rivalry across many business sectors. Also, indirect costs are becoming a higher percentage of
total costs for many companies as technology and automation investments become more crucial to
success. Because of this, managers need a deeper and more accurate understanding of the true cost of
delivering their goods or services. Activity-based budgeting (ABB) is a tool that helps with this and is
closely linked to activity-based costing (ABC).
Under an absorption costing system, indirect costs are pooled together and labelled ‘overheads.’ An
overhead absorption rate is then calculated, based on a single driver – for example, direct labour hours
(which can be easily found via payroll records). Overheads are then assigned to products on the basis of
the overhead absorption rate and direct labor hours per unit. This cost per unit can then be used for the
budgeting process.
ABB, in conjunction with ABC, focuses on understanding how overheads are consumed by the production
process. Overheads are analyzed, and ABB then looks at costs from the perspective of the activities that
are required to satisfy the customer. Production and non-production activities are measured and quantified,
and then a cost per activity (or cost per driver) is determined through detailed analysis of operations and
costs. Once the cost per driver is calculated, managers can then create a more accurate budget based on
departmental consumption of activities.
Example:
A bakery wants to create a budget using Activity-Based Budgeting (ABB). Instead of budgeting based on
historical spending, they focus on the activities required to produce their baked goods and the cost drivers
for those activities.
Step 1: Identify Key Activities and Cost Drivers
The bakery identifies the following key activities and their cost drivers:
Activity Cost Driver
Purchasing ingredients Number of batches baked
Mixing and baking Hours of oven use
Packaging Number of packages prepared
Delivery Number of deliveries made
Step 2: Estimate Cost Driver Usage
The bakery estimates the cost driver usage based on its expected production for the month:
Activity Cost Driver Usage
Purchasing ingredients 500 batches
Mixing and baking 100 hours of oven use
Packaging 500 packages
Delivery 50 deliveries
Step 3: Assign Costs to Activities
The bakery determines the cost per unit for each cost driver:
Activity Cost Per Unit
Purchasing ingredients $20 per batch
Mixing and baking $5 per hour of oven use
Packaging $2 per package
Delivery $10 per delivery
Step 4: Calculate the Budget
The budget for each activity is calculated by multiplying the cost driver usage by the cost per unit:
Activity Cost Driver Usage Cost Per Unit ($) Total Cost ($)
Purchasing ingredients 500 batches 20 10,000
Mixing and baking 100 hours 5 500
Packaging 500 packages 2 1,000
Delivery 50 deliveries 10 500
Total Monthly Budget: $12,000
Incremental budgeting
It is a simple, straight-forward approach which uses either last year’s budget or actual results as the
starting base for the next year’s budget, only making adjustments for new assumptions, for example, the
estimated change in sales, raw material price inflation, or other incremental factors. Whilst this approach
might be useful in a predictable, static environment.
Drawbacks;
First, a cost centre manager might include ‘slack’ in their budget proposal – this means ‘adding a little
extra,’ to cushion their budget. Last year’s budget might also include outdated assumptions which would
be carried forward into the new budgeting period using incremental budgeting. Managers may also be
motivated to spend everything in their budget towards the end of the year to ensure they receive the same
amount, or more, in the following year.
Zero-based budgeting
It was developed in response to the issues surrounding incremental budgeting. Zero-based budgeting is an
approach to budgeting where all expenses must be justified at the start of each new budgeting period. This
process starts at a ‘zero-base,’ and every organizational function is analyzed for their needs and costs
before an item is included in the budget.
First, ‘decision units’ can be defined as business units, departments or programs. Managers of each
decision unit then evaluate the activities and processes they need to achieve their objectives. This
information is recorded in a ‘decision package’ detailing information on costs, resources required and
different levels of output.
After the decision packages are generated, they are ranked, and a budget is created by allocating funds to
the most attractive decision packages. Under zero-based budgeting, there is now a business justification
for each item in the budget.
Example:
Scenario: A small business wants to create a marketing budget for the upcoming month using zero-based
budgeting. Instead of using last month’s budget, they justify each expense from scratch.
Steps and Budget Plan
1. Define Objectives: The business aims to attract new customers and increase sales through online
marketing.
2. Identify Necessary Activities:
o Social media advertising
o Email marketing campaign
o Website updates
3. Estimate Costs for Each Activity:
Activity Planned Cost ($)
Social media ads 500
Email marketing software 200
Website updates 300
Total Marketing Budget: $1,000
Beyond Budgeting
Beyond Budgeting is more than just a method of preparing an annual budget. Instead, Beyond Budgeting
encompasses a modern, alternative approach to performance management that looks past the traditional,
annual budget as the primary control tool of a company.
Instead of creating rigid, annual budgets, it emphasizes flexibility, adaptability, and decentralized decision-
making. Organizations using Beyond Budgeting rely on continuous planning, rolling forecasts, and
performance management tied to external benchmarks rather than static financial targets.
1. Decentralized Decision-Making: Empower teams to make decisions without waiting for top-
down approval.
2. Continuous Planning: Update plans and forecasts regularly instead of once a year.
3. Relative Targets: Use benchmarks and key performance indicators (KPIs) rather than fixed goals.
4. Focus on Value Creation: Align decisions with long-term goals rather than short-term budget
compliance.
Example:
Scenario: A retail chain decides to adopt Beyond Budgeting to improve performance in a dynamic market
where customer preferences change frequently.
Traditional Budgeting:
The company allocates $500,000 for store renovations for the year.
All stores must stick to this budget, even if some stores need more work than others.
Beyond Budgeting Approach:
1. Empower Teams:
o Each store manager is given authority to decide how much to spend on renovations based
on their local needs.
o Managers prioritize based on customer feedback, competitor activity, and sales trends.
2. Continuous Planning:
o Instead of setting a fixed yearly budget, the head office allocates funds quarterly based on
updated forecasts.
o If a competitor opens a new store nearby, funds can be reallocated quickly to focus on
marketing or store upgrades in that area.
3. Relative Targets:
o Performance is measured by comparing store sales growth to industry benchmarks or the
performance of similar stores, not against fixed sales targets.
4. Focus on Value Creation:
o Store managers aim to increase foot traffic and customer satisfaction instead of simply
staying under budget.
Outcome:
The retail chain adapts faster to market changes.
Stores that need more investment can receive it, while those that don’t require upgrades save
funds.
Local managers feel more empowered, which increases innovation and ownership.
