BA2 Introduction to Management Accounting
BA2 7 Budgeting Techniques
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The purpose of budgeting
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Preparing budgets serve several purposes within an organisation.
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Definition
Budget
A budget is a financial plan of operations, which serves as part of the planning and
control process.
Conflicts
Often these purposes can lie in conflict with one another.
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Example
Budgetary targets should be:
Motivating to employees to encourage the pursuit of the best possible results,
but,
Neutral, set at reasonable, achievable levels
Hence, there is a conflict between:
Setting budget at the normal, attainable level, or
Setting targets slightly higher
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Co-ordination
Interdependence between departments means that the budget of one will undoubtedly
influence others. Budgets should therefore be formed via the use of a budget committee,
which should include representatives from each part of the organisation.
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Example
It is difficult to determine a budgeted level of material purchases without a budgeted
level of production. Similarly, a budgeted level of production cannot be set without a
budgeted level of sales.
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Information
Information required for the budgeting process must be accurate and available to the budget
committee. This information is usually brought together in a budget manual. Information
required includes:
Current results and figures
The budgetary process
The organisation’s targets
Details of who is responsible for each function
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Budget preparation
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The process begins with identifying the principal budget factor.
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Definition
Principal budget factor
The bottleneck factor in the organisation.
E.g. A maximum production capacity would be a principal budget factor.
Failure to identify this factor will lead to all departments working towards targets that are
unattainable due to the bottleneck in the system. The budget containing the principle budget
factor should be prepared first and all others based around it.
Budgets required:
Production budget
Sales budget
Material budget
Labour budget
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Example
For company A sales are the principal budget factor (PBF). Their first step would
therefore be to use this number to calculate the production budget:
Sales required (units) - (PBF) X
Closing stock X
X
Less: Opening stock (X)
Production budget (units) X
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From this they can then calculate the material budget:
Direct Materials Plastics
Required to produce X units (kg) X
Add: Budgeted closing stock (kg) X
Less: Budgeted opening stock (kg) (X)
Material purchases required (kg) X
Price per kg £X
Material purchases budget £X
And the labour budget:
Direct labour Unskilled
Required to produce X units (hours) X
Cost per hour £X
Direct labour budget £X
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Note:
If material purchases were the principal budget factor, the known number would have to be
put into the materials budget calculation to work out the material purchases budget. From
this figure, the production budget and direct labour budget could be calculated.
Similarly, if labour was the principal budget factor, this would have to be the first budget to
be calculated and the result applied to work out the production budget and then the
materials budget.
In all cases, the known figure needs to be applied to the relevant proforma and the other
numbers worked out around them!
Master budget
The completion of all budgets will result in the preparation of a master budget.
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Definition
Master budget
A summary of all functional budgets. Usually includes, a budgeted profit and loss,
budgeted balance sheet and budgeted cash flow statement.
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This is valuable for senior management who can use this information for more of a ‘big
picture’ approach.
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Incremental budgeting
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Companies that use incremental budgeting set targets using this year’s figures and then add
an estimated amount to account for inflation and any amount of growth that could be
expected.
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Definition
Incremental budgeting
A method whereby targets are set based on the current year’s budget or results.
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Advantages and disadvantages of incremental budgeting
Advantages
A simple method to implement, avoiding the in depth analysis required by
many other techniques
Best suited to special cases, such as smaller or detached departments within an
organisation.
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Disadvantages
Any inaccuracies that occur will end up being carried forward year after year
Incremental budgets are only effective if the organisation is already operating
at optimal efficiency
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Zero based budgeting (ZBB)
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Instead of assuming that current expenditure levels are already acceptable and only
scrutinising any increases, ZBB effectively starts each period with zero budgets and reviews all
requests for funds via a budget committee.
Definition
Zero based budgeting
A method whereby every item of expenditure must be fully justified before its
inclusion in the budget.
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Process of preparing a Zero based budget
• Establishment of ‘decision packages’
• Ranking and prioritisation of decision packages
• Allocation of resources
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Definition
Decision package
A collection of the costs and benefits of a particular activity compiled by the manager
which aims to justify the levels of funding required from the budget committee.
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Conditions for successful ZBB
ZBB is not suitable for all businesses. It is suited to:
Organisations with high levels of discretionary spending e.g. marketing and
research costs
Public sector organisations, where a fixed amount of government funding is
received each year and must be allocated in the most effective way possible
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The advantages and disadvantages of ZBB:
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Activity based budgeting
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You should already be familiar with the concepts of activity based approaches and the idea of
focusing on activities that drive costs rather than the actual costs themselves. The same
approach can be used to budget.
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Definition
Activity based budgeting
A method that involves identifying the activities that are driving costs, and then
allocating funds based on the level of each activity.
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Activity based budgeting vs Traditional budgeting
Under traditional budgeting a budget may look like this:
Activity Cost
Wages £300,000
Vehicle costs £190,000
Equipment costs £110,000
£600,000
An activity based budgeting approach addresses the weaknesses of a traditional
budget by linking fund allocations to the actual cost drivers, and might look like this:
Activity Cost No. of activities
Order processing £115,000 190,000
Local delivery £165,000 100,000
Rural delivery £235,000 60,000
Packaging £85,000 175,000
£600,000
This approach provides a far better indication of how costs are incurred and in turn
allows for a more accurate budgeting process.
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Example
For example, if the number of local deliveries rose by 2,000, management can
accurately estimate the cost of this increase by first finding the cost of each delivery:
£165,000
= £1.65
100,000
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Then multiplying this figure by the increase in activity:
£1.65 x 2,000 = £3,300
In contrast, a traditional system would have them estimating the extra labour hours,
extra vehicle costs and extra equipment requirements of a rural order, all without
understanding how much the actual activity of a rural order really costs.
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Activity based budgeting gives a far better indication of how costs are incurred and in turn
allows for a more accurate budgeting process.
And finally...
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Stop!
By this stage you should know:
The purposes of budgeting
The definition of a principal budget factor
How to create a labour budget
How to create a zero based budget
What the advantages of ABB are
Got it?
If not, go back and re-read the study text before moving on.
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Question Time
It's now time to practise questions.
If you've signed up for our practice questions or are on our fully inclusive course, here's a
direct link to questions for this chapter:
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BA2 Introduction to Management Accounting
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If you want to sign up for our practice questions here's where you will find more details:
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