Budgeting
Week 3
Prepared by Simson 1
Budgeting
Budgeting models
Incremental budget – based on an increment (or growth) from previous year’s
actual results
• traditional budgeting model that is prepared by head office (i.e. top-down
approach)
• fixed for the whole year (i.e. inflexible), therefore, unrealistic/outdated when
the external environment is dynamic
• encourages budgetary slack (i.e. inefficiency) by over-budgeting expenses and
under-budgeting revenue (in order to be easier to achieve the budget)
• encourages dysfunctional behaviour by over-spending (i.e. to go on a
spending spree) in order to use up the budgeted expenses so as to justify the
same the level of expenses budget for next year
Prepared by Simson 2
Budgeting
Zero-based budget (ZBB) – every item in the budget starts from zero
and must be justified
• avoids past inefficiencies because it is responsive to the
anticipated changes in the external environment
• requires a lot of time and effort and training
• most suitable for non-profit organizations and public agencies
• in profit-seeking organizations, ZBB may be implemented every
few years and supplemented with other budgeting methods in
between the years when ZBB is not used
Prepared by Simson 3
Budgeting
Rolling budget – periodically revised/updated throughout the year
to reflect the changing external environment and continuously
adding new periods as the year progresses, so there is always a one-
year budget in the horizon
• adapting to the external environment that is dynamic
• more realistic (therefore, motivating for managers)
Prepared by Simson 4
Budgeting
Flexible budget – highlights costs of unused capacity if output falls
below budget
• Suitable for organisations using incremental budget, but operating
in an uncertain environment
• It allows the budget to be flexed according to the actual capacity
utilisation
• Enables planning for alternative uses of the spare capacity
Prepared by Simson 5
Budgeting
Activity-based budget (ABB) – amounts budgeted are based on the activities
that drive costs (i.e., cost drivers)
• based on the principle of activity-based costing (ABC) where it’s the activities
that consume costs, therefore, focusing on these activities (i.e. cost drivers)
provides a clearer understanding of how much to be budgeted
• need to justify the activities (i.e. cost drivers), therefore, emphasising on
improving efficiency by removing or eliminating the non-value adding
activities (i.e. wasteful activities)
• more accurate costing of activities, therefore, more accurate budgets
• suitable for budgeting fixed costs
• requires training because it is difficult to identify cost drivers correctly
Prepared by Simson 6
Budgeting
Top-down budgeting is the traditional method of budget preparation by
senior managers or Finance Department in the head office. Even though it
brings the benefit of ensuring coordination across all the different
departments in order to be consistent with the top-level strategies/goals, this
method is not suitable in a modern business environment because:
Top-down budgeting is usually fixed for the whole year, therefore, it will
become outdated very quickly due to the dynamic external environment
and intense market competition. As a result, the company is inflexible and
unable to adapt with appropriate changes in strategies in order to
overcome the challenges in the market.
Prepared by Simson 7
Budgeting
Top-down budgeting is rigid because it doesn’t allow the lower-level
managers to spend outside the budgeted amounts without prior approval
from the senior managers or Finance Department, which is often a
bureaucratic and long process. The lower-level managers will be
constrained with a rigid budget and unable to take immediate actions on
any unexpected operational issues such as customer complaints,
machine breakdowns, supply disruptions, etc.
Top-down budgeting will often result in an unrealistic budget because the
senior managers or Finance Department in the head office are too far
removed from the daily operational realities. Even though the lower-level
managers may have provided input in the budget discussions, the final
decision on the budget is at the head office. In fact, the lower-level
managers may manipulate the senior managers or Finance Department
into approving a more lenient budget.
Prepared by Simson 8
Budgeting
• Top-down budgeting doesn’t involve the participation of lower-
level managers and employees in setting their own budgets,
therefore, they feel demotivated and may not feel fully
committed towards achieving the company’s strategies/goals.
Bottom-up budgeting involves the participation of lower-level
managers and employees in setting their own budgets. The
benefits of participation (or the bottom-up process) have already
been discussed in Week 2 lecture (BPP Chapter 2).
Prepared by Simson 9
Budgeting
Beyond budgeting – Hope and Fraser (2003) argue that budgeting lacks
value, especially in a constantly changing environment. They argue that
alternative mechanisms should be used for planning and control:
1) Aspirational targets – encouraging managers to use benchmarking
information to set ambitious, aspirational medium-term goals in order to
improve performance against rivals; but these aspirational targets should
be set as short-term KPI targets, otherwise, managers will be more
cautious and risk-averse
2) Devolved strategy process – empowering all managers to participate in
the process
3) Effective resource management – efficient support from centralised
services at a fair cost
Prepared by Simson 10
Budgeting
4) Relative performance targets – KPIs and rewards are
measured against rivals (through benchmarking) and
performance in previous years (trend analysis), even if profits
are poor (that means, bonus is not paid based on meeting the
budget)
5) Flexible control – operational control is achieved by the use of
non-financial KPIs, trend analysis of costs and rolling
forecasts
Prepared by Simson 11
Budgeting
Therefore, they argue that the budgeting process should be eliminated
because:
Budgeting process takes a long time and distracts managers’ attention
from other more important issues
Budgeting process approves spending on expenditures, such as fixed
costs, that should have been reduced and controlled more effectively in
order to avoid over-spending
Budgeting process is usually an internal process that fails to focus on
dynamic competitors and customers demanding innovation
Budgeting process encourages ‘gaming’ or manipulation by managers in
order to preserve their self-interests, such as budgetary slack and over-
spending (i.e. to go on a spending spree) in order to avoid the budget
being cut for next year
Prepared by Simson 12
Budgeting
Activity-based budget (ABB) is a modern approach to budgeting that uses
activity-based costing (ABC) information to justify the budget.
Activity-based costing (ABC) is based on the principle that products create
the demand for activities that consume resources and these resources incur
costs:
ABC is focused on overheads, i.e., fixed costs, that are not able to be
directly attributable to the final products (indirect costs)
ABC is the modern costing approach that allocates overheads to the final
products based on the activities that are incurred for the products, e.g.,
machine maintenance overheads are allocated to each category of
product based on the number of machine hours incurred (versus the
traditional absorption costing approach that uses an arbitrary
apportionment method, such as quantity of output or sales revenue)
Prepared by Simson 13
Budgeting
Benefits of ABC:
More accurate and fair because it is based on the consumption of cost drivers
that incur the overheads
Identify the reasons (or the root causes) for incurring overheads, therefore,
improving upon the value-adding activities and eliminating the non-value adding
(or wasteful) activities
Encourages a long-term focus because removing the unnecessary or wasteful
activities will bring higher long-term profits
More aware of how the products/jobs will consume activities, therefore, able to
identify the cause-and-effect relationship between activities and costs
Removes the problem of cross-subsidisation between departments/divisions
where one department/division that consumes higher level of activities are being
“subsidised” by other more efficient departments/divisions due to the traditional
costing using an arbitrary rate
Enables the design of more relevant performance measures (or KPIs) that are
tied directly to the consumption of activities, hence, these KPIs are more
objective, fair and motivating, as well as achieving goal congruence
Prepared by Simson 14
Budgeting
Challenges of implementing ABC:
Difficult to identify the activities (or cost drivers) accurately, therefore,
training is required for all the managers to acquire the skills
Substantial amount of time and efforts are required, hence, causing
managers to neglect their operational activities
Costly investment in a sophisticated information technology (IT) system to
facilitate collation and analysis of information
Resistance to the change from managers and employees, therefore, a
strong commitment and a change of culture is required
Prepared by Simson 15
Budgeting
Examples of value adding activities:
• Innovate new products that meet the customers' needs
• Improve products/ services to meet the customers' preferences
• Produce high quality products/ services that match the
customers' requirements
• Implement new technologies to innovate/ improve, improve
efficiency to reduce costs
Prepared by Simson 16
Budgeting
Examples of non-value adding (or wasteful) activities:
(1) Handling customer complaints
(2) Reworks on defective products
(3) Accounting for obsolete inventories to be written-off
• Because these activities are not adding value to the
customers, i.e., not able to generate additional revenue or profits.
• Long-term actions are required to eliminate these activities
e.g., improve the quality of products, innovate new products,
implement new technologies.
Prepared by Simson 17
Budgeting
Evaluating budget variances
Budget variance analysis enables managers to manage by exception,
that is, focus on areas where things are not going to plan (i.e., the
exceptions). It also enables corporate-level senior managers to
monitor performance of business divisions by highlighting the
exceptions.
However, traditional budget variance analysis is unsatisfactory in
managing performance:
The budget itself was unrealistic, therefore, the variances are not
accurate measures of performance, hence, resulting in wrong
rewards/bonus awards
Prepared by Simson 18
Budgeting
Sometimes, the budget is not achieved due to uncontrollable
factors, therefore, the variances are unfairly punishing or
rewarding managers due to the uncontrollable factors
In fact, it could lead to misleading performance monitoring by
the corporate-level senior managers, resulting in misallocation
of resources by concentrating resources to business divisions
that are showing favourable variances.
Prepared by Simson 19
Budgeting
Below is an improved format of profit statement:
Benefits of this format:
Controllable profit is a fair
measure of budget performance,
hence, is a more appropriate
KPI that reflects the managerial
performance, which considers
only those items that are
controllable by the division
Annual bonuses should be
rewarded based on the
achievement of the controllable
profit, which will be motivating
because the divisional manager
is able to control actions towards
achieving the target KPI
Prepared by Simson 20
Budgeting
Furthermore, the variance is split into planning and operational variances:
The managerial performance should be
measured based on operational variance
only (i.e., controllable profit).
Divisional performance includes non-
controllable overheads and planning
variances that reflects the economic
performance of the division, i.e., net profit
after accounting all the traceable
(excluding non-traceable overheads):
Example of traceable overheads are
costs of hiring staff in the division that
are decided at the head office.
Example of non-traceable overheads are
the allocated head office expenses.
Prepared by Simson 21
Budgeting
Divisional profit gives a big-picture view of the economic viability
of the division over the long-term, helping corporate-level head
office to assess it as a portfolio of many business divisions in the
company. E.g., BCG classification as “Question Mark”, “Star”,
“Cash Cow” or “Dog”.
Prepared by Simson 22
Budgeting
Benchmarking
can be used to provide performance measures that are strategically
important (is a key part of the beyond budgeting approach)
is a way to improve performance by identifying best practices from other
external organizations or other internal business divisions
It is merely ‘catching-up’; no innovation except in external – functional
benchmarking
Types of benchmarking:
1) Internal benchmarking compares one operating unit or function with
similar ones in the same organisation
2) External – industry competitor benchmarking compares against direct
competitors
Prepared by Simson 23
Budgeting
3)External – industry, non-competitor benchmarking compares
against other companies that are not direct competitors within
the same industry e.g., electric car manufacturer and battery
manufacturer are in the same industry but are not direct
competitors
4)External – functional benchmarking compares against the
‘best-in-class’ practitioners, regardless of their industry e.g., the
customer service hotline function in a bank can be
benchmarked against the customer service hotline in a
telecommunications company
Prepared by Simson 24
Budgeting
Stages in benchmarking (Kaiser, 1988):
Step 1: Set objectives and determine the areas to benchmark
Step 2: Establish key performance measures (or performance
drivers) in the areas of performance which are most
important to be improved (i.e., the CSFs)
Step 3: Select organisations to compare performance against
(i.e., comparators)
Step 4: Measure own and comparators’ performance by
collecting the data based on the measures established
in Step 2 above
Step 5: Compare performance and identify performance gaps
Prepared by Simson 25
Budgeting
Step 6: Design and implement an improvement programme to close the
performance gaps, either by copying the comparators’
processes/techniques or create suitable customised
processes/techniques (because no two organisations are exactly
alike)
Step 7: Monitor improvements by collecting data based on the same
measures established in Step 2 above in order to assess whether
the desired improvements were achieved; ongoing improvements
may be implemented continuously by repeating Step 6 above; a
post-project review (or post-completion audit) may be required to
identify any weaknesses or mistakes in the design and
implementation in Step 6 above.
Prepared by Simson 26
Budgeting
Problems encountered in the benchmarking process:
1) Not easy to collect external data, especially from competitors
2) Data may be inaccurate or not detailed enough to enable deeper
understanding of the root causes of good performance
3) No one best way of doing business and not all businesses are alike
4) May focus on the wrong areas that are not the critical success factors,
hence, not achieving goal congruence
Root cause analysis – means to understand deeply about the
fundamental cause of a problem/good performance e.g. In Six Sigma,
root cause analysis requires asking the question “Why” for five times
(probing deep)
Prepared by Simson 27
