nnCHAPTER TWO

Budget Classification and Reform

Budget Classification
Budget data on expenditure and revenue must be organized in such a way that their significance
may be understood and that comparison may be facilitated. Budget classification is a means of
observation and gives information on government operations, the form and structure essential
for analysis and inference. The classification technique may also be judged in relation to their
ability to facilitate the decision making that comprises the various phases (stages) of budget
process.

The character of decision made in budgeting process determines the manner in which revenues
and expenditures are classified. Government activities are conducted by departments and
agencies that in turn administer programs designed to serve public function. It is legislative that
authorizes and appropriates the program for departments and agencies.

The budget classification system may serve four general purposes, namely,

1. Facilitate program formulation.

2. Contribute to effectiveness of budget execution.
3. Serve the purpose of accountability.
4. Analyze the economic effect of governmental activities.

2.1 Features and Importance of Budget Classification

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Budget classification is one of the fundamental building blocks of a sound budget management
system, as it determines the manner, in which the budget is recorded, presented and reported, and
as such has a direct impact on the transparency and coherence of the budget.
 A budget classification system provides a normative framework for both policy decision making
and accountability. In order to meet the requirement of providing accurate information to
policymakers, government managers, the legislature, and the broader public, the primary aim of
a classification scheme should be to ensure that the budget complies with three key principles of
sound budget management:

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The principle of comprehensiveness requires that the budget cover all government entities and
institutions undertaking government operations, and present a consolidated and complete view of
these operations.
The principle of unity requires that the budget include all revenues and expenditures of all
government entities undertaking government operations. This principle is important to ensure
that the budget is effective in constraining total and sectoral government expenditure, and in
promoting greater efficiency in the allocation of resources.
The principle of internal consistency between different components of the budget requires, in
particular, that the current expenditure needed for the operations and maintenance of past
investment projects be fully reflected in the budget. Moreover, this principle implies that there
should be a unitary budget system in which responsibilities for preparing and executing the
budgets for current and capital (or development) spending are consolidated within a single
central fiscal agency, usually the ministry of finance.
Classifying expenditures and revenues correctly is important for:

1. Policy formulation and performance analysis;

2. Allocating resources efficiently among sectors;
3. Ensuring compliance with the budgetary resources approved by the legislature; and

4. Day-to-day administration of the budget

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Characteristics of Budget Classification
A budget classification system should be designed to help focus the questions and clarify and
detail the answers. There are several characteristics that budget classification scheme should
possess to serve these purpose

1. The budget classification must be pertinent. It must produce information on the

points of interest to decision makers and at level of detail that they require. It should
neither bracket important question nor break dawn in to such pieces that the whole
cannot be recognized.
2. The classification structure should possess degree of uniformity. It is desirable
that the expenditures of all agencies be similarly treated to facilitate comparisons.
Uniformity however, should not be achieved at the expense of pertinences.
3. The budget classification must be practical – which means, among other things,
that the problems of accounting for translations must be considered. The accounting
resources should, of course, be adequately to produce information that is sufficiently
reliable to justify decisions
4. Finally, the structure should be manageable- maintaining a manageable system of
classification can become a particular problem in places where budgeting emphasizes
efficiency in government operations

Approaches to Budgeting/Budget Formats

Introduction
Budgeting is the process of allocating scarce resource to unlimited demands. Budget can
serve as legal documents, control mechanisms, means of communication, planning tools, and
bases for creation of short- and long-term policies. Depending on their intended usage, they
can be prepared under of several approaches. The major ones are based on type of
information presented and expenditure

1. Line – item Budgeting

2. Performance Budgeting
3. Program Budgeting
4. Zero based budgeting (ZBB)
5. Target-Based Budgeting
6. Outcome-Based Budgeting

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2.4. Budget Reform

The budget reforms have started in the late of 19th and early 20th centuries to promote
accountability and efficiency of public budgets. The reforms have generally fallen into one of
the two categories: (1) innovation designed to improve the budget type (2) innovation
designed to improve the budget preparation process. Budget reform is undertaken in order to
design the best system of budgeting that will ensure the effective attainment of objectives, the
efficient allocation of resources and better estimation of budgets. Budgeting helped guard
against fraud and misuse of public funds. This concern remains, but budget reformers have
long argued that a budget system should address other functions as well, such as better
management and planning, particularly since most states now have sophisticated accounting
and auditing systems to protect against misuse of funds. Efforts have exhibited a common
pattern. First, a new budget system is proposed that purports to serve particular functions of
budgeting better than the method in use. Some governments adopt variations of the new
system and keep using them. Other jurisdictions adopt new systems but then revert back to
their previous systems. The most common outcome though is that governments adopt parts of
the new approach but keep most of what they were using already. After a century of use and
study of budgeting methods, significant changes have occurred in the way budgeting is done.
Change has been gradual, however, usually not because a government quickly adopted and
retained a new system.

2.4.1. Line-Item Budget

Line-Item budgeting focuses on itemized classification of expenditures. The entire

expenditure is presented through a series of demands for grants. In a line item system,
expenditures for the coming year are listed according to objects of expenditure, or “line
items.” These line items are often quite detailed, specifying how much money a particular
agency or subunit will be permitted to spend on personnel, fringe/extra things that an
employer gives as well as wages/ benefits, travel, equipment, and the like (see table 2.1). The
most important focus of the budget system is to specify the line item ceilings in the budget
allocation process and to ensure that agencies do not spend in excess of their allocations. In
many systems, central budget offices and finance ministries play the role of “controller”
through establishing detailed procedures designed to prevent overspending. The strengths of
such a system lie in its relative simplicity, lack of ambiguity, and potential for control of
expenditures through easy comparison with prior years and through the detailed specification

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of inputs. Its function is expenditure control and safeguarding of funds based on assigned
budgets and the focus is on the attainment of balanced budget. Table 2.1 line-Item
Budgeting

Object/Items of expenditure Ministry A Ministry B

2004 2005 2004 2005
Salaries & wages 50,000 60,000 70,000 85,000
Utilities 10,000 12,000 12,000 15,000
Supplies & materials 11,000 13,000 10,000 12,000
Travel 1,000 1,200 15,00 2,000
Printing 1400 1,500 1,800 2,200
Telephone 2000 2,500 2,500 3,000
Contingency 3000 4,000 5,000 7,000
(Amount are in Birr)

Line item budgeting usually follows a system of incremental budgeting and is effective in
controlling and monitoring expenditure management.

Although, line item budgets are simple and effective in controlling funds, still it has a number
of drawbacks. Line item budgeting can proceed without knowing the purposes or
accomplishments of expenditures, questions regarding efficiency and effectiveness of the
program. While there is nothing in line item budgeting that prevents these issues from being
examined, the format itself does not require it. In fact, in order to justify requests for
increased expenditures it is common practice under line item budgeting formats to
incorporate a wide variety of quantitative information, such as workload measures, activity
indicators, etc. But the inclusion of such information is not necessarily systematic with line
item budgeting and usually begs the question of the larger purposes these measures are
intended to serve. Furthermore, line item budgeting does not usually consider planning and
policy option in the budget process. These deficiencies encourage governments to develop
and implement the performance budgeting that is based on enhancing efficiency and output.

2.4.2. Performance Budgeting

Performance Budgeting is a term that applies broadly to any number of budgeting formats
that attempt to incorporate the measurement of results as an important consideration in the

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allocation of budget resources. Performance budgeting systematically incorporates
measurement into the budgeting process and uses the results of this measurement to allocate
scarce public resources.

A performance budget is a presentation that clearly explains the relationship between

performance goals and the costs for achieving targeted levels of performance. In general, a
performance budget links strategic goals with related outcome-oriented long-term and annual
performance goals and with the costs of specific activities that contribute to the achievement
of those goals.

A performance budget starts with an overview of what the agency intends to accomplish in
the budget year. For each strategic goal, the overview provides background on what has been
accomplished, analyses of the strategies the agency uses to influence outcomes and how they
could be improved, and analyses of the programs that contribute to that goal, including their
relative roles and effectiveness, using information from Program Assessment Rating Tool
(PART) assessments. This type of budgeting drew on a long-term concern with the efficiency
of government and attempted to integrate information about government activities into the
budget process so that budget decisions could be based to a greater degree on the relationship
between what government did and how much it cost.

There are important management purposes that are served by performance budgeting. For
example, performance information provides an opportunity for administrators/managers to
determine whether an organization is achieving its general and specific goals. Because of
resource limitations, a manager must be able periodically to assess the current situation
against some agreed upon criteria. As achievement is measured, an information base on
which to make program adjustments is provided. Measuring the achievement of an objective
can also provide an improved basis for developing succeeding managerial strategies,
alternative budget proposals and service level objectives. In short, a performance system has
several managerial benefits:

 Performance measurements can be used to evaluate specific program or project

proposals by comparing planned to actual achievements. Programs can be evaluated
in terms of improved performance while at the same time considering whether
changes are cost effective.

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  Performance measurements can be used to forecast resource requirements in the
future.
 Performance information provides an important rationale to justify budgetary resource
requests. Performance-based rationales supplement, and sometimes counter, the
arguments made by political interest groups in favor of and in opposition to public
programs and services.

Any indicator that seeks to measure the success of a government unit’s achievement of its goals
or objectives can be considered a performance measure. The issue is what kind of performance is
being measured. The following levels of performance measurement range from those that are
easiest to construct to those that are most complicated. Not coincidentally, the measures also
range from a measure focusing on inputs to those measuring how well a program helps solve
some societal problems. These performance measurements are Input measures, output measures,
effectiveness measures, efficiency measures, and work load measures.

Input Measures. These are the volume of resources (such as personnel, operating expenses, and
capital) used or total expenditures (costs) consumed to achieve a given output. Inputs have the
advantage of being relatively easy to measure, usually in dollars. Since inputs are measured in
dollars, it is also easy to make comparisons of the costs of inputs across diverse public programs.
Workload Measures. These are indices that assess the level of effort required to carry out an
activity. It focuses on the amount of work done. E.g., Number of applications processed and
number of inspections completed, etc.

Output Measures. These are the quantifying of goods and services performed or delivered to
customers.
Efficiency Measures. These are indices that assess or compare how much output was achieved
per unit of input (costs). It focuses on how well resources are utilized without particular regard
for the amount of service output produced in relationship to the amount of resources required. An
efficiency measure relates costs to a unit of activity. Examples include annual cost per prisoner,
cost of filling a pothole, or cost per child vaccination.

Effectiveness Measures. These are the indices that assess how well a program achieved its goals
and objectives. Basically, effectiveness measures tell us "how well a service is meeting the needs
of the citizens and the community". Effectiveness is most difficult measure because it requires
ruling out the other feasible reasons for why a program succeeded or failed in attaining an
objective.

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 Merits of Performance Budgeting
In comparison to traditional line item budgeting, performance budgeting allows for more flexible
use of fiscal resources and transforms focus from inputs to results by providing the program or
department manager a fixed lump sum allocation that may be used for various needs in order to
achieve the agreed upon results in service deliver. It improves productivity; linking performance
to budget allocation, improves accountability, allows more decentralized decision-making and
more creative management.

Demerits of Performance Budgeting

1. The “result” or “performance” of some government activities (law and order) cannot be
quantified
2. Many assets of the government agencies cannot be accounted for the terms of unit costs.
(Example a research activity, civil rights movement, etc).
3. Performance budgeting does not address the fundamental questions; such as whether a
program is necessary at all, or how best to allocate limited resources among competing
ends. In other words, it gives more attention for efficiency and effectiveness of resources
rather than resource allocations among competing policies. Although, performance
budgeting is difficult to design and implement.
2.4.3. Program Budgeting

Program budgeting is the planning, authorization and execution of expenditure in terms of

programs. The classification of expenditure in terms of programs turns the budget into an
instrument for explicit choices about expenditure priorities such as how much to spend on
preventative health vs. treatment health; how much on tertiary education vs. primary
education; and how much on strengthening the army vs. promoting agriculture.

Program budgeting clearly requires not only budgeting in terms of programs, but also the
systematic use of program performance information. Only through the development of good
program performance information does it become possible to compare the budgetary cost of
each program with the results which the program delivers to the community. This means,
firstly, that program budgeting requires the systematic development of performance
indicators for each program (or sub‐program). Consistent with the expenditure prioritization
objective, these program performance indicators should as fa-r as possible measure program
outcomes and outputs.

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In contrast to performance budgeting, program budgeting was explicitly focused on
budgetary choices among competing policies. While performance budgeting was designed to
discover the most efficient method of accomplishing a given objective, program budgeting
treated the objectives themselves as variable.

A program budget requires the development and public presentation of key

performance and cost information about each program, including

 The program’s objectives and how these link to national and sectoral priorities;
 The key services “outputs” that the program delivers;
 How the program is intended to achieve its stated objectives (e.g., activities, projects,
etc.);
 Key performance indicators and evaluation results by program; and
 Program costs.
Programme budgeting classification, the budget would frame a programme structure to attain
a particular objective and specify spending to attain it. We may think of all those
expenditures allocated to the set of programmes under a particular objective as belonging to a
total spending agency which is responsible for attainment of the objective. If, for example,
the objective is poverty removal, these expenditures would constitute the poverty removal
programme. It is important to note that since these expenditure agencies are inter-related,
some programmes expenditure would draw support from a number of agencies. To explain
the anatomy of programme budgeting, let us take the following example.

Advantages of Program Budgeting

 It enables an organization to purposefully allocate its scarce resources. This

clarity of purpose in turn enables administrators/managers to understand how the
work of their particular unit contributes to the work of the organization as a whole.
 Producing a transparent budget. A program budget presents budget investment in a
format that enhances community understanding of the purpose and nature of the
services.
 Focusing attention on community goals, needs, and capabilities. With a program
budget you can bring budget investments in line with community objectives,
anticipated or desired growth, priorities, and financial capabilities.
 Achieving maximum use of the citizens’ taxes. The planning and management focus
of a program budget establishes an informed basis upon which you can make

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 decisions, thus helping you avoid costly mistakes. A program budget guides you in
making sound annual budget decisions.
 Serving wider community interest. A program budget, once approved, keeps the
citizens and business comm unity informed about community programs and activities
that affect their lives and enterprises. It also provides information on the results of
budget investments.
 Encouraging a more coordinated and efficient government administration. Using
a program budget to coordinate budget investments of municipal departments will
result in more efficient use of limited resources and will limit conflicts or overlap
among projects.
 Maintaining a sound and stable financial program. By programming investments
over many years, a program budget can limit the burden that these investments place
on the municipal budget. Where there is ample time for programming, you can select
the most economical means of designing and financing each project in advance.

Disadvantages of Program Budgeting: One serious disadvantage for

administrators/managers is that it limits their flexibility to shift dollars from one program to
another. True program budgeting is quite time consuming.

2.4.4. Zero-Based Budgeting (ZBB)

The key to Zero-based budgeting is that all departments must define their programs and
consequently their level of funding each year. Under this budgeting process each manager has
to justify a budget request from the "scratch" or "zero" base. This is done on the basis of
evaluation of programs, its alternatives and also the levels of performance of various
alternatives such an analysis is pointed out to help in better ordering of expenditure priorities.
Funds are allocated to those programs which would realize the objectives with an optimum
degree of efficiency.

Zero-base budgeting was designed to control expenditures by identifying the purposes and
measuring the effectiveness and efficiency of all activities. The form of zero- based
budgeting required the following steps:

 Identify logical “decision units”- The lowest level at which budget decisions are
made. Decision units could be formed along functional or organizational lines – for

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 example, a division of a department is a common decision unit, but programs could be
used as well. Managers in each decision unit then prepare a detailed description and
evaluation of all activities it performs, including alternatives to current service
delivery methods and the spending plans necessary to achieve the decision unit’s
goals.
 Create a “decision package” for each decision unit that included: statements of
intended agency results, preferably quantified; measures of workload, efficiency and
effectiveness; and budget requests. The package comprised four funding levels:
 The minimum amount necessary for viability;
 The current or maintenance level;
 An intermediate amount, between the minimum and current levels;
 An increased level to provide additional services.
 Rank decision packages within each manager’s jurisdiction according to policy
directives from the manager’s’ supervisors.
 Advance decision packages up the administrative chain for additional review,
prioritization, revision, consolidation or deletion.
 Consolidate the decision packages for budget requests.
Planning, programming and budgeting are integrated into a single process in ZBB. Planning
implies the determination of long-term objectives, programming gives an opportunity to
select appropriate programmes on the basis of cost benefit consideration and budgeting leads
to allocation of funds to those programmes. This combination/integration enhances efficiency
in public finance management.
Zero Base Budgeting involves the following important aspects:

 It emphasizes on all requisites of budgets.

 Evaluation on the basis of decision packages and systematic analysis, i.e., in view of
cost benefit analysis.
 Planning the activities promotes operational efficiency and monitors the performance
to achieve the objectives.
Advantages of Zero-Based Budgeting (ZBB)

 It helps to identify the uneconomical activities.

 It ensures the proper allocation of scarce resources on priority basis.
 It facilitates Co-operation and Co-ordination among all levels of management.
 It ensures each activity is thoroughly examined on the basis of cost benefit analysis.

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  Useful for service departments where the output is difficult to identify.
 Identifies and eliminates wasteful and obsolete operations.
 Necessary to train managers. Zero-based budgeting must be clearly understood by
managers at various levels to be successfully implemented.

Disadvantage of Zero-Based Budgeting (ZBB)

 Difficult to define decision units and decision packages, as it is time-consuming and

exhaustive.
 Forced to justify every detail related to expenditure. The R&D department is
threatened whereas the production department benefits.
 Difficult to administer and communicate the budgeting because more managers are
involved in the process
 In a large organization, the volume of forms may be so large that no one person could
read it all. Compressing the information down to a usable size might remove critically
important details.

2.2.5. Activity-based Budgeting (ABB)

Activity-based budgeting (ABB) calculates the total cost needed to hit the target of the
anticipated level of activities (thus its name). 

This top-down method first calls for the identification and thorough scrutiny of all the
activities that drive cost. This analysis will then give grounds for allocating resources to
achieve the level of activities that was anticipated beforehand. 

To give an example, you run a small toy manufacturer. Your forecast for the next year says
that sales would be 10,000 units, each of which is assigned the same Cost of Goods
Manufactured (COGM) at Birr 5. Employing ABB, you should compute a budget of Birr
50,000 (10,000 * 5). 

ABB could be easily confused with ZBB: Rather than starting from the basis of zero, ABB
allocates resources by studying the efficiencies of the activity that is under review. Instead
of starting everything from scratch, people leverage activity-based analysis to streamline the
process.  

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Advantages of ABB 

 Enhanced efficiency: By linking every function and department with their spending, ABB
provides a complete picture of the organization. Based on this visibility, the organization are
enabled to identify and close the performance gap as well as seize opportunities that may
arise 
 Cost management: By taking into account each and every activity that incurs costs, ABB
delivers better cost containment, thus improving the bottom line. 
 Eliminated redundancy: With the help of ABB, any non-value-added activity or function will
be easily diagnosed for taking corrective measure or removing 

Disadvantages of ABB 

 Suck out scarce resources: Just like any other discipline with structural implications, ABB
greatly expands the workload and requires the devotion of workforce and financial resources. 

Foster short-termism: ABB focuses on the contemporary goal rather than the long-term
strategy.

2.4.6. Outcome-Based Budgeting

A recent trend in government budgeting involves increasing the level of accountability for
public resources-how much money is being spent on each program or agency and the return
on public’s investment. Here, service organizations estimate how much outcome they will
provide and at what cost. The focus is not on programs but on the results the organization
says it will achieve (See Figure 2.1). The outcome budget reflects the endeavor of the
Government to convert outlays into outcomes by planning expenditure, fixing appropriate
targets and quantifying deliverables of each scheme.

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Figure 2.1 Outcome Based Budget Management Diagram

Establish Desired
Outcome
Report
Results
Define
Strategies to
Achieved
Analyze
Performance

Appropriate
Financial &
Measure & Personnel
Monitor Resources
Progress Develop
Measurable
Targets

Based upon the above diagram, outcomes were defined, required resources were identified,
projected expenditures were calculated, strategies were developed, and performance targets
were established and finally report the results of outcome to concerned bodies.

Budgeting for outcomes encourages innovation in the way outcomes will be produced. The
government might also pre-select the major outcomes it wants and establish a total
expenditure level for each outcome. Outcome budgeting assesses the long-term impact of
each policy, program or agency within its targeted area. Through based on quantitative
measures, outcome-based budgeting determines the qualitative result of government
initiatives. It observes the level of resources needed to reach goals and objectives and use that
information for budget decision-making.

Some scholars argue that outcome-based budget is more effective in producing desired
results, linked to planning process, more innovative, and more flexible. However, goals and
objectives must be identified and tied to budget allocations and also clear communication
with stakeholders should be established in advance.

Figure 2.2 Comparison of Outcome Budgeting with Other Public Budgeting Systems
Using the Expanded Systems Framework

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Budgeting System Purpose System Foci Target Audience
Line-Item Control Inputs/Program Internal
Performance Management Outputs/Inputs Internal
Program Planning Inputs/Program/Outputs
Internal/External
Outcome Outcome performance Outcomes/Inputs
External/Internal
Transparency & Communication
Using what can be called an “expanded systems model” Figure 2.2 illustrates how outcome
budgeting systems differ from other public budgeting systems. The emphasis in Figure 2.2 is
on comparisons between outcome budgeting and the three major public budgeting systems
(line item, performance and program).

The primary focus of outcome budgeting systems makes them qualitatively different from
other major public budgeting systems. As Figure 2.2 demonstrates, outcome budgeting is the
only public budgeting system that makes outcomes its primary focus.

According to most public budgeting scholars, performance budgeting is concerned with “the
things that government does”, rather than the outcomes governments achieve. Performance
budgeting: “a budget format that presents government program input and output, thus
allowing easy verification of the program’s economy and efficiency”. Outcome budgeting is
concerned not with outputs, economy, and efficiency, but rather with outcomes and
effectiveness (the ratio of outcomes to inputs). Because performance budgeting does not
recognize the importance, or even the existence of outcomes.

Figure 2.2 also draws attention to two other dimensions (purpose and target audience) on
which outcome budgeting systems differ from other major public budgeting systems. Public
budgeting practices over the last sixty years have provided a myriad of responses to the

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question: “How should one decide to allocate X dollars to activity A instead of activity B”?
The allocation question has been answered in terms of financial control (line-item budgeting);
managerial control (performance budgeting); planning and programming (program
budgeting), and others. Generally, public budgeting systems have long been held to have
three primary purposes: control, management, and planning. All public budgeting systems are
said to possess these primary purposes but with varying degrees of emphasis.

In addition to control, management, and planning purposes, outcome budgeting is a

manifestation of performance accountability, it has two additional purposes (transparency and
communication) not generally found in other public budgeting systems. Transparency in its
broadest sense is taken to mean that governments should be as open and visible as possible to
their stakeholders (e.g., elected officials, citizens, interest groups and others). Communication
means that governments should provide information about programs, outcomes, and attendant
costs in a language that stakeholders can understand. The argument can be made that
transparency and communication are inseparable from the concept of performance
accountability. Stakeholders armed with readily understandable performance information
about the outcomes and attendant costs of government programs will be better positioned to
hold government programs accountable. Therefore, outcome budgeting systems are as
concerned about making government programs transparent and communicating information
about these programs to stakeholders as they are about outcomes.

The target audience for outcome budgeting also differs from those of the other major public
budgeting systems. The argument can be made that the target audience for line-item,
performance and to a lesser extent program budgeting system is primarily internal,
government managers and administrators. Historically, these public budgeting systems have
not been what might be called “external stakeholder friendly.”

The combination of a focus on outcomes, its transparency and communication purposes and
its external target audience sets outcome budgeting apart from other public budgeting systems
and warrants it recognition as a new species of public budgeting.

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