ACCA - P5 Study text - Emile Woolf INT

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Chapter 8: Budgets and alternative budgeting models

Zero based budgeting (ZBB) and activity based budgeting (ABB)

 Incremental budgeting and zero based budgeting: a comparison

 The framework for a ZBB system

 Advantages of ZBB

 Disadvantages of ZBB

 ZBB and performance monitoring

 Activity based budgeting (ABB)

4 Zero based budgeting and activity based budgeting

(ABB)

4.1 Incremental budgeting and zero based budgeting: a comparison

Zero based budgeting (ZBB) is a method of preparing expenditure budgets that is

an alternative to incremental budgeting.

Incremental budgeting

With incremental budgeting, the starting point for preparing the budget for next

year’s expenditure is actual expenditure in the current year. Adjustments are then

made to the current year’s expenditure, to allow for estimated inflation next year

and also for known changes in expenditure (such as an increase or reduction in

employee numbers next year, or higher or lower depreciation charges).

Essentially, however, incremental budgeting means budgeting by adding extra

amounts of expenditure onto the costs actually incurred in the financial year just

ended.

In many cases, there is inefficiency and excessive spending in the budget for the

previous year. There is no incentive to identify inefficiency and reduce costs.

Zero based budgeting (ZBB)

Zero based budgeting was developed as a method of eliminating inefficiency and

wasteful spending from the budget.

The zero based budgeting approach requires an expenditure budget to be built up

from zero, so that all expenditure within the budget is properly considered and

estimated.

 Its aim is to eliminate wasteful allowances for spending from expenditure

budgets. Spending is not provided for in the budget unless it has been justified.

 ZBB is particularly appropriate for preparing overhead expenditure budgets. A

problem arises with budgeting for overhead costs, whenever overhead spending

levels cannot be related to particular activities (as in activity based costing) or to

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volumes of production output. The temptation is to budget for next year’s

spending by assuming that spending next year will be much the same as in the

current year, with perhaps an increase for inflation or a reduction for ‘cost

control measures’. This is incremental budgeting.

4.2 The framework for a ZBB system

If an entity wishes to introduce ZBB, it must divide its operations into ‘decision

units’. These may also be called budget cost centres. Each decision unit should have

a manager who is responsible for the budget for the unit. A decision unit, for the

purpose of ZBB, is an operating division for which ‘decision packages’ can be

associated.

Each decision unit starts with a budget allowance of zero. The manager of the

decision unit must then justify every programme and every item of spending for

inclusion in the budget for next year. Each of these programmes or items of

spending is called a ‘decision package’.

 A decision package is a program of activity that will achieve a specific purpose.

 Each decision package must have a clearly-stated purpose that contributes to the

goals and objectives of the entity.

 An expenditure estimate must be prepared for each decision package.

For each decision package, the decision unit manager should:

 identify the goal or objective of the programme

 identify the activities that must be carried out to perform the programme

 identify the resources required for the programme and their cost

 explain how the programme will contribute to the goals of the entity as a whole.

For each decision package, the decision unit manager must:

 justify the need for the decision package

 consider what would be the consequences of eliminating the decision package

 consider whether the decision package can be performed in a different way,

more effectively or more efficiently.

Decision unit managers must therefore justify all their spending. As a result, the

budget should eliminate wasteful spending (‘budget slack’) and spending that is no

longer required due to changes in business conditions.

In preparing a zero based budget, each decision package is costed, and the budget

planners must decide whether to accept the decision package for the budget, or

whether to reject it. If a decision package is accepted, the cost estimate for the

package goes into the budget.

Chapter 8: Budgets and alternative budgeting models

Two types of decision package: ranking packages in order of priority

There are two types of decision package.

 Decision packages for a minimum level of operation. For example, there may

be a minimum acceptable level of training for a group of employees. There may

be several alternative decision packages for providing the training – internal

courses, external courses, or computer-based training programmes. An

expenditure estimate should be prepared for each alternative basic decision

package.

 Incremental decision packages. These are programmes for conducting a more

extensive operation than the minimum acceptable level. For example, there may

be incremental decision packages for providing some employees with more

training, or for having more extensive supervision, or more extensive quality

control checks. For incremental decision packages, an estimate should be made

of the cost of the incremental operation, and the expected benefits.

A zero based budget is then prepared as follows:

 A decision must be taken to provide for a minimum level of operation. This

means deciding for each basic operation:

- whether or not to perform the operation at all – do the benefits justify the

costs?

- If the operation is performed at a basic level, which of the alternative basic

decision packages should be selected?

 Having decided on a basic level of operations, a basic expenditure budget can be

prepared.

 The next step is to consider each incremental decision package, and decide

whether this additional operation, or additional level of operations, is justified.

An incremental decision package is justified if the expected benefits exceed the

estimated costs.

 A budget can then be prepared consisting of all the selected basic decision

packages and incremental decision packages.

 If the total expenditure budget is too high when all these decision packages are

included, some incremental decision packages should be eliminated from the

budget. One method of doing this is to rank the incremental decision packages

in an order of priority (typically in order of net expected benefits, which are the

expected benefits minus the estimated incremental costs). The decision packages

at the bottom of the priority list can then be eliminated from the budget, until

total budgeted expenditure comes within the maximum permitted spending

limit.

Extensive use of value judgements by managers will be needed to rank decision

packages in a priority order. This is because the expected benefits from incremental

activities or incremental programmes are often based on guesswork and opinion, or

on forecasts that might be difficult to justify.

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4.3 Advantages of ZBB

The potential advantages of zero based budgeting, particularly when budgeting for

overhead costs, are that:

 all spending levels in the budget must be justified: wasteful spending (‘budget

slack’) should be eliminated

 all activities are reviewed and their value is assessed.

ZBB can be particularly useful in budgeting for ‘discretionary costs’. These are costs

that an entity does not have to incur, but chooses to incur because the expected

benefits exceed the expected costs.

Managers of decision units are required to answer several key questions about their

operational activities:

 Does each decision package support the goals and objectives of the entity?

 What would be the consequences for the entity if a decision package were to be

eliminated?

 Can the same operation be performed in a different way, and at less cost?

 At what level of activity should each operation be conducted? Would it be

appropriate to put in fewer resources, and conduct the operation at a lower

level?

4.4 Disadvantages of ZBB

There are many difficulties and disadvantages with zero based budgeting.

 A large effort is required to establish a framework for zero based budgeting.

Decision units must be identified, and for each decision unit, there must be a

system for identifying decision packages. This takes time and effort. Once

established, the framework must be kept up to date.

 Managers of decision units must spend much more time preparing budgets than

they would with a traditional system of incremental budgeting.

 An effective system of ZBB requires an excellent management accounting system

that can help managers to identify the incremental costs and benefits of different

decision packages.

 Estimates, particularly estimates of the benefits of decision packages, are often

based on the value judgements of managers.

 ZBB might be seen as a threat, to cut back expenditure allowances in the next

budget year.

 When incremental decision packages are ranked in priority order, there may be

disputes between managers of different decision units (budget cost centres), as

each tries to protect his own spending levels and argue that budget cuts should

fall on other cost centres.

ZBB can therefore be a very effective budgeting process for an occasional review of

costs, as a cost-cutting exercise. However, it is not suitable as a regular budgeting

system, because it would be too expensive and time-consuming.

Chapter 8: Budgets and alternative budgeting models

In view of the large amount of management time that is required to prepare a zero

based budget, an entity may decide to produce a zero based budget periodically,

say every three years, and to prepare incremental budgets in the intervening years.

In order to maintain the support of budget cost centre managers for a system of

ZBB, it is also necessary to make sure that any system of performance-based

rewards (such as annual bonuses for keeping spending within budget limits) is not

affected by the use of ZBB. If managers feel that their rewards will be threatened –

for example because it will be difficult to keep spending within the ZBB limits –

they are unlikely to give their support to the ZBB system.

Zero based budgeting techniques can be difficult to apply in practice. Decision unit

managers will be expected to identify and evaluate each decision package, and then

rank decision packages in order of priority. This calls for some skill and knowledge.

When a company is introducing ZBB for the first time, or when a new manager is

appointed, it is therefore advisable to provide suitable training in ZBB methods.

4.5 ZBB and performance monitoring

Within a system of zero based budgeting, actual performance should be monitored.

 For each decision package, there should be a measurable performance target.

 Actual results should be compared with this target.

Each decision package must therefore have one or more measurable performance

objective. The package must specify the objective or objectives, and the activities or

operations that will be required to achieve those objectives.

Actual performance should be measured and compared with the objectives.

Management must be informed whether or not the performance objectives are

achieved.

4.6 Activity based budgeting (ABB)

Activity based budgeting (ABB) is similar in concept to activity based costing

(ABC). When an entity uses activity based costing, it should be able to prepare

activity based budgets. These are budgets prepared using activity based costing

methods, and budgets for overheads are therefore prepared as activity costs.

Total budgeted overhead costs for the budget period are the sum of:

 overhead costs associated with specific activities, and

 general overhead costs that are not associated with any specific activities.

Failure to analyse overhead costs accurately: activity-based budgeting

Another criticism of traditional budgeting is that overhead costs are not estimated

with enough accuracy. It has often been assumed that overhead costs are mainly

fixed costs. In reality, this might not be true.

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Overhead costs now make up a large proportion of total costs of many

organisations. Since overhead costs are a substantial part of total costs, it would be

inappropriate to assume that these costs are largely fixed from one year to the next,

if the assumption is incorrect.

Activity based costing is based on the view that many overhead costs arise from

certain key activities that make use of resources. For each activity, there is one (or

more) ‘cost drivers’. A cost driver is something that results in the use of resources.

Cost drivers may therefore be seen as something that causes overhead costs to

happen. Many overhead costs may vary according to the activity level associated

with a cost driver.

Organisations that use activity based costing are able to budget for overhead costs

using activity based budgeting. This analyses overhead costs into fixed costs and

‘variable’ costs that vary with a particular activity. Overhead cost budgets can be

prepared, for each key activity, by:

 estimating the volume of activity in the budget period (this is the number of

units of the cost driver)

 from this, estimating the amount of resources required to carry out the activities,

and

 preparing a cost budget for these resources.

In principle, a system of ABB might help to remove ‘slack; and wasteful overhead

spending from the budget, because budgets are based on expected activity levels.

Paper P5

Advanced performance management

CHAPTER

Behavioural aspects of

budgeting. Beyond budgeting

Contents

1 The behavioural aspects of budgeting

2 Beyond budgeting

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The behavioural aspects of budgeting

 The relevance of attitudes and behaviour to effective budgeting

 Misunderstanding and worries about cost-cutting

 Opposition to unfair targets set by senior management

 Sub-optimisation

 Budget slack (budget bias)

 Corporate and individual aspirations

 Argyris: four behavioural issues in budgeting

 Budgeting as a bargaining process

 Budgets as a method of motivating individuals

 Expectancy theory of motivation

 Behavioural aspects of budgetary control: budgetrt control as a system of

performance measurement

 Management styles and budgetary control

1 The behavioural aspects of budgeting

1.1 The relevance of attitudes and behaviour to effective budgeting

The effectiveness of budgeting and budgetary control depends largely on the

behaviour and attitudes of managers and (possibly) other employees.

 Budgets provide performance targets for individual managers. If managers are

rewarded for achieving or exceeding their target, budgets could provide them

with an incentive and a motivation to perform well.

 It has also been suggested that budgets can motivate individuals if they are able

to participate in the planning process. Individuals who feel a part of the

planning and decision-making process are more likely to identify with the plans

that are eventually decided. By identifying with the targets, they might have a

powerful motivation to succeed in achieving them.

When budgeting helps to create motivation in individuals, the human aspect of

budgeting is positive and good for the organisation.

Unfortunately, in practice, human behaviour in the budgeting process has a

negative effect. There are several possible reasons why behavioural factors can be

harmful:

 Misunderstanding and worries about cost-cutting.

 Opposition to unfair targets set by senior management

 Sub-optimisation

 Budget slack or budget bias

Chapter 9: Behavioural aspects of budgeting. Beyond budgeting

1.2 Misunderstanding and worries about cost-cutting

Budgeting is often considered by the managers affected to be an excuse for cutting

back on expenditure and finding ways to reduce costs. Individuals often resent

having to reduce their spending, and so have a hostile attitude to the entire

budgeting process. This fear and hostility can exist even when senior management

do not have a cost-cutting strategy.

1.3 Opposition to unfair targets set by senior management.

When senior managers use the budgeting process to set unrealistic and unfair

targets for the year, their subordinates may unite in opposition to what the senior

managers are trying to achieve. Senior managers should communicate and consult

with the individuals affected by target-setting, and try to win their agreement to the

targets they are trying to set. Targets need to be reasonable.

A distinction can be made between:

 aspirational budgets, which are budgets based on performance levels and

targets that senior managers would like to achieve, and

 expectational budgets, which are budgets based on performance levels and

targets that senior managers would realistically expect to achieve.

Aspirational budgets might be considered unfair, especially if the individuals

affected have not been consulted. Expectational budgets, based on current

performance levels, do not provide for any improvements in performance.

Ideally perhaps, budgets might be set with realistic targets that provide for some

improvements in performance.

In addition to opposing budgets that are unfair, operational managers may resent

budgets because:

 they have been imposed by senior managers, without consulting the managers

who will be responsible for achieving the budget targets

 they are unachievable

 they are irrelevant.

1.4 Sub-optimisation

There may be a risk that the planning targets for individual managers are not in the

best interests of the organisation as a whole. For example, a production manager

might try to budget for production targets that fully utilise production capacity.

However, working at full capacity is not in the best interests of the company as a

whole if sales demand is lower. It would result in a build-up of unwanted finished

goods inventories. The planning process must be co-ordinated in order to avoid

sub-optimal planning. In practice, however, effective co-ordination is not always

achieved.

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1.5 Budget slack (budget bias)

Budget slack has been defined as ‘the intentional overestimation of expenses and/or

underestimation of revenue during budget setting’ (CIMA Official Terminology, 2005

ed.). Managers who prepare budgets may try to overestimate costs so that it will be

much easier to keep actual spending within the budget limit. Similarly, managers

may try to underestimate revenue in their budget so that it will be easier for them to

achieve their budget revenue targets. As a result of slack, budget targets are lower

than they should be.

When managers are rewarded for achieving their budget targets, the motivation to

include some slack in the budget is even stronger.

An additional problem with budget slack is that when a manager has slack in his

spending budget, he may try to make sure that actual spending is up to the budget

limit. There are two reasons for this:

 If there is significant under-spending, the manager responsible might be

required to explain why.

 Actual spending needs to be close to the budget limit in order to keep the

budget slack in the budget for the next year.

The problem of budget slack is particularly associated with spending on ‘overhead’

activities and incremental budgeting. One of the advantages of zero based

budgeting is that it should eliminate a large amount of slack from budgets.

In some cases, budget bias operates the other way. Some managers might prepare

budgets that are too optimistic. For example, a sales manager might budget for sales

in the next financial year that are unrealistic and unachievable, simply to win the

approval of senior management.

1.6 Corporate and individual aspirations

The behavioural problems with budgeting arise because the corporate aims of an

organisation are usually not the same as the aspirations of the individuals who

work for it. For example, the aim of a company might be to maximise shareholder

wealth, but there is no reason at all why this should be the aim of the company’s

employees and managers. Individuals have their own aims and ambitions, that

working might (or might not) satisfy.

The potential conflict between corporate objectives and the aspirations of the

company’s employees can become apparent in the budgeting process, when an

organisation sets its targets for the next year.

The accepted wisdom is that there is a potential conflict between corporate and

individual aspirations. Individuals will be inclined to do what they want for

themselves, regardless of whether this is good for the organisation.

The solution to the problem should be to bring the aspirations of individual

managers and other employees as closely as possible into line with the objectives of

ACCA - P5 Study text - Emile Woolf INT - 2010

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