Decision makers need to understand the strengths (advantages) and weaknesses (disadvantages) of different budget systems so as to ensure that optimal decision is being taken at all times. Organizations will not improve if budgets are set in the wrong way.
It is a well known fact that budgeting is one of the functions of management. However, a major mistake that is made by management in the area of budgeting is that they see budgeting as wholly the function of accounting and finance department. And that has caused a lot of problems and inefficiencies – proper budgeting and budgetary system has to be a task for all involved.
We need to in addition to all that will be discussed in this article be mindful of the costs that are associated with setting and implementing budgets.
An organization can mix and match different types of budgeting system depending on their unique prevailing circumstance.
Okay, let’s get down to the business of the day which to explore strengths and weaknesses of different budget systems.
I will adopt the approach of briefly explaining what each type of budget is and then explore their merits and demerits.
What is Incremental Budget?
Just as the name implies, this is a system of budget whereby certain percentage is added to previous period’s figures. This is often considered the lazy mans’ way of budgeting and suitable for use in matured steady environment- do we have any such thing? Incremental budgeting sadly is the one that most companies in practice use.
Advantages of Incremental budget system
Easy to implement and understand: one of the main selling points of the incremental budget system is the fact that it is quite easy to implement and easily understood by all involved.
Appropriate in a fairly stable environment: a major strength of incremental budget is that it is suitable for a stable environment. That it is appropriate if things do not change too much.
Can support flexed budgeting: activities can be flexed to actual activities to reflect actual volume
Matured industry: incremental budgeting works very well for matured industry and departments. Accounting and finance department for example uses this method as things don’t really change that much in accounting and finance department.
Disadvantages of incremental budgeting
More money given each year regardless whether it is needed or not: spend it or lose it attitude is encouraged by this method of budgeting system although it is common practice for more money to be given to an underperforming department in the government. The police for example gets more money when the crime rates are high.
Cost will be too high: an organization can be running at a loss simply due to the type of budgeting system in use. This is because incremental of the fact that managers could unnecessarily pad the budget thereby using £10,000.00 for a project that easily be completed for far less.
Incremental budgeting encourages laziness: one of the reasons why preparers of budget prefer to use the incremental budget is because of its ease of use and there lies a major problem. All it takes for an incremental budget to be complete is to change the percentage in the spreadsheet’s assumptions table and other things will be updated.
Incremental budgeting encourages inefficiency, waste and slack: not taking time to evaluate things in the light of current happenings increases the chance of continuing with and encouraging inefficiencies in processes. Managers will then use the opportunity of not being vetted to pad the budget as much as they could.
It assumes that the 3Es are already in place: simply increasing last year’s budget by some percentages is indirectly endorsing last year’s performance. The 3E principles states that resources must be used in such a way that Economy, Efficiency and Effectiveness would be achieved.
Flexible budgeting system
What is a flexible budget?
A flexible budget is that budget that changes or flexes in line with volume. This is also called a variable budget. Things are flexible just as the name implies.
Advantages of a flexible budget system
It identifies spare capacity: in practice, companies don’t usually use 100% of their capacity. There is always spare capacities that are used in times of emergency. A flexible budget makes sure that these spare capacities are accommodated on an ad hoc basis.
Dynamic: things hardly stay the same so why should a company assume that things will stay the same? A good thing about flexible budget is that it acts as an open source application ever ready to accommodate things.
Disadvantages of a flexible budgeting system
Irrelevant in a predominantly fixed cost environment: a flexible budget is irrelevant in environment where things don’t change that much.
Can lead to error if standards are incorrect: budgets compare standards with actual and reasons for any variance analyse. What then happens when the original standards are incorrect? This will lead to errors that will in turn be magnified by the deviation from the correct standards.
Zero based budgeting system
What is a zero based budget?
Here, budgets for each period have to start from the scratch and every budget item has to be justified. It is quite suitable for use in new departments or projects. The idea is that the manager gets absolutely nothing unless they can justify it.
Advantages of zero based budgeting
All spending justified: managers are forced to think of ways their activities will help an organization. This also means that cost behaviours are closely reviewed for improvements and adoption of business best practices.
Good for dynamic environment or department, e.g marketing and IT: zero based budgeting ensures that the best in marketing in a dynamic environment is brought out. Responds to changes in environment and this is good for the business as a whole especially in the face of fierce competition.
Lowers cost: best ways of doing things will continually be sought as managers are scrambling to ensure that best practices are employed. As accountants, it is common knowledge that quality saves money. Another reason why costs can be lowered under ZBB is the fact that there will be noticeable improvement and efficiency in the allocation of resources.
Useful in capital rationing situation: things that are not strongly justified are dropped when a company is constrained by tight budget. If for example the marketing department can justify why they need to spend 90% of allocated overhead funds and the IT department cannot justify even 15% of the earmarked funds, the money will be allocated to the marketing department.
Useful in aligning strategy with corporate objectives: zero based budgeting can be used to weed out strategies that are not in line with the overall companywide strategy. Managers in the cause of trying to justify an item in their budget tend to provide a lot of information that can be used to evaluate if doing that would be working towards the common good of the business.
Disadvantages of zero based budgeting
Time consuming: the fact time has to be spent putting the budget together and justifying all items in it and yet other people evaluating the claims made by the manager. For this to be worth implementing, the benefits that will accrue to the company must outweigh the cost of preparing and processing the information.
Costly– successful implementation of ZBB requires that adequate training be provided to those involved and this does not come cheap.
What is a rolling budget?
A rolling budgeting system is a system of budgeting which advocates that budgets be updated based on current prevailing economic condition. It tries to deal with managing targets. The idea behind rolling budget is to always have realistic twelve months budget as this will help keep managers motivated. This is good in a fast changing environment.
Advantages of rolling budget system
Deals with problem of unrealistic budgets: rolling budget helps to eliminate problem associated with setting unrealistic budget because of the fact that the budget is constantly updated to correctly reflect the prevailing situation.
Keep managers motivated: the fact that managers are being appraised on a revised budget increases the chance of them remaining motivated.
Good in environment where it is hard to accurately predict: most start-ups or companies that operate in an unstable predicted environment find it difficult to accurately predict events like sales. A rolling budget makes it possible for things to be updated based on new and more accurate estimates.
Disadvantages of rolling budget
Time consuming: the time used in updating the budget on a continuous basis can be used for something else.
Targets continuously changes: target would be become meaningless if they change frequently.
De-motivating to managers: managers can become laziness and lacklustre if they know that the budget would be revised downwards if they don’t meet targets.
Rolling budget system can upset managers as they may not see value in continuous update: Managers already complain that too much time is spent on budgeting and would be even angrier when asked to update things on a regular basis.
Activity based budgeting (ABB)
What is ABB?
According to CIMA official terminology, activity based budgeting is a method of budgeting that is based on an activity framework, using cost driver as a bases for budget setting
Advantages of ABB
ABB helps to identify critical success factors: ABB draws attention to those areas that a company must excel at in order to be successful. Critical success factors are better understood through the rigours of implementing ABB.
Evaluation of activities in great detail: the implementation of ABB gives managers the opportunity of gaining greater and in-depth knowledge of processes.
Disadvantages / Weaknesses of ABB
Time consuming: just like every other budgets, ABB can be time consuming. Things is even made worse considering that managers will have to be trained on the technicalities of ABC costing so that the idea of activity based budgeting would not be Greek to them.
Difficult to identify activities: just like Activity based costing (ABC), identifying activities and their drivers is always difficult in ABB.