Budgeting

1 Introduction

Budgeting is core to management accounting. A budget is a plan, expressed in financial terms, and it is the instrument through which an organisation plans, communicates, coordinates, motivates and controls.

This chapter is the whole of syllabus section P1B, Budgeting and budgetary control. You need to be able to explain why organisations budget, to prepare the individual budgets and see how they fit together into a master budget, to discuss the alternative approaches available and their suitability to a given situation, and to discuss budgetary control and its effect on the people who work under it. Calculations of key budget figures are expected.

It links directly to three other chapters: chapter 12 supplies the forecasting techniques the budget is built on, chapter 9 takes the flexed budget of section 5 and analyses the differences into variances, and chapter 13 supplies the risk techniques behind the what-if and stress-testing work in section 8.

2 The rationales for budgeting

YouTube videoLoad YouTube video

Organisations do not budget for one reason, and the reasons are not always compatible with each other — a budget set as a stretching motivational target is not the same budget as a realistic planning forecast. The syllabus names five rationales; two more are commonly added.

3 The principal budget factor

Normally the principal budget factor is the level of sales demand, so the sales budget is prepared first and leads to all the others. But it could be something else — a limit on the availability of a raw material, of skilled labour, or of machine capacity. If only enough material can be bought to make 10,000 units, the fact that customers would buy 50,000 is irrelevant, and the material budget is prepared first.

Identifying the principal budget factor is therefore the first step in budget preparation. Where a scarce resource has to be allocated between competing products rather than simply budgeted, the technique is limiting factor analysis in chapter 5.

4 Preparing the budget: functional budgets and the master budget

4.1 The budget cascade

Budgets are not prepared in one step. Each part of the organisation prepares its own plan — a functional budget — and each depends on the one before it. You cannot budget how much material to buy until you know how much to produce, and you cannot budget production until you know what can be sold.

4.2 The master budget and its components

The components interact, and it is the interaction the syllabus asks about. Three examples:

• The MATERIALS PURCHASES budget is not the materials usage budget. Purchases = usage − opening inventory + closing inventory, so a decision to build inventory raises purchases and cash outflow without changing production at all.

• The PRODUCTION budget is not the sales budget, for the same reason: production = sales − opening finished goods + closing finished goods.

• The CASH budget is driven by the others but is not derived from the profit statement. It reflects the TIMING of receipts and payments and includes items that never touch profit — capital expenditure, loan repayments, tax and dividends — while excluding depreciation, which touches profit but never cash.

A change anywhere propagates. Raise the closing inventory target and the purchases budget rises, the cash budget worsens, and the budgeted statement of financial position shows more inventory and less cash — while the budgeted profit is unchanged. That is what “their interaction with each other” means in practice, and it is why the master budget is prepared as one exercise and not as a pile of separate schedules.

5 Budgetary control

YouTube videoLoad YouTube video

5.1 Fixed and flexed budgets

The difference between the fixed and the flexed budget is the sales volume variance; the difference between the flexed budget and the actual results is every other variance. Chapter 9 analyses those differences in full.

5.2 Controllable and uncontrollable outcomes

A manager can only fairly be held responsible for what they can influence. Responsibility accounting is the system that makes this work: revenues and costs are separated into areas of responsibility, each assigned to a named manager, and each manager’s report shows only what that manager controls.

• CONTROLLABLE costs are those a manager can significantly influence within the period — the usage of materials by a production manager, the price paid by a buyer.

• UNCONTROLLABLE costs are those they cannot — an apportioned share of head office costs, a rent set years ago, a market price movement. Reporting these against a manager damages the credibility of the whole control system, because the manager knows the numbers are not theirs.

• The boundary depends on the LEVEL and the TIME HORIZON: a cost uncontrollable by a department manager may be controllable by the director above them, and a cost uncontrollable this month may be controllable over a year.

• Where a variance turns out to be uncontrollable because the STANDARD was wrong, the formal tool for separating it is the planning and operational variance analysis in CHAPTER 10.

5.3 Feedback and feedforward control

Budgetary control operates in two directions in time, and the syllabus names both.

The cash budget is the clearest everyday example of feedforward control: it is prepared precisely so that a shortage can be seen months before it happens and an overdraft arranged, an outflow deferred or a receipt accelerated. Nothing about it is a comparison with the past.

6 The human dimensions of budgeting

YouTube videoLoad YouTube video

If the budget process is not handled properly it will produce behaviour that damages the organisation, whatever the numbers say. The behavioural aspects are as examinable as the arithmetic.

6.1 Participation: top-down and bottom-up

Bottom-up is regarded as the better approach in most circumstances, and it is much the more common today. It is not universally better: where speed matters, where the necessary expertise sits only at the top, or where a turnaround requires targets that no incumbent manager would volunteer, a top-down budget is the right instrument.

6.2 Target setting and motivation

Targets assist motivation and performance appraisal only if they are set at the right level:

• a target that is too difficult demotivates, because the manager gives up;

• a target that is too easy leaves performance below what was achievable;

• ideally the target should be slightly above the level of performance anticipated — demanding but attainable.

A good target is: agreed in advance; dependent on factors within the individual’s control; measurable; linked to appropriate rewards and penalties; and chosen so that achieving it is good for the organisation as well as for the individual.

6.3 Dysfunctional behaviour and budgetary slack

Dysfunctional behaviour is action that helps the manager’s reported performance while harming the organisation. The budget process invites it, and the examinable examples are:

• BUDGETARY SLACK (budget padding) — deliberately overstating costs or understating revenues so the target is easy to beat.

• SPENDING TO THE BUDGET — using up a remaining allowance before the year end on things that are not needed, because an underspend will be taken away next year.

• DEFERRING NECESSARY SPENDING — postponing maintenance, training, advertising or research into the next period to protect this period’s result, at a cost to the organisation later.

• MANIPULATING THE TIMING of revenues and expenses across the year end, so that results fall in the period that suits the manager.

• EMPIRE BUILDING and inter-departmental competition — pursuing the department’s reported numbers at the expense of the organisation’s.

• GAMING THE ALLOCATION — arguing over apportionments and transfer prices rather than over real costs.

The defences are the same in every case: challenge budget submissions rather than accept them; use non-financial performance measures alongside the financial ones so that a manager who has cut maintenance cannot hide it; involve managers in setting targets so that the targets are believed; and evaluate over a longer period than one year, so that deferring spending does not pay.

6.4 Responsibility accounting and management by objectives

Responsibility accounting is a system of accounting that separates revenues and costs into areas of separate responsibility, which can then be assigned to specific managers. It is what makes the controllable / uncontrollable distinction in section 5.2 operational.

Management by objectives (MBO) is a system of management with clearly established objectives at every level of the organisation, each level’s objectives supporting the level above. There is less emphasis on monetary budgets and more on taking the actions that help the business achieve its objectives — so it addresses directly the criticism that a budget measures spending rather than achievement.

6.5 Ethical considerations in budgeting

The syllabus names ethical considerations in budgeting as a topic in its own right. The management accountant preparing or challenging a budget is bound by the CIMA Code of Ethics and its five fundamental principles: integrity, objectivity, professional competence and due care, confidentiality and professional behaviour. Four situations recur.

The behavioural link. The ethical risk in budgeting is not usually fraud; it is the ordinary, well-intentioned pressure to make the numbers say what somebody wants them to say. That is precisely the dysfunctional behaviour of section 6.3 seen from the accountant’s side, which is why the two topics belong together.

7 Alternative approaches to budgeting

7.1 Incremental budgeting

Incremental budgeting takes the prior period’s figures and adjusts them for inflation and for any other known change — usually the change in the level of activity.

It is by far the most common approach, it is quick, and for a stable business it tends to be reasonably accurate.

The problem is that it never questions anything. Errors and past inefficiencies are carried forward, because wasteful expenditure is not re-examined; it simply appears in next year’s base. Nor does it consider alternatives: ask the wages department for a wages budget and they will assume the work is done the way it has always been done and adjust for the pay rise. Nobody is encouraged to ask whether there is a better way, and budget time is exactly when that question should be asked.

7.2 Zero-based budgeting (ZBB)

Zero-based budgeting does not build on the prior period at all. Each activity is considered on its own merits: what alternative ways are there of achieving it, what does each cost and what does each deliver — and should the activity continue at all? Management then chooses the most effective method, and only then is the budget prepared.

ZBB is bottom-up by nature and it is aimed squarely at wasteful expenditure. In principle it is a much better approach than incremental budgeting, and there are two reasons it is not universal:

• it is TIME-CONSUMING and therefore expensive; and

• it requires EXPERTISE that is often split between two people — the operational manager knows how the work is done but cannot cost the alternatives, while the accountant can cost them but does not know the work. It needs a team, or training, or both.

The practical compromise is to apply ZBB to a few activities each year — a different few each year — and to budget everything else incrementally. Over several years every significant activity gets examined properly, and the cost in any one year is bearable.

7.3 Activity based budgeting (ABB)

Activity based budgeting uses the principles and the costing information of an ABC system (chapter 4). Overheads are budgeted using cost drivers — the number of orders, machine set-ups, inspections and so on — rather than as a block adjusted for inflation.

The premise is that certain costs are the result of a demand for activities rather than being output-driven, which is the assumption in the traditional model. The process still begins with the principal budget factor, usually sales, to establish the volume-driven costs and revenues; from there the overhead costs are budgeted according to the expected level of the support activities that drive them.

Its strength is that it makes the overhead controllable: if the number of set-ups is budgeted, the number of set-ups can be managed. The variance analysis that goes with it is in chapter 10 §4.

7.4 Rolling budgets

It is not the same as periodically revising a budget. Many organisations revise the annual budget quarterly because it has gone out of date. A rolling budget always covers the same length of time ahead, which a revised annual budget does not: by November an annual budget looks only one month forward however often it has been revised.

Rolling budgets sit between conventional annual budgeting and abandoning the annual budget altogether, which is the argument of the next section. They are also the classic answer to an exam scenario in which an organisation’s budget has been overtaken by events — see also the planning and operational variances in chapter 10, which deal with the same problem after the fact rather than in advance.

7.5 Beyond Budgeting

The case against the annual budget. Its critics argue that a fixed annual budget:

• is out of date almost as soon as it is approved, and takes months and a great deal of senior management time to produce;

• is a fixed performance contract negotiated once a year, which builds in slack and rewards negotiation rather than performance;

• encourages the dysfunctional behaviour in section 6.3 — padding, spending to the budget, deferring necessary costs, and manipulating the timing of transactions;

• sets a target that becomes a CEILING as well as a floor: a manager who could do far better has no reason to;

• measures performance against a forecast made a year ago rather than against what competitors actually achieved; and

• centralises decisions in an organisation that needs to respond quickly to customers.

What replaces it. The Beyond Budgeting model has two halves, and both are needed:

The criticisms. Beyond Budgeting is not a free lunch. Removing the budget removes the coordination and the authorisation mechanisms as well as the bad incentives, and something has to replace them. It requires a major cultural change and trust that many organisations do not have; it does not remove the need for cash and capital planning; relative and post-hoc targets can feel arbitrary and are harder to explain to the people being judged; and the number of large organisations that have genuinely abandoned budgeting remains small. It is best read as a coherent critique of what annual budgeting does to behaviour, and as the far end of a spectrum that runs from incremental budgeting through rolling budgets to no budget at all.

7.6 Choosing an approach

There is no universally correct method, and an exam scenario will always give you the factors that decide it. Consider:

• the STABILITY of the environment — incremental budgeting suits a stable business; volatility argues for rolling budgets or Beyond Budgeting;

• the SIZE of the organisation and the time and money available — ZBB and ABB are expensive;

• the EXPERTISE, skills and attitudes of the managers, and the culture: participation and devolved authority need managers able to use them;

• the TYPE of organisation — ZBB is well suited to service departments, to the public sector and to not-for-profit bodies, where the output is discretionary and there is no obvious volume driver; ABB needs an ABC system already in place;

• the PURPOSE the budget must serve most — planning, motivation, control or authorisation; and

• the economic climate, and whether the organisation is growing, stable or in trouble.

8 Budgeting in a digital age

8.1 Big data

Big data means extremely large collections of data that can be analysed to reveal patterns and trends, particularly relating to human behaviour.

A large online retailer, for example, collects an enormous amount of information about each customer: not only what was bought, but what was looked at and not bought, how payment was made, where the customer lives, what was returned, what has been ordered more than once, and what ratings and comments have been left. All of it allows the retailer to recommend other items that might appeal.

8.2 Big data analytics in budgeting and forecasting

Data can be collected — sometimes purchased, sometimes gathered through the organisation’s own processes — then analysed to provide insights that lead to better decisions based on better-informed knowledge.

Sales forecasts are the principal budget factor in most businesses, so this is where the value is greatest. Big data can be used to predict buyer behaviour and product popularity, and to estimate likely sales demand in the form of detailed forecasts. It may show why customers are choosing a competitor’s product, or explain other subtle shifts in behaviour that a sales history alone cannot.

The cautions matter as much as the benefits. The data may be misleading and can be misinterpreted; it can be overwhelming in volume; correlation in a very large data set is not causation, and with enough variables spurious correlations are guaranteed; and there are data protection and consent obligations attached to personal data. Used well, it gives competitive advantage and genuine insight into customer preferences. Used badly, it produces a confident forecast that is wrong.

8.3 What-if analysis in budgeting

A budget is built on assumptions — a sales volume, a selling price, a material price, a wage rate, an exchange rate — and every one of them is a forecast that may be wrong. A single-point budget hides that. What-if analysis makes it visible by rebuilding the budget with one assumption changed, and it answers two questions:

1. WHICH assumptions actually matter? Change each in turn by, say, 10% and see what happens to budgeted profit and to budgeted cash. The ones that move the answer are the ones worth spending money to forecast accurately, and worth monitoring during the year.

2. HOW MUCH ROOM is there? For each critical assumption, by how much can it move before the budgeted profit disappears, or before the cash balance breaches the overdraft limit? That margin is the answer management actually needs.

Why it is easy now and was not before. A budget held in a spreadsheet or a planning system with the assumptions as separate, labelled inputs can be re-run in seconds, which is why what-if analysis is treated as a technology topic as well as a technique. The requirement it imposes on the model is that assumptions must be inputs, not numbers typed into the middle of formulae.

Scenario analysis is the natural extension: instead of flexing one assumption at a time, build two or three complete, internally consistent pictures — a downside in which volume falls and prices are cut together, a base case, an upside — and budget the cash requirement of the worst of them. Changing assumptions one at a time understates risk, because in a downturn they tend to move together.

The same arithmetic applied to a DECISION rather than to a budget is sensitivity analysis, and it is covered in chapter 13.

8.4 Stress testing budgets

Stress testing is a form of analysis that identifies which factors are critical to a budget’s success, how far they could move, and what the effect on the final outcome would be. Where what-if analysis asks what happens if an assumption changes a little, stress testing asks what happens under a severe but plausible shock.

Big data analytics has a direct role in it. It can help to:

• identify stress events;

• quantify the effect of those events;

• test the validity of the assumptions in the measures designed to deal with them;

• identify correlations between stress events — which is the point most often missed, because stresses arrive together; and

• create and identify warning signs and triggers for stress events.

Financial institutions, for example, use big data analytics routinely to test the adequacy of the assets backing retirement and insurance funds. Through modelling and simulation they establish whether they could withstand an economic shock, using data on employment shifts, credit conditions and recession indicators to inform the models and so make their decisions more resilient.

9 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.