In the complex environment of Financial Planning & Analysis (FP&A), budgeting stands as a foundational pillar of strategic financial management. Budgeting provides a structured financial plan or roadmap for allocating resources to achieve financial goals, assisting organizations in goal-setting, effective resource allocation, and making informed decisions based on data-driven insights.
We will embark on a comprehensive exploration of budgeting and explore the types of budgeting. Furthermore, we will elucidate the concept of Rolling Budgets— a dynamic tool aligning financial plans with evolving business landscapes.
Types, techniques amp; Methods of Budgeting
There are three common types of budgeting — Incremental, Zero-Based, and Activity-Based Budgeting. Each approach brings its own strategic advantages to the financial planning table.
Incremental Budgeting
The traditional approach to budgeting, known as incremental budgeting, involves grounding the budget on the current year's results, with an additional amount allocated for estimated growth or inflation in the next year. While this method is convenient for certain costs, such as staff salaries, where estimates can be straightforwardly derived from current figures with an added increment for inflation.
While incremental budgeting can be reasonable if current operations are as effective, efficient, and economical as possible. But the method has the tendency to encourage inefficient and wasteful spending, continuing past inefficiencies as cost levels are rarely subjected to close scrutiny.
Zero based budgeting
The principle behind zero-based budgeting (ZBB) asserts that the budget for each cost centre should be created from 'scratch' or zero. Every item of expenditure must be thoroughly justified to be included in the next year's budget.
ZBB challenges the assumption embedded in incremental budgeting that this year's activities will persist at the same level next year, and that next year's budget can be built upon this year's costs with an additional amount, often allocated for expansion and inflation.
Although, in practice, managers don't necessarily start from zero, they can begin from their current level of expenditure and work downwards. By assessing what would happen if specific aspects of current expenditure and operations were removed from the budget, every aspect is scrutinized in terms of its cost and benefits. This encourages the exploration of better alternatives.
The implementation of ZBB involves a number of steps but of greater importance is the development of a questioning attitude by all those involved in the budgetary process.
Advantages Zero based budgeting
· It is possible to identify and remove inefficient or obsolete operations.
· It forces employees to avoid wasteful expenditure.
· It responds to changes in the business environment.
· It challenges the status quo.
Disadvantages of implementing Zero based budgeting
· The most serious drawback to ZBB is that it requires a lot of management time and paperwork.
· Short-term benefits might be emphasized to the detriment of long-term benefits.
· Managers may have to be trained in ZBB techniques.
· The organization’s information systems may not be capable of providing suitable information.
ZBB is particularly useful for budgeting for discretionary costs and for rationalization purposes and not particularly suitable for direct manufacturing costs, which are usually budgeted using standard costing, work study and other management planning and control techniques. It is best applied to support expenses, that is expenditure incurred in departments which exist to support the essential production function. These support areas include marketing, finance, quality control, personnel, data processing, sales and distribution.
ZBB can also be successfully applied to service industries and non-profit-making organizations such as local and central government departments, educational establishments, hospitals and so on.
Activity based budgeting
At its simplest, activity based budgeting (ABB) is merely the use of costs determined using activity based costing (ABC) as a basis for preparing budgets. It involves defining the activities that underlie the financial figures in each function and using the level of activity to decide how much resource should be allocated, how well it is being managed and to explain variances from budget.
Implementing ABC leads to the realization that the business as a whole need to be managed with far more reference to the behavior of activities and cost drivers identified. For example, traditional budgeting may make managers 'responsible' for activities which are driven by factors beyond their control: the personnel department cost of setting up new employee records is driven by the number of new employees required by managers other than the personnel manager.
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ABB is therefore based on the following principles.
· It is activities which drive costs and the aim is to control the causes (drivers) of costs rather than the costs themselves, with the result that in the long term, costs will be better managed and better understood.
· Not all activities are value adding and so activities must be examined and split up according to their ability to add value.
Rolling budgets
Rolling budgets (continuous budgets) are budgets which are continuously updated by adding a further period (say a month or a quarter) and deducting the earliest period.
Actual conditions may differ from those anticipated when the budget was drawn up for a number of reasons
a) Organizational changes may occur
b) Action may be needed to combat an initiative by a competitor
c) New technology may be introduced to improve productivity, reduce labor requirements or enhance quality.
d) Environmental conditions may change: there may be a general boom or a recession, an event affecting supply or demand, or a change in government or government policy.
e) The level of inflation may be higher or lower than that anticipated
f) The level of activities may be different from the levels planned
Any of these changes may make the original budget quite inappropriate, either in terms of the numbers expected, or the way in which responsibility for achieving them is divided, or both.
Rolling budgets are an attempt to prepare targets and plans which are more realistic and certain, particularly with a regard to price levels, by shortening the period between preparing budgets.
Instead of preparing a periodic budget annually for the full budget period, there would be budgets every one, two, three or four months (three to six, or even twelve budgets each year). Each of these budgets would plan for the next twelve months so that the current budget is extended by an extra period as the current period ends: hence the name rolling budgets.
Suppose, for example, that a rolling budget is prepared every three months. The first three months of the budget period would be planned in great detail, and the remaining nine months in lesser detail, because of the greater uncertainty about the longer-term future. If a first continuous budget is prepared for January to March in detail and April to December in less detail, a new budget will be prepared towards the end of March, planning April to June in detail and July to March in less detail. Four rolling budgets would be prepared every 12 months on this 3- and 9-month basis, requiring, inevitably, greater administrative effort.
The advantages and disadvantages of rolling budgets
The advantages are as follows.
a) They reduce the element of uncertainty in budgeting because they concentrate detailed planning and control on short-term prospects where the degree of uncertainty is much smaller.
b) They force managers to reassess the budget regularly, and to produce budgets which are up to date in the light of current events and expectations.
c) Planning and control will be based on a recent plan which is likely to be far more realistic than a fixed annual budget made many months ago
The disadvantages of rolling budgets can be a deterrent to using them
a) They involve more time, effort and money in budget preparation
b) Frequent budgeting might have an off-putting effect on managers who doubt the value of preparing one budget after another at regular intervals.
c) Revisions to the budget might involve revisions to standard costs too, which in turn would involve revisions to stock valuations. This could replace a large administrative effort from the accounts department every time a rolling budget is prepared.
NOTE: If the expected changes are not likely to be continuous, there is a strong argument that routine updating of the budget is unnecessary. Instead, the annual budget could be updated whenever changes become foreseeable, so that a budget might be updated once or twice, and perhaps more often, during the course of the year.
In conclusion, navigating the intricate landscape of financial planning and analysis (FP&A) demands a robust understanding of budgeting methodologies. As explored in this comprehensive article, incremental budgeting, zero-based budgeting, activity-based budgeting, and rolling budgets offer distinct approaches to financial planning, each with its own set of advantages and challenges and organizations must align their choice with their specific needs, capabilities, and goals. While no single approach fits all, a judicious selection and application of these budgeting techniques can empower organizations to navigate the ever-evolving financial landscape with resilience and strategic foresight.
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