[caption id="attachment_29387" align="alignright" width="252"] Dada Adefolami[/caption] By Dada Adefolami The budgeting process is an essential component of management control systems, as it provides a system of planning, coordination and control for management. It is often an arduous process, and often strikes dread in the hearts of those involved in budget preparation. A budget is a set of interlinked plans that quantitatively describe an entity’s projected future operations. A budget is used as a yardstick against which to measure actual operating results, for the allocation of funding, and as a plan for future operations. In the public sector, the budgeting process can be even more difficult, since the objectives of the government are more difficult to define in a quantifiable way than the objectives of a private company. For example, a private company’s objectives may be to maximize profit. The meeting of this objective can then be set out in the budget by aiming for a percentage increase in sales and perhaps the cutting of various costs. If, on the other hand budgeting for a public sector organization, why budgeting is particularly difficult in the public sector. Just as objectives are difficult to define quantifiably, so too are the organization’s outputs. In a private company the output can be measured in terms of sales revenue, for example. There is a direct relationship between the expenditure that needs to be input in order to achieve the desired level of output. The legal framework of public sector organizations would probably prevent such a system being introduced. As with all alternatives, the success of a particular process depends on the needs of the individual organization. The alternative of the beyond budgeting model places considerable emphasis on the need for organizational, managerial and cultural changes in order that it may be successfully applied by organizations. This will present considerable behavioural challenges and individual managers might become overwhelmed by the complexity of decision-making in such an unregulated decision-making environment. In the public sector, the budget process inevitably has considerable influence on organizational processes, and represents the financial expression of policies resulting from politically motivated goals and objectives. Yet the reality of life for many public sector managers is an increased pressure to perform in a resource-constrained environment, while also being subjected to growing competition. In essence, a public sector budget: 1. Establishes the level of income and expenditure 2. Authorizes that expenditure, once agreed, out of the planned income 3. Acts as a control on expenditure and income 4. Communicates policies and plans 5. Focuses attention on the future 6. Motivates workers and politicians. In the public sector, on the other hand, it is difficult to define a quantifiable relationship between inputs and outputs. What is easier to compare is the relationship between how much cash is available for a particular area and how much cash is actually needed. Therefore, budgeting naturally focuses on inputs alone, rather than the relationship between inputs and outputs. The budgeting process typically begins with a strategy planning session by senior management. The management team then applies the agreed strategic direction to a series of plans that roll up into a master budget. The plans include a sales budget, production budget, direct materials budget, direct labor budget, manufacturing overhead budget, sales and administrative budget, and fixed assets budget. All of these plans roll up into the master budget, which contains a budgeted income statement, balance sheet, and cash forecast. There may also be a financing budget in which is itemized the debt and equity structure needed to ensure that the cash requirements of the budget can be met. Let us critically evaluate the two main methods for preparing budgets - the incremental approach and the zero-based approach. Both of these have been used in both public sector and private sector organizations, with varying degrees of success. Incremental budgeting Incremental budgeting is the traditional budgeting method whereby the budget is prepared by taking the current period’s budget or actual performance as a base, with incremental amounts then being added for the new budget period. These incremental amounts will include adjustments for things such as inflation, or planned increases in sales prices and costs. It is a common misunderstanding of some people that one of the biggest disadvantages of incremental budgeting is that it doesn’t allow for inflation. Of course it does; by definition, an ‘increment’ is an increase of some kind. The current year’s budget or actual performance is a starting point only. Example: ABC school will have a sizeable amount in its budget for staff salaries. Let’s say that in one particular year, staff salaries were N1.5m. When the budget is being prepared for the next year, the principal thinks that he will need to employ two new members of staff to teach languages, who will be paid a salary of N30,000 each before any pay rises and also, that he will need to give all staff members a pay increase of 5%. Therefore, assuming that the two new staff will receive the increased pay levels, his budget for staff will be N1.638m [(N1.5m +N30k + N30k) x 1.05] It immediately becomes apparent when using this method in an example like this that, while being quick and easy, no detailed examination of the salaries already included in the existing N1.5m has been carried out. This N1.5m has been taken as a given starting point without questioning it. This brings onto the reasons why incremental budgeting is not always seen as a good thing and why, in the 1960s, alternative methods of budgeting developed.the benefits and drawbacks of both budgeting methods will be classified below Benefits of incremental budgeting 1. As indicated above, it is easy to prepare and is therefore quick. Since it is easy to prepare, it is also easily allocated to more junior members of staff. 2. As well as being easy to prepare, it is easy to understand. 3. Less preparation time leads to lower preparation costs. 4. Prevents conflict between departmental managers since a consistent approach is adopted throughout the organization. 5. The impact of change can be seen quickly. For example, the increase of N138k in staff costs for the aforesaid school can quickly be traced back to the employment of two new staff members and a 5% pay increase because everything else in the staff salaries budget remained unchanged. Drawbacks of incremental budgeting 1. It assumes that all current activities and costs are still needed, without examining them in detail. In ABC school example above, we know that the principal has budgeted for two new language teachers. How carefully has he looked into whether both of these new teachers are actually needed? It may be that, with some timetable changes, the school could manage with only one new teacher, but there is no incentive for the principal to actually critically assess the current costs of N1.5m provided, of course, that the funding is available for the two new teachers. 2. With incremental budgeting, the principal does not have to justify the existing costs at all. If he can simply prove that there is an increase in the number of language lessons equivalent to two new staff’s teaching hours, he can justify the cost of two new teachers.By its very nature, incremental budgeting looks backwards rather than forwards. While this is not such a problem is fairly stable businesses, it will cause problems in rapidly changing business environments. 3. There is no incentive for departmental managers to try and reduce costs and in fact, they may end up spending money just for the sake of it, knowing that if they don’t spend it this year; they won’t be allocated the cash next year, since they will be deemed not to need it. 4. Performance targets are often unchallenging, since they are largely based on past performance with some kind of token increase. Therefore, managers are not encouraged to challenge themselves and inefficiencies from previous periods are carried forward into future periods. In ABC school example above, the Principal may have hired an extra cook for the school kitchen when he thought that there was going to be greater demand for school dinners than there actually turned out to be. One of the cooks may be sitting idle in the kitchen most of the time but, with no-one looking at the existing costs, it is unlikely to change. Time for change After World War II, when money was tighter than ever, the problems with incremental budgeting began to give rise to a feeling that change was needed. By the 1960s, something called ‘programme budgeting’ began to develop in the US, introduced by the then US Secretary of Defence. This budgeting system requires objectives, outputs, expected results and then detailed costs to be given for every activity or program. Only when all of the budgets are then put together for all of the activities is the ‘programme budget’ then complete. This budgeting system requires a degree of transparency never before seen under incremental budgeting systems and, as can imagine, it was not welcomed by the public sector at whom it was largely aimed. Therefore, it was closely followed by the development of zero-based budgeting. Zero-based budgeting emerged first in the public sector in the 1960s, but it also gained popularity in the private sector and was adopted by Texas Instruments in 1969. It gained notoriety in the 1970s when US President Jimmy Carter introduced it in the state of Georgia. With zero-based budgeting, the budgeting process starts from a base of zero, with no reference being made to the prior period’s budget or actual performance. All of the budget headings, therefore, literally start with a balance of zero, rather than under incremental budgeting, when they all start with a balance at least equal to last year’s budget or spend. Every department function is then reviewed comprehensively, with all expenditure requiring approval, rather than just the incremental expenditure requiring approval. The budgeting process typically begins with a strategy planning session by senior management. The management team then applies the agreed strategic direction to a series of plans that roll up into a master budget. The plans include a sales budget, production budget, direct materials budget, direct labour budget, manufacturing overhead budget, sales and administrative budget, and fixed assets budget. All of these plans roll up into the master budget, which contains a budgeted income statement, balance sheet, and cash forecast. There may also be a financing budget in which is itemized the debt and equity structure needed to ensure that the cash requirements of the budget can be met. Zero-based budgeting tries to achieve an optimal allocation of resources to the parts of the business where they are most needed. It does this by forcing managers/ Ministers/ Commissioners to justify every activity in their department/ Ministries as they know that, until they do this, the budget for their department/ Ministries are zero. If they are unable to do this, they aren’t allocated any resources and their work therefore stops as does their employment within the organization, at this point, presumably. In this way, all unjustifiable expenditure theoretically ceases. A questioning attitude is developed by management/Ministers/ Commissioners, who are constantly forced to ask themselves the following questions: 1. Is the activity really necessary at all? 2. What happens if the activity ceases? 3. Is the current level of provision adequate? 4. What other ways are there of carrying out the activity? 5. How much should the activity cost? 6. Do the benefits to be gained from the activity at least match the costs? All of these questions are largely answered by breaking the budgeting process down into three distinct stages, as detailed below. Zero-based budgeting Activities are identified by Ministers/ Commissioners/managers. They are then forced to consider different ways of performing the activities. These activities are then described in what is called a ‘decision package’, which: 1. Analyses the cost of the activity 2. States its purpose 3. Identifies alternative methods of achieving the same purpose 4. Establishes performance measures for the activity 5. Assesses the consequence of not performing the activity at all or of performing it at different levels. Regarding the last point, the decision package may be prepared at the base level, representing the minimum level of service or support needed to achieve the Ministries/ organization’s objectives. Further incremental packages may then be prepared to reflect a higher level of service or support. If ZBB was used by ABC School principal in our example above, one of the activities that would have to be performed would be the provision or facilitation of school lunches. The school catering manager may consider three options. Option 1: providing an area where students can bring their own cold food to, with some sandwiches and other cold food and drinks being prepared and sold by catering staff. Option 2: providing a self-service cafeteria with hot and cold food and drinks available. Option 3: providing a full, hot food, catered service for pupils. The base level of service would be option 1, with options 2 and 3 being higher level service options. The school may, on the other hand, consider two mutually exclusive decision packages - providing a service internally or outsourcing the whole catering activity to an external provider. While some form of cost-benefit analysis may be useful at this stage, a degree of quantitative analysis must also be incorporated. For example, cost-benefit analysis may show that the minimal level of provision for the school (option 1) is the most cost-effective. However, this would present the school in a negative light to parents of potential pupils and would deter some parents from sending their children to that school. Consequently, more able students may be discouraged from applying, thus leading to poorer results which, in turn, could have a negative impact on the school’s future funding. Simple cost-benefit analysis would find it difficult to incorporate the financial effect of such considerations. 2. Management will then rank all the packages in the order of decreasing benefits to the organization. This will help management decide what to spend and where to spend it. This ranking of the decision packages happens at numerous levels of the organization. For example, in the case of the school, the catering manager will rank the numerous decision packages that he prepares. Then, the principal will rank the catering packages amongst all the packages prepared for the rest of the school. 3. The resources are then allocated based on order of priority up to the spending level. [caption id="attachment_29387" align="alignright" width="252"] Dada Adefolami[/caption] Benefits of ZBB: The benefits of ZBB are substantial. They would have to be otherwise no organization would ever go to the lengths detailed above in order to implement it. These benefits are set out below: 1. Since ZBB does not assume that last year’s allocation of resources is necessarily appropriate for the current year, all of the activities of the organization are re-evaluated annually from a zero base. Most importantly therefore, inefficient and obsolete activities are removed, and wasteful spending is curbed. This has got to be the biggest benefit of zero-based budgeting compared to incremental budgeting and was the main reason why it was developed in the first place. 2. By its nature, it encourages a bottom-up approach to budgeting in order for ZBB to be used in practice. This should encourage motivation of employees. 3. It challenges the status quo and encourages a questioning attitude among Ministers/Commissioners/managers. 4. It responds to changes in the business environment from one year to the next. 5. Overall, it should result in a more efficient allocation of resources. Drawbacks of ZBB 1. Departmental managers may not have the necessary skills to construct decision packages. They will need training for this and training takes time and money. 2. In a large organization, the number of activities will be so large that the amount of paperwork generated from ZBB will be unmanageable. 3. Ranking the packages can be difficult, since many activities cannot be compared on the basis of purely quantitative measures. Qualitative factors need to be incorporated but this is difficult. Top level management in the Ministries/organizations may not have the time or knowledge to rank what could be thousands of packages. This problem can be somewhat alleviated by having a hierarchical ranking process, whereby each level of managers rank the packages of the managers who report to them. 4. The process of identifying decision packages and determining their purpose, costs and benefits is massively time consuming and costly. One solution to this problem is to use incremental budgeting every year and then use ZBB every three to five years, or when major change occurs. This means that an organization can benefit from some of the advantages of ZBB without an annual time and cost implication. Another option is to use ZBB for some departments but not for others. Certain costs are essential rather than discretionary and it could be argued that it is pointless to carry out ZBB in relation to these. For example, heating and lighting costs in a school or hospital are expenses that will have to be paid, irrespective of the budget amount allocated to them. Incremental budgeting would seem to be more suitable for costs like these, as with building repair costs. 5. Since decisions are made at budget time, managers may feel unable to react to changes that occur during the year. This could have a detrimental effect on the business if it fails to react to emerging opportunities and threats. 6. The organization’s management information systems might be unable to provide the necessary information. Zero-based budgeting tries to achieve an optimal allocation of resources to the parts of the business where they are most needed. It does this by forcing managers/ Ministers/ Commissioners to justify every activity in their department/ Ministries as they know that, until they do this, the budget for their department/ Ministries are zero. If they are unable to do this, they aren’t allocated any resources and their work therefore stops as does their employment within the organization, at this point, presumably. In this way, all unjustifiable expenditure theoretically ceases. It could be argued that ZBB is far more suitable for public sector than for private sector organizations. This is because, firstly, it is far easier to put activities into decision packages in organizations which undertake set definable activities. governments, for example, have set activities including the provision of housing, schools and local transport. Secondly, it is far more suited to costs that are discretionary in nature or for support activities. Such costs can be found mostly in not for profit organizations or the public sector, or in the service department of commercial operations. Finally Budget helps to aid the planning of actual operations by forcing managers to consider how the conditions might change and what steps should be taken now and by encouraging managers to consider problems before they arise. It also helps co-ordinate the activities of the organization by compelling managers to examine relationships between their own operation and those of other departments. The budget of a government is a summary or plan of the intended revenues and expenditures of that government. There are three types of government budget : the operating or current budget, the capital or investment budget, and the cash or cash flow budget. The cash budget is important because it helps the business owner manage the net working capital of the company. Business owners You normally prepare a cash budget every month, although some business owners choose to prepare the cash budget quarterly. You can think of the cash budget as a short-term financial instrument; it’s less formal than a comprehensive statement of cash flows and, therefore, easier and faster to prepare. It describes how much cash your firm is taking in and how much cash it is taking out. The cash budget document, therefore, tells you how much cash is available to the firm at the end of each month. If the cash budget shows an increase in net working capital, you may use that increase to reduce operating costs — by repaying borrowed money, for example. If the cash budget shows a decrease in net working capital, you may need to find some way of increasing available cash — by drawing on a line of credit, taking out a bank loan or by factoring. Factoring, which is particularly common in the clothing industry, consists of selling your accounts receivable at a discount to a third-party. Because the factoring party takes over the ownership of the receivable from the business owner, therefore looking to your customers rather than to your company for payment, it’s a good way of raising capital when your credit status may not support a loan. The Statement of Cash Flows is a more comprehensive statement prepared along with the Income Statement and Balance Sheet. Generally speaking, the Statement of Cash Flows is a more formal presentation of the credit and debit items presented in the cash budget. It looks at many of the same sources and uses of cash presented in the Cash Budget document over a longer period of time, normally at the end of the fiscal quarter and again a year’s end. For a more comprehensive explanation of how statements of cash flows are prepared, read preparing a Statement of Cash Flows. One of the differences between the Cash Budget and the Statement of Cash Flows is that for public companies, the Statement of Cash Flows is part of the required financial statement that must be prepared and presented according to the standards of the FASB (the independent Financial Accounting Standards Board). Although not legally required, most accounting firms preparing financial statements for private companies adhere to the same FASB standards. Another big difference between the short term Cash Budget and the longer term Statement of Cash Flows is that the latter includes depreciation. Although the depreciation expense does not change a company’s net cash position, the real value of a company necessarily accounts for the decline in value of most business assets over time. ZBB requires all costs to be justified, it would seem inappropriate to use it for the entire budgeting process in a commercial organization. Why take so much time and resources justifying costs that must be incurred in order to meet basic production needs? It makes no sense to use such a long-winded process for costs where no discretion can be exercised however. Incremental budgeting is, by comparison, quick and easy to do and easily understood. Therefore, the use of incremental budgeting indisputably gives rise to inefficiency, inertia and budgetary slack. Beyond budgeting model as having particular relevance for knowledge-based companies which are increasingly features of a developed economy. Other companies may see specific benefits in such a system, given the rapidly changing environment in which they operate. These changes will not be introduced without conflict and difficulty due to the challenges faced in introducing change. Such challenges may be beyond the achievement of the public sector, due to the expression in the budget of politically-motivated policies and objectives developed within a complex legal and financial framework. What we can say, however, is that if we are to see the successful application of the beyond budgeting model in both private and public sectors, then this must be underpinned by a considerable organizational, cultural and managerial change. Otherwise it is doomed to failure. In conclusion, neither budgeting method provides the perfect tool for planning coordination and control. However, each method offers something positive to recommend it and one cannot help but think that the optimal solution lies somewhere between the two. In summary, the purpose of budgeting tools: A. The tools provide a forecast of revenues and expenditures, that is, construct a model of how a business might perform financially if certain strategies, events and plans are carried out. B. The tools enable the actual financial operation of the business to be measured against the forecast. C. Lastly, tools establish the cost constraint for a project, program, or operation. Dada Suraju Adefolami, Professor of Finance, School of Business Administration. UNEM University, Costa Rica, is a Finance / management Consultant and Certified Forensic Accountant. You can reach him via: surajudada@yahoo.com: 08052043855