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Budget Methodologies
Comparing Flexible, Rolling, Activity-Based, Zero-Based, and Project Budgeting
Topic Outline
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Master Budget
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Continuous Rolling Budget
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Flexible Budget
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Activity-Based Budgeting
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Zero-Based Budgeting
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Project Budget
Definition of Terms
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Master Budget - is the culmination and the goal of the budgeting process. It expresses management’s operating and financial plans for a full year, usually the entity’s fiscal year
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Operating Budget - used to identify the resources that will be needed to carry out the planned activities during the budget period, such as sales, services, production, purchasing, marketing, and research and development
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Financial Budget - identify the sources and uses of funds for the budgeting operations.
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Static Budget - is prepared for just one planned activity level, and the activity level is projected before the period begins.
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Continuous Rolling Budget - is sometimes referred to as the rolling budget. It is used to establish and maintain a constant number of operating periods moving forwards in the master budget.
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Flexible Budget - are used to examine possible future scenarios in sales volume.
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Activity-Based Budgeting (ABB) - is prepared based on the budgeted overhead costs to perform the budget activities.
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Zero-Based Budgeting - take a structured approach to regularly demand that all budgeting choices are taken back to a “black page” to be fully evaluated and, if approved, put into the master budget plan. Nothing is assumed to carry forward to next year’s budget without working through a complete evaluation and approval process.
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Project Budget - a budget for a specific project.The time frame of the budget may be very short or more long-term, depending on the length of the project.
The structure of the master budget embodies the execution of strategy in a dual approach. It serves as a fundamental framework through which managers opt for specific budgeting methodologies and tools.
Also known as the comprehensive budget, the master budget encompasses a complete set of projected financial statements for the fiscal year. These statements include the anticipated balance sheet, income statement, and cash flow statement. Initially, individual departments or units prepare their respective budgeted financial statements, which are then consolidated to formulate company-wide projections. The amalgamation of individual unit budgets and the consolidated figures constitutes the master budget, which remains static.
In its creation, the master budget integrates both financial and non-financial assumptions, established during the planning phase, and reflects both operational and financial decisions.
CONTINUOUS ROLLING BUDGET
Organizations generally have long-running budget plans with more detailed operating periods early on in the budget plan (e.g., weekly, monthly) and more general operating periods later in the plan (semiannual, annual). For example, consider the 3-year budget plan below:
This budget plan establishes six months of weekly budget, followed by a half year of monthly budgets, followed by a year of quarterly budgets, and finally at the third year the plan concludes with an annual budget.
As each month of operations concludes, the budget team rolls forward the budget plan to maintain this same structure. As shown below, with January operations for Year 1 (Y1) completed, the organization has rolled forward the budget plan to build the monthly budget for January in Year 2 (Y2)
Benefits of Continuous Rolling Budgets:
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Once the master budget plan is set, the rolling budget mechanism divides the budgeting process into smaller, monthly segments instead of an extended annual procedure. This enables managers to systematically plan for each month, thereby gaining insight into future developments. Managers who consistently consider the organization's long-term prospects are likely to adopt a more strategic approach to their work and decision-making.
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The rolling budget strategy aims to enhance the relevance of data and perspectives utilized in the master budget process by integrating current data, perspectives, and experiences into the budget plan on a monthly basis.
Limitation of Continuous Rolling Budget:
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The primary drawback of implementing rolling budgets is the requirement for the entire organization to remain consistently engaged in ongoing budgeting activities. The time and resources allocated to budgeting efforts inevitably divert attention and resources away from daily operational tasks.
FLEXIBLE BUDGETS
A flexible budget adapts the planned revenues and costs from the master budget (also known as the static budget) to reflect what these amounts would have been if the budget had been based on the actual sales volume.
Prepared subsequent to determining the actual level of activity, a flexible budget for a production department adjusts the budgeted variable costs per unit to match the actual volume of units produced. It incorporates all standard variable costs per unit and the predetermined total fixed costs established at the beginning of the year. This budget is supplementary to the master budget and is distinct from it in that it focuses on variances resulting from factors other than deviations in volume from the assumed volume used when creating the master budget.
Benefits of Flexible Budgeting:
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Flexible budgeting allows management to concentrate on variances resulting from factors other than disparities between actual and budgeted volumes.
Limitations of Flexible Budgeting:
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If sales decline below the planned level, the decline does need to be addressed and a flexible budget will not be useful for pinpointing a decline in sales below what was planned.
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Flexible budgeting must be paired with a standard costing system; the two are complementary, and the effectiveness of one relies on the presence of the other.
ACTIVITY-BASED BUDGETING
Activity-based budgeting is an intricate budgeting approach that yields a more intricate and comprehensive understanding of the numerous activities influencing costs in organizations. In contrast, traditional budgeting methodologies typically employ a straightforward cost allocation method, grouping costs by departments and then allocating them based on unit measures like direct labor hours, headcount, or square footage. The traditional cost allocation model is represented below:
Conversely, activity-based budgeting methods focus on identifying and using core activities throughout the organization to establish activity cost rates in order to assign costs to products, customers, and other business targets based on actual consumption relationships. It is important to note activity-based budgeting methods result in significantly more cost rates compared to traditional budgeting methods.
Benefits of Activity-Based Budgeting:
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The process of crafting an activity-based budget unveils opportunities for cost reductions and the elimination of inefficient activities. Consequently, activity-based budgeting facilitates the identification and enhancement of high-value activities while eliminating low-value ones, thereby fostering continuous improvement.
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It aids managers in pinpointing the necessary resources and anticipating resource adjustments required for changes in product offerings, design, mix, manufacturing processes, etc. Budgeted costs are rooted in the resources needed to execute budgeted activities, establishing a transparent correlation between resource utilization, costs, and output.
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Activity-based budgeting can uncover budgetary slack and elucidate the correlation between activities undertaken and output produced. This system enables managers to assess the impact of changes in products, design, mix, manufacturing processes, etc., on budgeted activities and associated costs.
Limitations of Activity-Based Budgeting:
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Activity-based budgeting necessitates utilization alongside activity-based costing. Both ABC and ABB demand more effort compared to traditional costing and budgeting systems, thus incurring higher implementation costs. These costs involve the research essential for cost allocations and the time invested in educating managers about these allocations. The complexity of cost allocations directly correlates with the costs associated with educating managers.
ZERO-BASED BUDGETING
A simplified budgeting approach involves starting with the previous year's budget, identifying changes in conditions or costs, and then making incremental adjustments to create the new budget. This incremental method contrasts sharply with the more rigorous zero-based budgeting, which assumes no carryover from previous years.
In zero-based budgeting, all current and proposed projects are evaluated, prioritized based on their alignment with the organization's evolving strategy, and assessed for their benefits and costs. This process determines which projects are scaled back or eliminated and which ones are implemented or expanded.
Zero-based budgeting is highly rigorous and promotes efficiency within the organization. Unlike incremental budgeting methods where assumptions about operations and processes are carried over each year, zero-based budgeting is more effective in controlling and reducing budgetary slack.
Benefits of Zero-Based Budgeting:
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In zero-based budgeting, departments identify and justify all planned activities. Only revenues and costs associated with justified activities are included in the budget. Since the budget is built from scratch, each manager must justify all department expenses. This approach is preferred over incremental budgeting because it allows the company to pinpoint non-value-adding expenses or those that should be reduced due to changes in production methods or similar factors.
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The requirement to justify every activity necessitates prioritization based on cost-benefit analyses to determine which activities are justified. This prioritization establishes a systematic foundation for resource allocation.
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As managers scrutinize every expenditure and activity within their department, they are more likely to devise improved or more cost-effective methods of achieving objectives. This exploration of alternative methods is the primary advantage of zero-based budgeting.
Limitations of Zero-Based Budgeting:
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The major limitation of zero-based budgeting is that it can require a nearly impossible amount of work to review all of a company’s activities every year.
PROJECT BUDGETS
Project budgets generally represent strategy-focused investments made by the organization to strengthen or shift its competitive position. Project budgets are fundamentally different from the master budget and the flexible budget. The master budget or the flexible budget covers a distinct time span.. In contrast, a project budget covers an identifiable project that has its own time span. The focus in project budgeting is on one separate project.
Projects should be meticulously planned throughout their entire durations and regarded as unique commitments. Their budgeted figures need to be incorporated into the company's master budget for the applicable period(s).
A project budget must encompass all expenses, encompassing both indirect costs and overheads, essential for the project's execution.
Benefits of Project Budgeting:
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Management can pre-assess the viability of undertaking a project.
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The project budget allows management to anticipate the necessary resource levels.
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It directs management's focus towards projected cash flows and the decisions influencing them.
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Project budgeting promotes collaboration and coordination among impacted responsibility centers.
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A project budget pertains to a distinct project with its designated timeframe.
Limitations of Project Budgeting:
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Projects must be planned over their entire life spans and thus they should be viewed as special commitments.
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Unless the budgeted figures for projects are integrated into the company's master budget for the relevant period or periods, the project budget cannot be effectively utilized.
EXERCISE QUESTIONS:
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A company wishes to prepare a budget that will enable it to compare the amount actually spent to service 20,000 clients with the amount that should have been spent to service 20,000 clients. Which budgeting system would be the most appropriate system for the company to use?
a. A master budgeting system
b. A flexible budgeting system
c. A project budgeting system
d. A zero-based budgeting system
2. A major feature of zero-based budgeting is that it
a.Assumes all activities are legitimate and worthy of receiving budget increases to cover any increased costs
b. Focuses on planned capital outlays for property, plant, and equipment
c. Evaluates each activity and determines whether it should be maintained as it is, reduces, or eliminated.
d. Uses the previous year’s budget and adjusts it for inflatio
3.Which of the following statements correctly describes a benefit of using a master budgeting system?
a.A master budgeting system uses non volume cost drivers to more accurately estimate costs that other budgeting systems
b. A master budgeting system is designed to develop a comprehensive budget that aligns an organization’s operations with its strategy.
c. A master budgeting system results in budgets that are up-to-date and that reflect current conditions
d. A master budgeting system is designed to eliminate wasteful spending.
4. A starting point for preparing a master budget is the:
a.Sales forecast
b.Production forecast
c.Cash expenditure forecast
d.Cash collection forecast
5. Which of the following statements correctly describes a disadvantage of using an activity-based budgeting system?
a. An activity-based budgeting system is only useful is only useful for control purposes, not planning purposes
b. If a project uses resources that are used in other areas of the organization, an activity-based budgeting system may not give an accurate estimate of its costs
c. Managers need to spend time every month to use an activity-based budgeting system
d. An activity-based budgeting system is quite expensive to design, implement, and maintain.
6.Company D is expecting to produce 8,500 units in July and projects variable labor costs of $22,100. If production drops to 8,000 units in August, what is the expected labor cost in August?
a.$20,800
b. $20,705
c.$23,481
d.$21,500
7. Company E is planning to start a project to build a new warehouse. To build the warehouse, Company E estimates that in 2024 labor costs will be $1,500,000, material costs will be $500,000, legal costs will be $250,000, architectural/engineering costs will be $1,200,000, and a charge for corporate administrative costs will be $250,000. If Company E uses the project budgeting system, what will be the total costs included in that budget?
a.$2,500,000
b.$3,700,000
c.$2,000,000
d. $3,450,000
8. Company C has gathered the information below concerning budgeted and actual selling costs. Based on this information, what would Company C’s flexible budget selling costs be for 2024?
9. In 2023, Company G incurred $5,860,400 in set-up costs. It spent 98,000 hours on set-up to produce 619,000 units that year. In 2024, Company G expects to need 99,500 hours of set-up to produce 630,000 units. Using activity-based budgeting and 2023 cost data, what would Company G budget for set-up costs equal in 2024?
a.$5,949,700
b.$5,920,200
c.$5,950,100
d. $5,772,052
10. As of the start of 2024, Company A forecasts sales for the next 8 quarters as follows: $400,000, $410,000, $430,000, $440,000, $410,000, $420,000, $430,000, and $440,000. Sales in the first quarter of 2024 totaled $420,000. Based on this, Company A revises sales estimates as follows (starting with 2nd Quarter of 2024): $430,000, $440,000, $460,000, $430,000, $440,000, $450,000, $470,000, and $480,000. If Company A uses continuous or rolling budgeting, what will be the new annual budgeted sales figure (as of the beginning of the 2nd Quarter of 2024)?
a.$1,750,000
b.$1,700,000
c.$1,680,000
d.$1,760,000
ANSWER KEY
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B. A flexible budgeting system
A flexible budgeting system is a budgeting system that shows the budget that would have been prepared if the organization knew in advance what its actual volume would be. It is the only budgeting system that will enable the company to compare the amount actually spent to service 20,000 clients with the amount that should have been spent to service 20,000 clients.
2.C. Evaluates each activity and determines whether it should be maintained as it is, reduces, or eliminated.
Zero-based budgeting requires justification of each item on the budget. Therefore, each activity is evaluated to determine if it will remain on the budget
3.B. A master budgeting system is designed to develop a comprehensive budget that aligns an organization’s operations with its strategy.
A master budgeting system is a comprehensive budgeting system that shows every aspect of an organization’s revenue and cost flows and results in the preparation of pro forma financial information. The comprehensive nature of the master budgeting system helps ensure alignment between an organization’s operations and strategy.
4.A. Sales forecast
A master budget system is a comprehensive budgeting system that shows every aspect of an organization’s revenue and cost flows and results in the preparation of pro forma financial information. The sales forecast is the starting point since it helps determine budgeted revenue and budgeted production.
5.D. An activity-based budgeting system is quite expensive to design, implement, and maintain.
An activity-based budgeting system is a budgeting system where activities are the focus, not departments, products, or services. An activity-based budgeting system uses non volume cost drivers to more accurately estimate costs since not all costs vary with volume. While this approach typically results in more accurate cost estimates, it can be quite expensive to design, implement, and maintain an activity-based budgeting system.
6. A. $20,800
= $22,100 / 8,500 units
= $2.6 x 8,000 units
= $20,800
7.D. $3,450,000
=$1,500,000 + $500,000 + $250,000 + $1,200,000
= $3,450,000
8. B. $213,200
= $229,600 / 28,000 units
=$8.2 x 26,000 units
= $213,200
9. C. $5,950,100
= $5,860,400 / 98,000 hours
= $59.8 x 99,500 hours
= $5,950,100
10. D. $1,760,000
= $430,000 + $440,000 + $460,000 + $430,000
= $1,760,000
Reference:
Hock, B. & Roden, L. (2023). CMA Preparatory Program Part 1 Volume 1: Sections A - C Financial Planning, Performance, and Analytics. Hock International
Wiley. (2023). Wiley CMA Exam Review 2023 Study Guide Part 1: Financial Planning, Performance, and Analytics. Wiley
