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“A budget is a comprehensive, formal plan, expressed in quantitative terms, describing the expected operations of an organization over some future time period”
In any of the described approaches to budgeting, the key point is that the budget is a management tool to assess whether the business is on track, or adjustments are required. Budgets should take account of market conditions such as margin pressure, macroeconomic factors such as changing tax legislation, as well as internal factors such as resource allocation.
In Incremental Budgeting last year’s budget is used as a starting point for the new budget, and a number of increases are ‘pre-programmed’. These include inflationary increases, salary increases, and overall market growth increases.
Incremental budgeting is relatively easy to implement, but it has a number of serious limitations, including:
An inherent assumption that the current methodology and cost structure is the best way, and should be built upon
It encourages people to have expectations of inflationary increases in salary and business, for doing the same role in a changing market
It assumes that existing customers will grow in line with market growth, without accurately reflecting the incremental costs of winning new customers
It encourages departments to spend all of their allocated budget to ensure that there is an increase next year
In ZBB the budget for any activity at the start of each year is set at zero. All expenditure must be justified on a cost/benefit basis, including justification of continuing existence.
ZBB introduces an environment where only the projects that deliver the best cost/benefit to the organisation will succeed. This tends to focus all company resources on agreed goals and objectives, since by inference, successful delivery of a justified project will deliver cost/benefit. ZBB also gives managers a better understanding of the other parts of the organisation, and the priorities of the company, as they can see relative project priorities. In principle, ZBB leads to the most efficient allocation of resources, as they have to be justified and deployed to the most important projects on a cost/benefit basis.
The limitations of ZBB include:
Huge effort required to prepare cost/benefit analyses
The focus on money-driven decisions can lead to short-term thinking rather than long-term strategic thinking.
There is a tendency to assume that since the budget approves all spending, that all business decisions will somehow lie within the ‘Oracle of the budget’
In BB, Phase 1 of the budget is designed with ‘just enough’ resources to run the organisation as a going concern. Any incremental spending above this level must be justified on a cost/benefit basis.
BB is less resource intensive than ZBB, but once again has some limitations, including:
Who decides ‘just enough’ resource allocation?
‘Just Enough’ is impacted by the anticipated revenue/margin levels, and the product mix. For example, revenue of £1M may require one warehouse as a minimum, but £2M may require three warehouses.
does nothing to promote better productivity in the ‘Just Enough’
resource space. For example, if the warehouse is always included, and
alternatives such as outsourcing are not considered, what incentive is there
to drive costs down in the warehouse?
In ABB, the budget recognises that it is activities which generate cost in a business, and the desire is to control these cost drivers. For each identifiable activity, the cost of a unit is measured, the demand is measured, a budgeted cost is set for each unit of activity, and the budget is designed around activity terms (e.g. Laptop Z3200 Product Build) rather than the traditional functional areas (e.g. Manufacturing).
ABB means that costs can be assigned to activity and product level, rather than averaged out across a number of products or services. This means that real cost behaviour and cost drivers can be analysed, leading to better cost focus and more targeted customer pricing.
ABB requires a large effort to measure and analyse activities, and assumes a causal, linear relationship between activity and overheads. This may be erroneous, as multiple factors may drive the costs, including the sharing of costs over activities, and the method of allocating fixed and variable costs.
Kaizen implies continuous improvement. As such, a Kaizen Budget is designed with anticipated cost improvements integrated at the start of the year.
The process of designing a Kaizen Budget encourages analysis of performance improvements and cost savings. The cost/benefit of any improvement can be analysed in terms of best fit for the company. For example, if a department states a predicted saving of £x by changing a process, but to do so would lead to increased costs of > £x in another, it should be analysed in more detail. This is an example of sub-optimisation - “Situations where a sub-system is configured such that its performance appears to be optimal, yet the performance of the larger system is prejudiced.”
The success of a Kaizen budget depends not only on achieving the numbers, but also on delivering the anticipated improvements.
Les Heitger, Forecasts
and Budgets, from The Portable MBA in
Finance and Accounting, John Leslie Livingstone
Mullen & McMillan, Operations
1, SGBS, The Evolution of Operations
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