Zero based budgeting A method of budgeting in which all expenses must be justified for each new period. Zero based budgeting starts from a "zero base" and every function within an organization is analyzed for its needs and costs. Budgets are then built around what is needed for the upcoming period, regardless of whether the budget is higher or lower than the previous one. ZBB allows top-level strategic goals to be implemented into the budgeting process by tying them to specific functional areas of the organization, where costs can be first grouped, then measured against previous results and current expectations. Investopedia Says : Because of its detail-oriented nature, zero-based budg eting may be a rolling process done over several years, with only a few functional areas reviewed at a time by managers or group leadership.
Zero-based budgeting can lower costs by avoiding blanket increases or decreases to a prior period's budget. It is, however, a time-consuming process that takes much longer than traditional, cost-based budgeting. The practice also favors areas that achieve direct revenues or production; their contributions are more ea sily justified than in departments such as client service and research and development. Related Links : Make it to the end of the month, before you run out of money. The Beauty Of Budgeting Think of yourself as your own little company. To make it run smoothly, you need to take a look at your books. Run Your Finances Like A Business Can you have perfect abs in just six minutes a day? Maybe not, but you can have a rocksolid budget in six months. 6 Months To A Better Budget Zero-based budgeting is a technique of planning and decision-making which reverses the working process of traditional budgeting traditional budgeting.. In traditional incremental budgeting incremental budgeting,, departmental managers justify only increases over the previous year budg et and what has been already spent is automatically sanctioned. By contrast, in zero-based budgeting, every department function is reviewed comprehensively and all expenditures must be approved, rather than only increases. increases.[1] No reference is made to the previous level of expenditure. Zero-based budgeting requires the budget request be justified in complete detail by each division manager starting from the zero-base. The zero-base is indifferent to whether the total budget is increasing or decreasing.
The term "zero-based budgeting" is sometimes used in personal finance to describe "zerosum budgeting", the practice of budgeting every dollar of income received, and then adjusting some part of the budget budge t downward for every other part that needs to be adjusted upward.
Zero based budgeting also refers to the identification of a task or tasks and then funding resources to complete the task independent of current resourcing.
Advantage of zero-based budgeting 1. 2. 3. 4. 5.
Efficient allocation of resources, as it is based on needs and benefits. Drives managers to find cost effective ways to improve operations. Detects inflated budgets. Useful for service departments where the output is difficult to identify. Increases staff motivation by providing greater initiative and responsibility in decision-making. 6. Increases communication and coordination within the organization. 7. Identifies and eliminates wasteful and obsolete operations. 8. Identifies opportunities for outsourcing. 9. Forces cost centers to identify their mission and their relationship to overall goals. 10. It helps in identifying areas of wasteful expenditure and, if desired, it can also be used for suggesting alternative courses of action.
Disadvantages of zero-based budgeting 1. Difficult to define decision units and decision packages, as it is time-consuming and exhaustive. 2. Forced to justify every detail related to expenditure. The R&D department is threatened whereas the production department benefits. 3. Necessary to train managers. Zero-based budgeting must be clearly understood by managers at various levels to be successfully implemented. Difficult to administer and communicate the budgeting because more managers are involved in the process. 4. In a large organization, the volume of forms may be so large that no one person could read it all. Compressing the information down to a usable size might remove critically important details. 5. Honesty of the managers must be reliable and uniform. Any manager that exaggerates skews the results.
Incremental budgeting Incremental Budgeting uses a budget prepared using a previous period’s budget or actual performance as a base, with incremental amounts added for the new budget period. The allocation of resources is based upon allocations from the previous period. This approach is not recommended as it fails to take into account changing circumstances. Moreover, it encourages “spending up to the budget” to ensure a reasonable allocation in the next period. It leads to a “spend it or lose it” mentality.
Advantages of incremental budgeting
1. 2. 3. 4. 5. 6.
The budget is stable and change is gradual. Managers can operate their departments on a consistent basis. The system is relatively simple to operate and easy to understand. Conflicts are avoided when departments appear to be treated similarly. Co-ordination between budgets is easier to achieve. The impact of change can be seen quickly.
Disadvantages of incremental budgeting
1. 2. 3. 4. 5.
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Assumes activities and methods of working will continue in the same way. No incentive for developing new ideas. No incentive to reduce costs. Encourages spending up to the budget so that the budget is maintained next year. The budget may become out-of-date and no longer relate to the level of activity or type of work being carried out. 6. The priority for resources may have changed since the budgets were originally set. 7. There may be budgetary slack built into the budget, which is never reviewed. Managers might have overestimated their requirements in the p ast in order to obtain a budget which is easier to work within, and which will allow them to achieve favourable results. activity based budgeting A method of budgeting in which the activities that incur costs in every functional area of an organization are recorded and their relationships are defined and analyzed. Activities are then tied to strategic goals, after which the costs of the activities needed are used to create the budget. Activity based budgeting stands in contrast to traditional, cost-based budgeting practices in which a prior period's budget is simply adjusted to account for inflation or revenue growth. As such, ABB provides opportunities to align activities with objectives, streamline costs and improve business practices. Investopedia Says : By looking at the cost structure of an organization via the processes that are actually being performed, managers can more effectively analyze the profit potential of a company's products and services. Cost efficiencies can be found by comparing activities performed in different areas of the organization and consolidating or rerouting certain functions.
At its essence, activity-based budgeting begins by looking at results and the activities that created them, as opposed to cost-based budgeting, which often begins with raw input and
material and works outward. ABB can also help firms create more accurate financial forecasts.
Zero and incremental budgeting The difference between zero and incremental budgeting: the pros and cons of each.
What is the difference? In zero-based budgeting the financial planners start from a zero base. In other words, they assume that no programme is necessary and no money need be spent. For a programme to be accepted, it will have to be proven worthwhile and financially sound in an evaluation of all elements of revenue and spending. An incremental budget, on the other hand, treats existing programmes and departments as already approved, subject only to increases or decreases in the financial resources allocated. The organisation's historical costs are the base from which budget planning starts. The focus of the budgeting process is on the changes anticipated in last year's figures. The planning process has already been completed and the programme priorities established.
What are the advantages and disadvantages? In zero budgeting, each programme is examined in order to justify its existence, and is compared to alternative programmes. Priorities are established and each cost centre is challenged to prove its necessity. This can make programme managers feel threatened, so budget setters should exercise sensitivity when using the zero-based method. In comparison, there are dangers in using last year's figures as in incremental budgeting. There is a risk of 'creeping' costs year on year. For example, each year the organisation may take 'last year plus 5%' as its figure and fail to query the basis for the decision. In this way, an arbitrary decision in a given year can continue unchallenged for a decade. Moreover, basing the budget on the actual results can encourage the practice of spending up to the budget in the last few months, to prevent future cuts. However, incremental budgeting is often less time-consuming than the zero-based method, and is also felt to be less threatening to programme managers.
Activity-based Budgeting (ABB) While basing the budget on previous effective costs figures, and therewith accepting the cost of non-unit level activities to be fixed, and consequently inherent past inefficiencies and wast in the current way of doing things, activity-base budgeting allows to manage costs more effectively. Adopting the underlying ideas of Activity-based costing (ABC),
ABB authorizes the supply of only those resources that are needed to perform activities required to meet the budgeted production and sales volume. In this budgeting process, cost objects are the starting point and their budgeted output determines the necessary activities which are then used to estimate the resourced that are required for the budget period. The process stages are[5]: • • • • •
estimate the production and sales volume by individual products and customers estimate the demand for organizational activities determine the resources that are required to perform organizational activities estimate for each resource the quantity that must be supplied to meet the demand take actions to adjust the capacity of resources to match the projected supply.
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Kaizen Budgeting : Budgeting approach that explicitly incorporates continuous improvements during the budget period into the resultant budget numbers[17 Kaizen is the Japanese word for "continuous improvement." In organizations in which Kaizen is practiced, continuous improvements are made in processes. These improvements must show up in the budget as improved costs based on reductions in time and resource needs. Kaizen budgeting shows these improved costs. When comparing actual results with a Kaizen budget, the analysis shows whether or n ot a company met its goals, since unfavourable variances indicate missing the target. Activity-based budgeting (ABB) focuses on the costs of activities necessary to produce and sell products and services, rather than focusing on the functional department costs. ABB separates indirect costs into separate homogeneous cost pools and uses cause-and-effect criteria to identify cost drivers for each cost pool. Here are the four steps in ABB: 1. Determine the demand for each individual activity based on budget. 2. Determine the cost of performing each activity. 3. Calculate the cost of each activity as demand times cost. 4. Create the budget from the resulting costs. The benefits of using ABB include the following: ● Creation of more realistic budgets ● Better identification of resource needs ● Linking of costs to outputs ● Clearer linking of costs with staff responsibilities ● Identification of budgetary slack (difference between actual/expected output and full capacity) Whichever type of budget an organization uses as part of its management control systems, the key to good budgeting is to remember that budgets also affect employee behavior. To be effective, a budget must motivate managers to work toward the common goals of the company. A good budget requires clear, complete, and transparent communication from lower managers and staff to upper management, and this can be very difficult to achieve.
Budgeting is a process currently in transition; it is increasingly seen as an important part of quality initiatives, continuous improvement initiatives, and value creation. Decisions made on the basis of budget information can have far reaching effects on all stakeholders. Care should therefore be taken in planning and undertaking the process of budgeting to make sure that the process is transparent and that it provides valid and realistic information to decision-makers. The traditional kaizen approach:
1. Analyzes every part of a process down to the smallest detail. 2. Sees how every part of the process can be improved. 3. Looks at how employees’ actions, equipment, and materials can be improved. 4. Looks at ways of saving time and reducing waste (Cane, 1996, p8). Kaizen is based on the belief that the people doing a particular job will often know better than everyone else, including their superiors, how that job can be improved; and that they should be given the responsibility for making those improvements (Cane, 1996, p13). The production area is by no means the only area within a company where kaizen can be implemented. Every department within a company can make continuous improvements in its operations by making small changes on a daily basis. The first step in the process is to break down all communication barriers between the various units within the company. The master budget is one such tool that can be used to improve coordination and communication between all of the departments or other subunits within a company.
KAIZEN BUDGETING Kaizen Budgeting is an approach that explicitly incorporates continuous improvement during the budget period into the budget numbers. The emphasis here is on many small improvements, rather than on quantum leaps. A journey of a thousand miles starts with a single step. The budget numbers are based on changes that are yet to be implemented, rather than on current practices or methods (Horngren, 2006, p185). An example is that to build a certain product requires 3.75 hours of direct manufacturing labor per unit of output. We apply the kaizen budgeting approach to the direct manufacturing labor budget as follows: BUDGETED HOURS PER UNIT 1st Quarter 2007: 3.75 2nd Quarter 2007: 3.70 3rd Quarter 2007: 3.65 4th Quarter 2007: 3.60 The implications of these labor-cost reductions would result in corresponding reductions in variable manufacturing overhead costs because direct manufacturing labor costs are usually the primary cost drivers for many of these overhead costs. Unless the kaizen goals are met, the actual hours will exceed the budgeted hours in the latter quarters of the budget year. Managers will explore reasons for not meeting these goals and will make the necessary adjustments to meet these goals. For example, let us consider a description of Toyota’s budgeting system. Upper management determines both the short-term target profit and the long-term sales-to-profit ratio, one year in advance. The budget is based on a profit target and a volume of production and is segregated into variable and fixed cost budgets. The fixed costs are separated into “controllable” and “uncontrollable” costs. Uncontrollable costs are those that have no room for further reduction. Kaizen Budgeting attempts to reduce the controllable costs. The variable costs budget is mostly concerned with those production costs not related to parts acquisition. The cost of raw materials cannot be simply reduced because they involve negotiation and there are complex considerations that go into these purchase transactions. The remaining variable costs such as direct manufacturing labor, utilities, and manufacturing overhead costs are controlled by the kaizen budget (Tanaka, 1994). A useful way to evaluate the performance of a process is in terms of kaizen value, which is defined as the reduction in costs that would occur by altering the cost standard for each process. However, it is very important to note that reducing costs is only half of the target profit equation. To reach a target profit, it is equally important to increase sales revenues per unit of output. Variable costs increase as production increases thereby making it difficult to reduce costs. Therefore, it is preferable to increase sales revenue by increasing the price per unit sold, rather than to merely increase the number of units sold. To reduce costs, Toyota focuses on controllable variable production costs and requires across the board cuts to improve the cost standard for each major production process (also known as kaizen units). Kaizen units are segments of the production process that exist only for the kaizen value distribution purposes and for the accumulation of variable manufacturing costs. Once the kaizen goals have been established, plant managers submit plans for achieving them twice a year. Such plans include improvements in daily operating procedures as well as technical and engineering improvements (Tanaka, 1994). KAIZEN COSTING
Kaizen costing focuses on obtaining small incremental cost reductions in the production stage of the products life cycle. Emphasis is placed on target cost decreases and employee empowerment to make it happen. The causes of waste, excess, and variation can be continually reduced over time. The traditional costing approach compares actual costs with standard costs, which are based on static conditions, and views employees as a cause of unfavorable variances. Kaizen costing compares actual costs with target cost reductions under dynamic conditions, and views employees as the primary source of the solutions to problems (Atkinson, et.al, 2001). Cane, Sheila; Kaizen Strategies for Winning Through People ; Pitman Publishing, London, England, United Kingdom; 1996 Horngren, Charles T., Datar, Srikant M., Foster, George; Cost Accounting: A Managerial Emphasis, 12 th Edition; Pearson Prentice Hall; Upper Saddle River, NJ; 2006 Tanaka, T., 1994; Kaizen budgeting: Toyota’s cost-control system under TQC. Journal of Cost Management (Fall 2002) ; Summary by Rosalyn Mansour, retrieved from the Internet at http://maaw.info/ArticleSummaries/ArtSumTanaka94.htm on 26 March 2006 Atkinson, A.A., R.D. Banker, R.S. Kaplan, and S.M. Young. 2001. Management Accounting, 3rd Edition. Upper Saddle River, NJ: Prentice Hall; Summary by James R. Martin; retrieved from the Internet at http://maaw.info/ABKYBook/ABKYChapter9.htm on 26 March 2006 Deming, W. Edwards; Out of the Crisis; Massachusetts Institute of Technology, Cambridge, MA; 1986
Approaches to Budgeting
Kaizen budgeting If your company uses Kaizen budgeting, cost reductions are built into the budget on an incremental basis so that continual efforts are made to reduce costs over a given time period. The advantage of Kaizen budgeting is that the budget process puts continuous pressure on managers to achieve cost efficiencies. A disadvantage is that Kaizen budgeting is difficult to maintain because the rate of budgeted cost reduction declines over time, making it more difficult to achieve improvements after the "easy" changes have been achieved. Forecasting process Incremental budgeting (traditional)
The previous period's budget and actual results, as well as expectations for the future, are used in determining the budget for the next period. Zero-based budgeting
The budgeting process begins from the ground up, as though the budget was being prepared for the first time.
A budget is the financial blueprint or action plan for an organization. It translates strategic plans into measurable expenditures and anticipated returns over a certain period of time. Budgeting is the process of creating and fine-tuning budgets. Budgeting activities include: •
• • •
Forecasting future business results, such as sales volume, revenues, capital investments, and expenses Reconciling those forecasts to organizational goals and financial constraints Obtaining organizational support for the proposed budget Managing subsequent business activities to achieve budgeted results
If you have profit and loss responsibility, the financial results of your division or business unit versus the budget may be a key factor in evaluating your job performance, and may also be tied to your compensation. An understanding of the basics of budgeting and the budget process is, therefore, essential to creating realistic budgets that will later serve as performance benchmarks. Moreover, if you are skilled at "selling the budget" within your organization and negotiating compromises during the budgeting p rocess, you will be more likely to see your budget requests met.
Approaches to Budgeting
Traditional budgeting and alternate approaches Mei Po holds up two different kinds of budget spreadsheets.
Many organizations use a "traditional" budget—a b udget that covers a one year period and presents forecasts that do not change during the life of the budget cycle. Companies use traditional budgets because they are easy to put together and simplify coordination of budget assumptions across different departments. Traditional budgets, however, have been under growing attack from those who feel that they no longer serve a modern organization's needs. Critics complain that budgets are timed incorrectly (too long or too short); rely on inappropriate measures; and are either too simplistic (or too complex), too rigid (inflexible in a chan ging business environment), or too political (the incentives for managers send the wrong messages). As a result, some organizations blend alternative ap proaches to budgeting to meet their individual needs. The table below shows the elements of a "traditional" budget and some alternative approaches to budgeting that your company may use.
