Budgeting

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Budgeting for business plays an important role in management control system. It gives
a brief understanding of what are budgets, what are budgeting and its different methods
i.e. zero-based, incremental, traditional and activity-based budgeting.
Before we understand the different types of budgeting methods, let us understand the
meaning of budget.
What is a Budget?
A budget is a written estimation of the financial performance of a particular department,
a specific project, a business unit or an organization. There are different budgeting
methods in accounting.
What is Budgeting?
Primarily, the activity of preparing a budget is called budgeting. In many organizations, it
is a separate department taking care of only preparation and implementation of
budgets. The comparison of budgeted performance with actual performance provides
an indication if something is going wrong and requires immediate attention.

The purpose of this article is to highlight different budgeting methods and procedures.
Types of Budgeting Methods / Techniques

Listed below are the most popular types of business budgeting methods.
1. Zero-based

2. Incremental

3. Traditional

4. Activity Based

Above are just the popular forms of budgeting methods, there are a few more types also
which are mentioned as follows:

1. Rolling Budgets
2. Performance Budget
3. Master Budget
4. Operating Budget
5. Program Budget
6. Financial Budget
What is Zero-Based Budgeting Method?
Zero-based budgeting is a commonly used method. In ZBB, current year’s budget is
prepared from the scratch, without considering the budget of the previous year. For
every financial period, a fresh budget is prepared taking the base as zero and resources
allocated to each department is justified according to the expenses of that particular
period. The ranking for allocation of resources is on the basis of priority of all the
activities of the business. Though this method is time-consuming, it gives accurate
results.
To have a detailed understanding of the method and its pros and cons visit – Zero
Based Budgeting
What is Incremental Budgeting Method?
Incremental budgeting is a method where current year’s budget is prepared by making
changes in the past year’s budget. The changes are in the form of addition or reduction
of expenses to last year’s budget. In Incremental budgeting, the starting point for
preparing a budget is prior period’s budget. The budgeting technique gives no priority to
vital activities of a business. We simply adjust last year’s budget considering the
inflation factor. This is a quick and easy method of preparing budgets.

For a detailed understanding of the advantages and disadvantages visit – Incremental

Budgeting,
What is Traditional Budgeting Method?
Traditional budgeting is a budget preparation method which considers last year’s budget
as the base. Current year’s budget is prepared by making changes to previous year’s
budget by adjusting the expenses based on the inflation rate, consumer demand,
market situation etc. Current year’s budget is prepared on the basis of the past year’s
revenues and costs. Only those items in traditional budgets need to be justified which
are over and above the last year’s budget. This technique is easy to prepare and
implement barring some amount of rigidity as budgets once prepared, cannot change.

To have a detailed understanding of the method and its advantages and disadvantages
visit – Traditional Budgeting.
What is Activity Based Budgeting Method?
Activity-based budgeting is a method where a budget is prepared after considering
the cost drivers. It does not take into account last year’s budget. This method does an
in-depth analysis of all the activities that incur the cost. The outcome of the research
determines the allocation of resources to an activity. This method aligns the business
activities with business goals. This helps in increasing the efficiency and profitability of a
business.
To have a detailed understanding of the method and its advantages and
disadvantages visit – Activity Based Budgeting.
Choosing a Method of Budgeting
These methodologies are suitable for every kind of business, but you need to compare
and meticulously choose which budgeting technique fits right into your organization.
The decision to select a particular method depends on a lot of factors like size of
business, operations of a business, the focus of the business, competition in business,
market situation, etc.
Like for example, zero-based and activity-based budgeting can be used in the
businesses where there is stiff competition. Zero-based justifies and gives an
explanation of each item of cost. Similarly, in activity-based, all the business functions
are aligned with the business goals. This leads to the elimination of all the wasteful
activities, resulting in cost savings. So in order to cut the cost of production and
surviving the competition, zero-based budgeting and activity-based budgeting are the
best choices.

Incremental and traditional budgeting methods can be used where there is limited
fluctuation in the market price, consumer demand, etc. Since these methods of
budgeting consider taking previous year’s budget as a base and doing only incremental
changes like an adjustment for the inflation rate, consumer demand, market situation
etc., these changes can be made in the market where the organization will not be much
affected by the change in environment.

Same way, large-scale organizations generally do not opt for zero-based and activity-
based budgeting, because these methods are costly and consume a lot of resources.
Also here manager’s main focus is to prepare a good budget and because of that, the
core activities of the business gets ignored.

In a nutshell, there are different methods of preparing budgets and there is no best
method which fits all. Choice of method depends upon the type of business
requirements

Advantages and Disadvantages of Zero Based

Budgeting
Zero Based Budgeting is a method of budgeting wherein no base is considered for any
budget. Having learned Zero Based Budgeting in past, we shall, in this article discuss
the Advantages and Disadvantages of Zero Based Budgeting.
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ZERO BASED BUDGETING – MEANING

As the name indicates, zero-based budgetingis a budgeting method in which there is a
zero base consideration while preparing the budget. It justifies all the expenses each
time, we prepare a new budget. Zero-based budgeting does not aim to consider any
base. Each expense has to be drilled down and analyzed well before the actual
allocation of the budget. It is known as need analysis. The preparation of the budget is
on the basis of actual need of the expenses for the forecasted period. It does not
consider the fact that the previous budget was lower or higher than the current budget.
Zero-based budgeting targets to identify efficient and alternative methods for the
organizations who opt for optimum utilization of resources. This will not only ensure
efficiency and effectiveness but also wealth and profitability.

Any process will have advantages and disadvantages. However, we can call a process
to be a feasible one only when its advantages exceed its disadvantages.

ADVANTAGES OF ZERO BASED BUDGETING

EMPHASIZE ON DECISION MAKING
Traditional budgeting considers the fact that “how much” expense shall be incurred.
However, zero-based budgeting is on “why” approach. It goes to the root of the
expense. Zero-based budgeting aims towards achieving the objectives of the
organization. For better decisions, Zero-based budgeting completely ignores the past
years’ figures.
ORIENTATION TOWARDS COST-BENEFIT ANALYSIS
Zero-based budgeting aims at cost-benefit analysis. It does not focus on studying the
changes in expenses and preparing a variance analysis (such as why the expenses
increased or reduced). However, it considers the necessity of the expense and the
benefit which will be derived from the expense. In order to prepare an effective zero-
based budget, more and accurate information is a must. Zero-based budgeting operates
vertically as well as horizontally. And hence it enables all the levels of management to
participate in the decision-making process of the organization.
EFFICIENCY IN RESOURCE ALLOCATION
The ultimate objective of any organization is to maximize the profitability of the
organization and enhancing the wealth of the shareholders. The zero-based budget
helps in achieving this objective. Zero-based budgeting ensures that the resources of
the organizations are economically and efficiently allocated.
IMPROVEMENT FOR NEXT PERIOD
For each year, the preparation of the zero-based budgeting is with the same
assumption of not taking a base for any previous period. Each department of the
organization analyzes the expenses every year. They make sure that there is an
inclusion of only those expenses in ZBB which are necessary and which derive benefits.

DISCONTINUATION OF AN OBSOLETE PROCESS

At first, the zero-based budget identifies all the obsolete processes of the manufacturing
unit or other departments of the organization. If the process is not essential for the
organization, the same has to be analyzed and scrapped by the management.
Discontinuation of obsolete operation results in better costing, better pricing and better
profitability of the organization. Zero-based budgeting helps in enhancing the
interpretation and knowledge of different cost patterns.

CHANGES WITH THE CHANGE IN AN ORGANIZATION

Due to technological changes, with the new and advanced processes, the underlying
assumptions and expenses have to be changed. Hence, zero-based budgeting
responds to the changes in the organization.

DISADVANTAGES OF ZERO BASED BUDGETING

SUBJECTIVE IN NATURE
Some of the expenses in the organization are difficult to judge whether the same is
essential or not. The reason is the benefits are qualitative in nature and one cannot
measure it in numbers.

Well, the organization can overcome this disadvantage by a thorough analysis of the
expenses and with the help of management consultants.

DETRIMENTAL TO THE LONG-TERM GOALS

Zero-based budgeting is based on a cost and benefit analysis of a particular period. In
the short run, the company may not get benefit in the same year of incurring the
expenses. However, some of the expenses which have to be incurred for achieving the
long-term goals of the organization.

The top management shall make a list of all the expense which has long-term benefits
and exclude the same while preparing the budget.

RIGIDITY
The organization should not always stick to the budget in every situation. Sometimes
circumstances may arise which lead the management to incur the expense of the
unexpected opportunity or to mitigate the possible threat.
The company can make a provision of the same in zero-based budgeting and overcome
the same.

SKILLS AND MANAGERIAL CONFLICTS

Management conflicts may arise since the zero-based budgeting requires a large
amount of time and efforts of the managerial and executive staff. Sometimes, the
required skills are also not present in the staff for preparation of zero-based budgets.

The management shall make proper planning and involvement of qualified and
experienced staff to participate in the zero-based budgeting process.1–3

Sales Volume Variance

Sales volume variance (or Sales quantity variance) is nothing but the dollar variance in
total sales as a result of ‘over or underachievement of sales numbers’. The
mathematical representation of the same is as follows:

Sales Volume Variance = Standard Price per Unit * (Actual Units Sold – Budgeted Units
Sold)

It is the difference between the target selling units as per budget and units actually sold.
The resultant figure is then multiplied by the standard selling price of the product. It is
also referred to as sales quantity variance.

All the growing organization should follow the best practices of budgeting. One such
important practice is the standard costing. The management sets the standard cost,
selling price, production volume, and sales volume. This variance is a part of the
standard costing analysis.

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MEANING
As the name indicates, sales volume variance is analyzed based on the volume. i.e. the
number of units sold. It is the difference between the target units (defined in the budget)
to sell and the units actually sold. To arrive at the value of variance due to variance in
selling quantity, the standard selling price is multiplied by the difference between
expected and actual units.

Sales volume variance also referred as sales quantity variance. It is the nothing but a
subcategory of sales value variances. A sales value is a result of Selling Quantity *
Selling Price. Logically, an actual sales value can vary from a budget only when there is
a variation from budget either in “Quantity of Products Sold” or “Selling Price per Units”.
So, the overall sales value variance is subdivided into following two the variances.
 Sales price variance
 Sales volume variance
FORMULA
Sales volume variance = Standard Price per unit * (Actual units sold – Budgeted units
sold)

You can check the list of all the formulas for standard costing here.
EXPLANATION
Based on the past trends the projected number of units to be sold is derived. Further,
the marketing team also derives the projected demand based on the market scenarios.
There are a number of factors which affect the sales volume.

The management sets the standard price. The actual number of units sold is provided
by the accountant of the organization.

FEATURES
 The sales volume variance is based on the number of units sold by the organization.
 The sales volume variance can be either favorable or adverse. Accordingly, favorable
sales volume variance indicates the sales volume is achieved or exceeded. On the
contrary, adverse sales volume variance indicates sales volume, not achieved.
 Thus, favorable variance indicates over performance and adverse sales volume
variance indicates underperformance.

HOW DOES IT HELP IN DECISION MAKING?

The sales volume variance is an important management tool. It helps the management
to assess the effect of sales volume on the profitability.

Thus, favorable variance indicates the marketing team is performing as per the target
and unfavorable variance indicates that it is not performing as per the target set by
management.

Accordingly, unfavorable sales volume variance helps in introspecting the factors which
led to the low sales volume. Although, the analysis may vary from industry to industry.
As an illustration, a number of units of air conditioner sold in summer shall obviously be
higher than the other two seasons. Hence, while setting up the standards, one has
to consider these facts in mind.

REASONS FOR ADVERSE SALES VOLUME VARIANCE

Now let us study the possible reasons for adverse sales volume variance. The factors
responsible for adverse sales volume variance may be as below.

CHANGE IN TREND
Due to advancement in technology, there are changes in taste and preference of the
customer in the market. As an illustration, if the company introduces a new and
advanced version of the mobile device, it affects the sale of the previous version
adversely. Accordingly, because of the change in customer preferences, customer shifts
to a new and improved product. This is cannibalization of product.

CHANGE IN LAW
Sometimes, change of law also may affect highly in a drop in the sales volume. For
example, the foreign trade policy has changed and the government has restricted to
export certain products. It affects the export sales volume adversely. Accordingly, the
variance will be adverse.

CHANGE IN PRICE
If the production cost increases, the management may decide to increase the selling
price of the product. As the law of demand suggests, the price and volume have an
adverse relationship. Hence, if the price increases, the volume automatically drops.

COMPETITION
It may so happen that the competitor launches a new product in the market. It affects
the target volume adversely. Accordingly, it results in adverse variance. 1–4
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Rolling Budgets
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WHAT IS ROLLING BUDGET?

Rolling simply means continuous. Rolling budget continuously updated by adding
further accounting period when the earlier accounting period is completed. The rolling
budget has a dynamic approach. Instead of a static budget of 12 months, it rolls forward
by a quarter or a month.
Rolling budget is the extension of existing budget. Hence, it requires more efforts to
update and implement compared to static budget. It requires time and efforts in
preparation.

Rolling budget is also known as a continuous budget.

Approach
 As the name suggests, rolling budget follows the “incremental” approach. The budget
for an incremental period is added to the previous budget. This is a “short-term
approach”. It helps in micro-planning and management. The rolling budget for the new
period is prepared not only based on the previous assumptions. However, the
fundamental changes in the assumptions are to be considered.
FACTORS AFFECTING A ROLLING BUDGET
The organization shall segregate the financial drivers in the below areas;

VARIABLE EXPENSES
Variable expenses vary based on the volume of the production and sales. Hence, variable
expenses can be updated regularly. The volume of sales and production is decided on
the external factors and internal factors.
FIXED EXPENSES
Fixed expenses are easy to forecast. It has most compelling evidence. As an illustration,
office or factory rent is easy to predict. There is a remote possibility that it will change.
OTHER EXPENSE
Following expenses are also considered;

o Payment to shareholders by way of dividends

o Interests paid on loan from the bank or
o Any other non-operational expenses

ROLLING BUDGET VS TRADITIONAL BUDGET

The differentiation helps in understanding the concept better.

Traditional Budget is prepared by the organization on a yearly basis. On the contrary,

rolling budget is prepared yearly but updated on a monthly or quarterly basis.
The preparation of a traditional budget for the next year begins in the fourth quarter of the
year while rolling budget is a continuing process.

Another key point of difference is Traditional budget cannot be changed upon approval.
However, if there is a change in underlying assumptions, improvement can be made in
rolling budget.

Based on proper and in-depth planning, the forecast is prepared.

ADVANTAGES OF ROLLING BUDGET

PLANNING AND CONTROL
Rolling budget helps in planning and controlling more accurately. Therefore, It helps in
reducing the uncertainty of budgeting. Rolling budget plans for near-term future instead
of long-term. It helps the management to know where the company is moving in terms of
sales and profitability.
ADAPTATION OF CHANGE
12 months period budget can be considered as a long term. This is because of
technological advancement. The technology changes at a rapid rate. It may lead the
organization to change with the latest technology. The budget also needs to be updated
based on assumptions.

SPENDING WISELY
The managers tend to spend more money even when the expenditure is not really
required. In contrast, a lower level executive may need to spend money on identified
opportunities. It helps as a guiding tool to spend the money with wisdom.
DISADVANTAGES OF ROLLING BUDGET
TIME CONSUMING
Rolling budget requires more efforts, time and money. Employees spend a large number
of hours to prepare the budget. A budget is a tool which helps in decision making. Without
a doubt, it cannot run the business.

It is a best practice that the team of few people is involved in preparation and updating of
rolling budget.
DEMORALIZE EMPLOYEES
An employee may feel that the budgetary targets are changing constantly. Spending
much time on preparation of budget may lead to demoralizing the employees.

Undoubtedly, all the fundamental assumptions shall be considered while preparing the
budget. Accordingly, It helps in archiving the objective with less time.

UNEVEN UPDATE
The biggest disadvantage of rolling budgets is not updated for the entire period. It is
updated only for the incremental period. But The incremental period may have some new
assumptions. These assumptions are not considered in the original budget.

Indeed, The organization shall always try to align the incremental budget with the previous
period budget.

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Budgeting
Budget Models
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WHAT IS A BUDGET?
Budget is a financial plan of expected cash inflows and outflows that a business
generates. A sound budget guides the business managers regarding the funds at hand
and effective spending of the same. Having a tight budgetary policy is indispensable for
any organization that wants to succeed. Without one, a business might as well be
shooting in the dark. It is what sets the boundaries for any organization. It represents
the maximum financial resources at their disposal using which they must achieve all
business targets.
The saying – “Failing to plan is planning to fail” is very apt here. A business with great
products, dynamic management or a dominating client base may still fail if it does not
mind its margins. Without a budget a company is directionless. With a budgetary policy
in hand, the firm will always be aware of the cash on hand and save itself from running
into debt. Also, a realistic budget goes a long way in setting out the long-term financial
requirements of the firm. Enabling a firm to prepare in advance for contingencies.

BUDGET TEMPLATE
A fundamental budget tableau consists of a list of very basic items. It gives a list of
budgeted income and expenditure and compares them with the actual. Deviations in
such figures are undesirable and must be reported to the management for corrective
action. Overspending indicates gross negligence and lack of control over expenditure.
On the other hand, under-spending may mean that the company is not utilizing its
resources to the fullest extent and thus remains unable to achieve its true potential.

Below mentioned is a suggestive budget template:

BUDGET ACTUAL
CATEGORY AMOUNT AMOUNT DEVIATION
Sales Revenue

Other Income

TOTAL INCOME
 EXPENSES
Accounting Services

Advertising

Estimated Taxes

Installation / Repair of Equipment

Interest on Debt

Inventory Purchases

Loan Payments

Payroll

Professional Fees

Rent/Lease Payments

Utilities and Telephone

Vehicle Expenses

TOTAL EXPENSES

TOTAL INCOME MINUS TOTAL

EXPENSES
The budgeted figures derived may be based on several assumptions. The expected
turnover, forecasted growth, current demand, the scale of operations are some of the
factors which influence the budgetary figures. A very simple and effective approach is to
build upon the number of previous years to arrive at the current year forecasts. Along
the way, some tweaks are made to adjust for factor specific changes that have occurred
in the current year.
Below mentioned is a derivation of a single line item :

Previous Year Purchase

(+/-) Adjustment for orders
(+/-) Adjustment for change in prices
(+/-) Adjustment for applicable taxes
= Budgeted Purchases
TYPES OF BUDGETS
ZERO BASED BUDGETING
As the name goes, zero-based budgeting starts from zero. It does not borrow from any
prior budgets. It is a management based budget. the only factors considered are
leadership vision and priorities. For every new year, goals are set afresh and the
budgets are built accordingly. It represents are very dynamic and fast-paced form
of budgeting. However, it may be a time-consuming process to start from a scratch
every year. Also due to fresh revisions every year, the departments always remain in an
uncertainty of the funds that may be allocated to them. This may impact their
productivity and consistency.
STATIC BUDGET
A static budget is one which remains fixed throughout the period under question
irrespective of the level of activity. The anticipated figures of expenses do not change
with the change in the level of sales. For example, if a firm sets out its commission
expenses to be $300,000. Thereafter, the budgeted commission for the year shall
remain $300,00 irrespective of whether the sales stand at $2 million, $5 million or $10
million. Obviously, actual results will vary widely due to lack of an all accommodative
approach. A static budget is ideal for firms with predictable sales such as utility
companies and PSU’s.

FLEXIBLE BUDGET
A stark opposite of static budgets, a flexible budget is designed to display the
forecasted budget at various levels of activity. Certain expenses being a direct function
of sales are expressed as a percentage of the same. Sales commission, packaging,
material are examples of the same. Then there are fixed expenses which remain
constant irrespective of the level of activity. They are hard-coded into the budget and do
not change. Examples include lease rentals, license fees, salaries among others.
Below is an example of a flexible budget at different activity levels:

Level of Activity 50% 75% 100%

Sales (A) $7,50,000 $11,25,000 $15,00,000

Variable Expenses

Material 15% $1,12,500 $1,68,750 $2,25,000

Labour 10% $75,000 $1,12,500 $1,50,000

Power & Fuel 12% $90,000 $1,35,000 $1,80,000

Commision 5% $37,500 $56,250 $75,000

Total Variable Expenses

(B) $3,15,000 $4,72,500 $6,30,000

Fixed Expenses
 Rent $1,50,000 $1,50,000 $1,50,000

Licence Fees $37,500 $37,500 $37,500

Total Fixed Expenses (C

) $1,87,500 $1,87,500 $1,87,500

Budgeted Surplus [A-

(B+C)] $2,47,500 $4,65,000 $6,82,500
ROLLING BUDGET
A rolling budget also called a continuous budget is a form of an ongoing budget drafting.
It involves extending the existing budget to keep adding newer layers. As soon as a
reporting period concludes the budget for the next period must be immediately prepared
and added to the existing one. In this way, the company always has a budget that
extends over a 12-month horizon. For example, a firm has a reporting period stretching
from January to December. Now, when the budget for January expires, the firm must
prepare and attach a budget forecast for the January month of the coming year. This
way it sits over a 12-month budget stretching over February to January.
BUDGET VARIANCE ANALYSIS
A budget is only an estimation based on a number of assumptions. Its main aim is to
provide a ballpark number. The management then strives to operate within those
boundaries. Deviations in actual results are inevitable. It is therefore necessary to trace
them. Variance analysis and reconciliation of actual and budgeted figures are
necessary to bridge the gap in operations. The results of such variance study provide
valuable insights into the operational aspects, thus uncovering areas for improvement.
Let us go through a few types of variances:

MATERIAL COST VARIANCE

Measures the impact on total material cost due to the difference in actual quantity and
cost of materials consumed.
= Standard Cost – Actual Cost
=(SQ*SP)-(AQ*AP)
LABOUR COST VARIANCE
Measures the impact on total labor cost caused by changes in the labor mix, wages and
actual hours from the budgeted.
=Standard Cost – Actual Cost
=(SH*SR)-(AH*AR)

SALES PRICE VARIANCE

Measures the impact on revenue caused by actual selling price differing from
budgeted selling price. It is measured by tweaking the prices and referring to actual
quantity sold.
=Actual Sales-Budgeted Sales
=(AP*AQ)-(BP*AQ)
 The following example provides a brief understanding of the concepts of variance
analysis:

Material Labour

SR ($ AR
SQ per per
(kg) SR($) AQ(kg) AR($) SH(hours) hour) AH(hours) hou

A 500 2 550 2.5 Skilled 200 3 210 3.2

B 750 3 740 4 Unskilled 100 1.5 120 1.5

Material Cost Variance
A: (500*2) – (550*2.5) = $375 (Adverse)
B: (750*3) – (740*4) = $710 (Adverse)
Total = $1085 (Adverse)

Labour Cost Variance

Skilled: (200*3) – (210*3.2) = $72 (Adverse)
Unskilled: (100*1.5) – (120*1.5) = $30 (Adverse)
Total = $102 (Adverse)

BUDGETING VS FORECASTING
Budgeting and forecasting are terms often used simultaneously. However, they are not
interchangeable. There lie distinct differences between the two, discussed as below:

 A budget is a financial plan emphasizing on the monetary constraints to be adhered to

by an organization. A forecast is a futuristic outlook of important variables such as
sales, profit, and consumer habits.
 A budget is based on the existing scale of operations of the company and borrows from
actual numbers of the previous year. A forecast is an anticipation of predicted patterns
based on various trends and correlation research.
 A budget is a long-term statement generally involving annual updates. Financial
forecasts are dynamic and active. Therefore, regular revisions are important to
maintain its authenticity.
The effective conciliation and coordination of budgeting and forecasting figures play a
key role. It ensures that the company has set an appropriate goal for itself in terms of
budget. And forecasting results keep the management assured of routing the company
efforts in the right direction.