A company’s annual financial plan is called a budget. In short words; a budget is a set of pro-forma statements about the company’s finances and operations. Before a company or other organizations can develop operating budgets, management must decide what planning approaches to budgeting will be used for the various revenue and expenditure activities and organizational units. What are the four approaches?
A budget is a tool for both planning and control. At the beginning of the period, the budget is a plan or standard; at the end of the period, it serves as a control device to help management measure the firm’s performance against the plan so that future performance may be improved.
The budget itself is classified broadly into two categories: the operational budget, which reflects the results of operating decisions; and the financial budget, which reflects the financial decisions of the firm. The operating budget consists of: (a) Sales budget; (b) Production budget; (c) Ending inventory budget; (d) Direct materials budget; (e) Direct labor budget; (f) Factory overhead budget; (g) Selling and administrative expense budget; and (h) Pro forma income statement. So what are the four planning approaches to the operating budget? Widely used planning approaches to budgeting include the input/output, activity-based, incremental, and minimum level approaches which are discussed through this post. Read on…
1. Output/Input Approach
The output/input approach budgets physical inputs and costs as a function of planned unit-level activities. This approach is often used for service, merchandising, manufacturing, and distribution activities that have defined relationships between effort and accomplishment.
For example, if each unit produced requires 2 pounds of direct materials that cost $5 each, and the planned production volume is 25 units, the budgeted inputs and costs for direct materials are 50 pounds (25 units X 2 pounds per unit) and $250 (50 pounds X $5 per pound).
The budgeted inputs are a function of the planned outputs. The output/input approach starts with the planned outputs and works backward to budget the inputs. The downside of the output/input approach is, that it’s difficult to use this approach for costs that do not respond to changes in unit-level cost drivers.
2. Activity-Based Approach
The activity-based approach is a type of output/input method, but it reduces the distortions in the transformation through emphasis on the “expected cost” of the planned activities that will be consumed for a process, department, service, product, or other budget objective.
Overhead costs are budgeted on the basis of the cost objective’s anticipated consumption of activities, not based only on some broad-based cost driver such as direct labor hours or machine hours.
The amount of each activity cost driver used by each budget objective (for example, product or service) is determined and multiplied by the cost per unit of the activity cost driver. The result is an estimate of the costs of each product or service based on cost drivers such as assembly-line setup or inspections, as well as the traditional volume based drivers such as direct labor hours or units of direct materials consumed.
Activity-based budgeting predicts costs of budget objectives by adding all costs of the activity cost drivers that each product or service is budgeted to consume. In evaluating the proposed budget, management would focus their attention on identifying the optimal set of activities rather than just the output/input relationships.
3. Incremental Approach
The incremental approach budgets costs for a coming period as a dollar or percentage change from the amount budgeted for (or spent during) some previous period. This approach is often used when the relationships between inputs and outputs are weak or nonexistent.
For example, it is difficult to establish a clear relationship between sales volume and advertising expenditures. Consequently, the budgeted amount of advertising for a future period is often based on the budgeted or actual advertising expenditures in a previous period. If budgeted advertising expenditures for 2011 were $200,000, the budgeted expenditures for 2012 would be some increment, say 5 percent, above $200,000. In evaluating the proposed 2012 budget, management would accept the $200,000 base and focus attention on justifying the increment.
The incremental approach is widely used in government and not-for-profit organizations. In seeking a budget appropriation, a manager using the incremental approach need only justify proposed expenditures in excess of the previous budget. The primary advantage of the incremental approach is that it simplifies the budget process by considering only the increments in the various budget items. A major disadvantage is that existing waste and inefficiencies could escalate year after year.
4. Minimum Level Approach
As the portion of non-variable costs increased for most companies throughout the twentieth century, an increasing portion of costs was budgeted using the less precise incremental approach. This lack of good budgetary controlled to further increases in costs. Management attempted to better control costs by employing a number of variations on the incremental approach. The minimum level approach is representative of these attempts to control the growth of costs not responding to unit-level drivers.
Using the minimum level approach, an organization establishes a base amount for budget items and requires explanation or justification for any budgeted amount above the minimum (base). This base is usually significantly less than the base used in the incremental approach. It likely is the minimum amount necessary to keep a program or organizational unit viable.
For example, the corporate director of product development would need some basic amount to avoid canceling ongoing projects. Additional increments might also be included, first to support the current level of product development and second to undertake desirable new projects.
Some organizations, especially units of government, employ a variation of the minimum level approach, identified as “zero-based budgeting.” Under zero-based budgeting every dollar of expenditure must be justified. The essence of zero-based budgeting is breaking an organizational unit’s total budget into program packages with related costs. Management then ranks all program packages on the basis of the perceived benefits in relationship to their costs. Program packages are then funded for the budget period using this ranking. High-ranking packages are most likely to be funded and low-ranking packages are least likely to be funded.
Budgeting for objectives is a variation on the minimum level approach that combines elements of activity-based and zero-based budgeting with a need to live within fixed financial constraints.
The minimum level approach improves on the incremental approach by questioning the necessity for costs included in the base of the incremental approach, but it is very time consuming. All three approaches are often used within the same organization. A manufacturing company might use the output/input or the activity-based approach to budget distribution expenditures, the incremental approach to budget administrative salaries, and the minimum level approach to budget research and development.