Question

What are the two types of information available to complete the budget? Describe the benefits and disadvantages of them and give an example of each.

Answer 1

Answer on Question #54484, Economics / Accounting

What are the two types of information available to complete the budget? Describe the benefits and disadvantages of them and give an example of each.

Explanation:

One of the most important factors determining the efficiency of doing business for the company is the ability to control their solvency. The main tool for cash management is a system of management accounting and budgeting. Cash flow is controlled by means of a budgeting, cash flow budget.

Information from a variety of sources must be accumulated prior to completing the budget document. An organization can choose several different budgeting methods to support operations. Incremental budgeting always begins with the budget from the last period. Once there is an established starting point, if a department needs more money than the previous budget, they have to be able to justify the extra expenses. This type of budgeting often leads to wasteful spending by employees because they do not want to lose their budget.

Zero-based budgeting always begins the new budget from an established point of zero. This budgeting method utilizes much more detail and makes everyone accountable for their necessary expenses. The biggest drawback with this method is that it requires much more work to implement this method and it is often unpopular with employees.

The advantages of the incremental budgeting are the following:

- A primary advantage of incremental budgeting is the ease of use. This budgeting system can only work if the organization has assurance that funding will continue in the future.

- Additionally, incremental budgeting requires limited fluctuations in the allocation of the funds.

- Incremental budgeting allows an organization to better understand the capacity of the budget and focus on the reduction of interdepartmental conflicts regarding fund allocations.

- Incremental budgeting is easy to understand and the calculations required are relatively simple and straightforward.

- This approach has the advantage of producing budgets that are relatively stable, with gradual changes from year to year.

The disadvantages of the incremental budgeting are the following

Assumes activities and methods of working will continue in the same way.

- No incentive for developing new ideas (this form of budgeting does not encourage innovation).

- No incentives 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.

- The priority for resources may have changed since the budgets were set originally.

- There may be budgetary slack built into the budget, which is never reviewed-managers might have overestimated their requirements in the past in order to obtain a budget which is easier to work to, and which will allow them to achieve favorable results.

A good example of incremental budgeting comes from the annual energy budget of the town, which consists of the total of all bills paid in the prior year by the two operate all buildings, multiplied by factors provided to the town by the energy vendors that give each vendor's prediction of how much energy costs will rise in the succeeding year. The cycle is repeated from year to year. Incremental budgeting of items like energy is typically non-competitive. There is no independent check that the price paid in any given year has been confirmed through competition. Incremental budgeting typically ignores any evaluation of whether expenditures could be reduced through other means. For example, would the installation of windows with better insulation, or the installation of roof insulation produce savings in energy costs that would pay for, or substantially subsidize the replacement of windows or roofs? Incremental budgeting practices ignore such questions. The information about the energy budget is represented in the Table 1.

Table 1 Energy Budget of the town.

An incremental approach may be suitable for all routine activities. New ventures may use a zero-based approach. The culture of the organization may dictate whether a participative or imposed budgeting style is more effective.

The process for zero-base budgeting consists of the following steps: program managers first rank the decision packages above minimum service levels; department heads can then review and revise these orderings. These priorities are then sent to the executive budget office, which attempts to set overall program budget levels, according to the rankings identified by the agencies. The Legislature can also use the ranked decision packages to determine appropriations levels incrementally above the minimum funding level. An important feature of zero-base budgeting is that it can be integrated with any existing budget system (line item or program budget).

Now, we consider the advantages and disadvantages of the Zero-based budgeting.

There are a number of advantages to zero-base budgeting, which include:

Zero-base budgeting requires that managers identify alternative ways to perform each activity (such as keeping it in-house or outsourcing it), as well as the effects of different levels of spending. By forcing the development of these alternatives, the process makes managers consider other ways to run the business.

Budget inflation. Since managers must tie expenditures to activities, it becomes less likely that they can artificially inflate their budgets – the change is too easy to spot.

The zero-base budget should spark a significant debate among the management team about the corporate mission and how it is to be achieved.

Eliminate non-key activities. A zero-base budget review forces managers to decide which activities are most critical to the company.

Mission focus: Since the zero-base budgeting concept requires managers to link expenditures to activities, they are forced to define the various missions of their departments.

Redundancy identification: The review may reveal that the same activities are being conducted by multiple departments, leading to the elimination of the activity outside of the area where management wants it to be centered.

Required review: Using zero-base budgeting on a regular basis makes it more likely that all aspects of a company will be examined periodically.

Resource allocation: If the process is conducted with the overall corporate mission and objectives in mind, an organization should end up with strong targeting of funds in those areas where they are most needed.

The disadvantages of zero-base budgeting are the following:

Creating a zero-base budget from the ground up on a continuing basis calls for an enormous amount of analysis, meetings, and reports, all of which requires additional staff to manage the process.

Some managers may attempt to skew their budget reports to concentrate expenditures under the most vital activities, thereby ensuring that their budgets will not be reduced.

It can be difficult to determine or justify expenditure levels for areas of a business that do not produce "concrete," tangible results. For example, what is the correct amount of marketing expense, and how much should be invested in research and development activities?

The operational review mandated by zero-base budgeting requires a significant amount of management time.

Managers require significant training in the zero-base budgeting process, which further increases the time required each year.

The extra effort required to create a zero-base budget makes it even less likely that the management team will revise the budget on a continuous basis to make it more relevant to the competitive situation.

Now, we consider the following example: the company A has the marketing department, it is known that the department in the previous year spent funds in the amount of $500 000. The challenge is to determine the amount of planning for the next year. According to the methodology of the zero-base budgeting, the department starts with the planning of budget and justifying all the expenses that must be included in the budget for the coming year. This can lead to the budget, such as $620,000, which is higher than last year, but at the same time reflects the real needs of the next year.

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