Financial Decision Making (TYU 6)

Scenario

For a number of years, the research division of Z has produced its annual budget (for new and continuing projects) using incremental budgeting techniques. The company is now under new management and the annual budget for 20X4 is to be prepared using zero based budgeting.

Tasks:

1. Explain the differences between incremental and zero based budgeting techniques.

2. Explain how Z could operate a zero based budgeting system for its research projects.

The operating divisions of Z have in the past always used a traditional approach to analysing costs into their fixed and variable components. A single measure of activity was used which, for simplicity, was the number of units produced. The new management does not accept that such a simplistic approach is appropriate for budgeting in the modern environment and has requested that the managers adopt an activity-based approach to their budgets for 20X4.

Tasks:

3.   (i) Briefly explain activity-based budgeting (ABB).

(ii)  Explain how activity-based budgeting would be implemented by the operating divisions of Z.

Solutions:

1. An incremental budget starts off with last year’s budget or last year’s actual results and adds on a certain percentage to take account of expected inflation and/or any expected changes in the level of activity. It is a very simple, quick and cheap budget to produce, but it does not promote a questioning attitude. Activities are undertaken without a thought. They are simply incorporated into the next budget because they were in the last budget and nobody has given any thought as to whether the activity is really worthwhile.
   With ZBB, each manager sets out what he or she wishes to accomplish over the forthcoming period. For each activity they want to undertake, they look at different ways of achieving the objective and they look at providing the service at different levels. They estimate the costs and benefits and the activity only takes place if the benefits exceed the costs. Also once all the activities has been evaluated, they can be ranked against each other and the company’s resources directed to the best activities.

2. The managers/researchers responsible for each project should decide which projects they wish to undertake in the forthcoming period. These projects will be a mixture of continued projects and new projects. For the projects which have already been started and which the managers want to continue in the next period, we should ignore any cash flows already incurred (they are sunk costs), and we should only look at future costs and benefits. Similarly, for the new projects we should only look at the future costs and benefits. Different ways of achieving the same research goals should also be investigated and the projects should only go ahead if the benefit evaluated if there are sufficient funds to undertake all the worthwhile projects, then the funds should be allocated to the best projects on the basis of a cost-benefit analysis.
   ZBB is usually a highly subjective nature ( The costs are often reasonably certain, but usually a lot of uncertainty is attached to the estimated benefits.) This will be even truer of a research division where the researchers may have their own pet projects which they are unable to view in an objective light.

3. (i) Activity based budgeting is where the budget is based upon a number of different levels of activity, i.e. on a number of different cost drivers, rather than being based on just one level of activity such as machine hours or outputs in units.
   The activity based budget will be based upon the number of units of the cost drivers multiplied by the cost per unit of cost driver. The cost driver is that factor that usually causes the cost and therefore should lead to a more accurate budget as the budgeted costs will be based on the thing that should influence the cost. The alternative is to use absorption costing and assume that all overheads vary with output or machine hours or that they are fixed.
   (ii) Z may employ an outside specialist such as a management consultant who will investigate the business and determine what activities the business undertakes during the course of its operations.
   The consultant will discuss matters with the staff and the process will normally be time consuming. For each activity, efforts will be made to determine the factor which is most closely related to the costs of that activity, i.e. the cost driver. The investigation may bring to light non-value-added activities which can then be eliminated. It should improve the understanding of all those involved as to the true relationship between cost and level of activity.
   Managers would then estimate the expected incidence of their cost drivers and multiply by the budgeted cost driver rate to get the budget for the forthcoming period. ABB would be more complicated than a traditional budget and the overheads would be broken down into many activities such as set-up costs, materials, handling costs, etc rather than expenses rent, heating, depreciation, etc.
   With ABB the majority of the overhead costs would be perceived as variable rather than fixed. Of course it is not necessary to employ an outside consultant. The company may feel that they have their own managers with sufficient skills and time to undertake the exercise.

References:

Kaplan Publishing

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