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. 300–350 words

Answer 1

Budgeting requires a great deal of information that can be drawn from many sources. The main sources of information for budgeting purposes are:
1. previous year's actual results;
2. other internal sources which may include manager's knowledge concerning the state of repair of fixed assets, training needs of staff, long-term requirements of individual customers, etc.;
 estimates of costs of new products using methods such as work study techniques
and technical estimates;
 statistical techniques such as linear regression may help to forecast sales;
 models, such as the EOQ model, may be used to forecast optimal inventory levels;
 external sources of information may include suppliers' price lists, estimates of
inflation and exchange rate movements, strategic analysis of the economic
environment.
Budgets are open to uncertainty. For example, non-controllable factors such as a
recession or a change in prices charged by suppliers will contribute to uncertainty in the budget
setting process.
Incremental budgeting" means that next year's budget is established based upon the current budget plus an "increment" added to cover the increasing costs of services generally each year (inflation). 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. Incremental budgets are based on aggregate data. They might not match company’s targets. Incremental budgets can potentially cause over or underfunding of certain areas.
Advantages of incremental budgeting include the following characteristics:
1. The budget is stable and change is gradual.
2. Managers can operate their departments on a consistent basis.
3. The system is relatively simple to operate and easy to understand.
4. Conflicts are avoided when departments appear to be treated similarly.
5. Co-ordination between budgets is easier to achieve.

6. The impact of change can be seen quickly.
Disadvantages of incremental budgeting are the following:
1. Assumes activities and methods of working will continue in the same way.
2. No incentive for developing new ideas.
3. No incentive to reduce costs.
4. Encourages spending up to the budget so that the budget is maintained next year.
5. 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 past in order to obtain a budget which is easier to work within, and which will allow them to achieve favourable results.
Incremental methods are used when the external and internal business environments are relatively stable and are applied for items that are business driven – which, in fact, represent the
majority. Such a scenario happens in most of the situations and the past evolutions are highly relevant (the past real figures, together with assumptions about the future, are used as the
ground for estimating the future evolutions of the budget items within the budget plan). Like all budgeting processes for business, incremental budgeting can be used in conjunction with other budgeting and spending control techniques, and can be modified to suit the needs of its users.
Let’s say our business has been very stable and growing at a rate of about 8% each year.
If we were to apply this technique to create a new budget for the next year, we would start with last year’s budget and then add somewhere around 8% to all of the necessary company budgets
that are not fixed. For example, we wouldn’t have to add 8% in costs to any fixed costs like debt or fixed overhead costs, but we probably want to make incremental changes to such things as
sales costs (needed to drive the growth), as well as product and cost of goods budgets.
Zero-based budgeting is a technique of planning and decision-making which reverses the working process of traditional budgeting. In traditional incremental budgeting, departmental managers justify only increases over the previous year budget and what has been already spent is automatically sanctioned. No reference is made to the previous level of expenditure. By contrast, in zero-based budgeting, every department function is reviewed comprehensively and all expenditures must be approved, rather than only increase. Zero-based budgeting requires thebudget 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.