1.7 Budgeting Approaches
1.7.1 Static and Flexible Budgeting
The budgets which we have looked at so far in this chapter can be called static budgets. This means that they predict a certain level of activity based on informed estimates, and then budget based on that level of activity . However, as engineers we know that the assumptions underlying our estimates carry a degree of uncertainty; the estimates we make even just one a single year in advance may not accurately reflect the amount that your company produces or expends on certain activities. If the actual levels of productivity observed do not match with our estimates, it can be useful to have more flexibility .
Flexible budgets still use estimates to prepare for a certain level of activity, but then can be used to continually review the variance between actual and expected levels of activity . The variance is simply the difference between the budgeted costs and actual costs for any line item on a budget, which can be either favourable or unfavourable depending on how it influences the bottom line of the budget. For example, raw material expenses being lower than budgeted would be favourable, but sales volume being lower than budgeted would be unfavourable. When flexible budgeting is applied to an activity based budget, it is known as an activity flexible budget.
The table below shows a flexible budget for the costs on the first month of a construction project. What can we learn from this?
For this construction budget, no income is listed, so the unfavourable variances are all negative and marked in red, with the favourable variances marked in black. This flexible budget shows that the project is slightly overbudget, with some estimates being slightly under and some slightly over. For instance, the company might wish to investigate why it underestimated the payroll for its labourers, and whether they were needed to work additional hours or overtime that was not accounted for. However, the clear issue with this budget, which accounts for almost all of the negative variance, is that the actual cost for timber piles was almost double that of the budgeted price. If the company is planning on placing more piles for this project, it should either look for a cheaper supplier or set aside more money for them in subsequent months. Overall, it should be noted that although this budget has a negative variance overall it is still very accurate, since it is only about 4% over budget.
1.7.2 Incremental and Zero-Base Budgeting
Imagine that it is your first day on the job as the project manager at an enormous factory for a large and well-established business. Although you have no previous experience with the business, you are told by the president of the company that your first job is to create a master budget planning the factory’s operations for the next year. Where do you begin?!
The most common response would likely be to find the budget from the previous year, and use that as the basis for your new budget. Some small changes and updates would likely be necessary, but for a large, well-established business the master budget is likely to remain very similar from year to year, and it would likely not make sense to start from scratch and compute each cost and revenue source individually. This method of beginning with an existing budget, and making small adjustments for variables like price, sales, and product mix is known as incremental budgeting.
The alternative to this method – using no prior budget as a basis, and tallying each cost or activity individually – is known as zero-base budgeting. On one hand, we can see how this might be time-consuming and inefficient for the example of the factory master budget given above. On the other, this approach might be very well suited to reviewing discretionary or support activities within that same company. The zero-base budgeting approach requires you to prioritize each activity and justify its associated expenses, which makes it great for reviewing resource allocation and spending priorities. Where incremental budgeting might preserve inefficiencies in a business by transferring them year-to-year into the new budget, zero-base budgeting allows you to catch and eliminate these inefficiencies by investing more time and effort into the budgeting process.