Question Tag: Incremental Budgeting

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  • 1 Marks

MI – May 2016 – L1 – SA – Q12 – Budgeting

Identify the term used for the intentional overestimation of expenses or underestimation of revenue in a budget.

The intentional overestimation of expenses and/or underestimation of revenue in a budget is the definition of:

A. Budget slack
B. Sub-optimization
C. Budget targets
D. Incremental budgeting
E. Budget setting

Answer: A

Explanation:
Budget slack refers to the deliberate overestimation of expenses or underestimation of revenue in a budget to make it easier to achieve financial targets. It is used to create a buffer for unforeseen expenses or to ensure that performance appears better than expected.

  • 10 Marks

MA – Aug 2022 – L2 – Q3b – Budgetary control

This question focuses on explaining how a rolling budget works and calculating a revised budget for Baya Ltd.

The Finance Manager of Baya Ltd has been criticised for using an incremental budget method in preparing the company’s budget. She, however, needs to respond to the issues raised at a board meeting and as a result, she is considering using different budgeting methods for the year-end 31 December 2022. She has asked you, the Management Accountant, to do some preliminary work to help her decide on which of the methods to use. She believes a rolling budget would be ideal for the fast-growing Baya Ltd in a relatively high inflationary country.

Baya Ltd’s incremental budget for the year-end 31 December 2022 is given below:

Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
Revenue (GH¢’000) 17,520 17,958 18,407 18,867 72,752
Cost of sales 9,636 9,877 10,124 10,377 40,014
Gross profit 7,884 8,081 8,283 8,490 32,738
Distribution costs (1,577) (1,616) (1,657) (1,698) (6,548)
Administration (4,214) (4,214) (4,214) (4,214) (16,856)
Operating profit 2,093 2,251 2,412 2,578 9,334

The actual figures for quarter 1 (which has just been completed) are:

On the basis of the quarter 1 results, sales volume growth of 3% per quarter is now expected.

Required:
i) Explain how Baya Ltd will operate a rolling budget.
(2 marks)

ii) Recalculate the quarterly rolling budget for Baya Ltd for the last three quarters of the year 2022 and the first quarter of 2023.
(8 marks)

i) Explanation of Rolling Budget:
A rolling budget is one that is continually updated by adding a new budget period as the most recent period is completed. For example, if the company has a budget for a full 12 months, once one quarter is over, the next quarter’s budget is added, keeping the budget always covering the upcoming 12-month period. This approach is suitable for companies operating in a dynamic environment, where it is essential to adjust targets and expectations frequently in response to changing market conditions.
(2 marks)

ii) Recalculation of Quarterly Rolling Budget for Baya Ltd:
Adjustment Basis:

  • Revenue: Expected to grow by 3% per quarter.
  • Cost of sales and distribution costs are assumed to grow in line with sales growth.
  • Administration costs remain fixed.

Revised Quarterly Rolling Budget:

Quarter 2 (GH¢’000) Quarter 3 (GH¢’000) Quarter 4 (GH¢’000) Q1 2023 (GH¢’000)
Revenue 18,470 19,024 19,595 20,183
Cost of sales 10,159 10,464 10,778 11,101
Gross profit 8,311 8,560 8,817 9,082
Distribution costs (1,662) (1,712) (1,764) (1,817)
Administration (4,214) (4,214) (4,214) (4,214)
Operating profit 2,435 2,634 2,839 3,051

Assumptions:

  • Revenue: Grows by 3% each quarter.
  • Cost of sales: Follows the same pattern as revenue growth.
  • Distribution costs: Follows the same growth pattern.
  • Administration costs: Remain fixed throughout the period.

(8 marks)

  • 10 Marks

MA – April 2022 – L2 – Q3b – Activity-based costing

Differentiate between Activity-Based Budgeting and Incremental Budgeting, explain ABB processes, and discuss arguments for and against ABB.

Kankum Industries is considering switching from Incremental Budgeting to Activity-Based Budgeting (ABB) because of the argued pricing specificity of the ABB approach. The Chairman of the Finance Sub-Committee of the board, who does not have an accounting background, has contacted you for clarification on some key issues relating to ABB in order to assist in his explanation to the board.

Required:

i) Differentiate between Activity-Based Budgeting and Incremental Budgeting. (3 marks)

ii) Explain the process in ABB. (3 marks)

iii) State TWO (2) arguments in favour and TWO (2) arguments against ABB. (4 marks)

i) Differentiation between Activity-Based Budgeting and Incremental Budgeting:

  • Activity-Based Budgeting (ABB): ABB is a method of budgeting that is based on identifying activities that incur costs within an organization and then determining the cost drivers of those activities. Budgets are prepared based on the expected activity levels, making the budgeting process more accurate and aligned with operational realities.
  • Incremental Budgeting (IB): IB is a traditional approach where the previous period’s budget is used as a base, and adjustments (usually increments) are made to create the current period’s budget. This method is less detailed and relies heavily on historical data without necessarily considering the actual activities or changes in the organization.

ii) The Process in ABB:

  1. Identify Activities: The organization must identify the key activities that incur costs within its operations.
  2. Accumulate Costs into Cost Pools: Similar activities are grouped into cost pools to better track and manage expenses.
  3. Determine Cost Drivers: The organization then identifies the factors that drive the costs of each activity, known as cost drivers.
  4. Assign Costs Based on Activities: Costs are then assigned to each activity based on the identified cost drivers, leading to a more accurate and activity-focused budget.
  5. Prepare the Budget: The budget is prepared using the costs and activities identified, ensuring that it reflects the operational needs and cost drivers.

iii) Arguments in Favour of and Against ABB:

Arguments in Favour:

  1. Improved Cost Control: ABB allows for more accurate budgeting and cost control by focusing on the activities that drive costs, enabling organizations to allocate resources more efficiently.
  2. Aligns Budget with Operational Activities: ABB ensures that budgets are closely tied to the actual activities of the organization, making the budgeting process more realistic and aligned with business needs.

Arguments Against:

  1. Complexity and Cost: ABB is more complex and time-consuming to implement than Incremental Budgeting, requiring detailed analysis and identification of activities and cost drivers.
  2. Resource Intensive: The implementation of ABB requires significant resources, both in terms of time and personnel, to identify, measure, and manage activities and their associated costs, which can be burdensome for some organizations.
  • 6 Marks

MA – May 2017 – L2 – Q2c – Budgetary control

Identify and explain three steps in the preparation of a Zero-Based Budget.

Zero-based budgeting attempts to improve upon incremental type of budgeting, which is perceived to carry over inefficiencies from previous periods. It allows for budget reductions and permits the re-allocation of resources from low to high priority programs. Critics are of the opinion that such an approach or process of budgeting can be cumbersome in its execution.

Required:

Identify and explain THREE steps in the preparation of Zero-Based Budget. (6 marks)

The steps in the preparation of a Zero-Based Budget include:

  1. Identification of Decision Units:
    • Explanation: Each cost center or unit is identified as a decision unit. These units are the basic elements that carry out specific activities or functions. A decision unit can be a department, section, or any operational entity within the organization that incurs costs.
  2. Preparation of Decision Packages:
    • Explanation: A decision package is created for each decision unit. This package includes a detailed analysis of each activity, its objectives, and the costs associated with it. The decision package also outlines the benefits and consequences of funding the activity at different levels (e.g., existing level, reduced level, or enhanced level).
  3. Ranking and Prioritization of Decision Packages:
    • Explanation: The decision packages are ranked in order of priority based on their importance to the organization’s goals. This ranking helps in allocating resources effectively, ensuring that high-priority activities receive the necessary funding while low-priority activities may be reduced or eliminated.

(6 marks)

  • 20 Marks

PSAF – Nov 2018 – L2 – Q3a – Public sector fiscal planning and budgeting

Prepare a budget for 2019 using 2018 as a base and analyze the budgeting approach.

a) You are the head of the Budget department of the Ministry of Works. The Ministry intends to prepare the budget for the 2019 fiscal year and has intended to use the 2018 budget as a base. Below is the detail of the 2018 Budget:

Assumptions for 2019 Budget: i) The Ministry has introduced new equipment, leading to a 36% increase in IGF, but government grants will be cut by GH¢9,600,000. ii) Established post salary will increase by GH¢3,920,000, non-established post salaries will increase to GH¢4,960,000, and allowances will increase by 15%. iii) Utility cost will decrease to GH¢9,700,000; repairs cost will increase by 9%; and training and seminar cost will increase to GH¢17,820,000. iv) The Ministry expects to acquire new equipment, increasing the equipment cost by GH¢150,000,000.

Required: Using the 2018 Budget as a base and assumptions made, prepare the Budget for the 2019 fiscal year. (10 marks)

b)
i) Identify and explain the type of Budget approach used by the Ministry in the Budget preparation. (2 marks)

ii) Explain THREE (3) merits and THREE (3) demerits of the Budget approach adopted in the preparation of the 2019 Budget. (3 marks)

iii) Explain an alternative approach you would have suggested to the Ministry for their subsequent budget preparation and explain THREE (3) reasons why that approach is appropriate under the circumstance. (5 marks)

a) Budget for 2019

b) i) The Ministry used the Incremental Budgeting approach in the preparation of the 2019 Budget. This approach involves using the previous year’s budget as a base and making adjustments for expected increases or decreases in revenues and expenditures.

(2 marks)

ii) Merits of Incremental Budgeting:

  • Simplicity and Time-Efficiency: This method is straightforward and quick to apply, saving time in the budgeting process.
  • Stability: It provides stability as it builds on existing budgets, which are familiar to all stakeholders.
  • Ease of Justification: There is less need to justify the entire budget, as only the increments or decreases are usually scrutinized.

Demerits of Incremental Budgeting:

  • Inefficiencies are Carried Forward: Inefficiencies in the previous budget may be perpetuated if they are not critically examined.
  • Lack of Innovation: The approach discourages a fresh evaluation of activities and can stifle innovation as it assumes past activities are still relevant.
  • Resource Allocation Issues: The approach may not align resources with strategic priorities, leading to the potential misallocation of funds.

(3 marks total – 1.5 marks for three merits and 1.5 marks for three demerits)

iii) An alternative approach that could be suggested is Zero-Based Budgeting (ZBB).

Reasons for ZBB:

  • Resource Optimization: ZBB ensures that every department starts from a “zero base,” justifying all expenditures, leading to better resource optimization.
  • Eliminates Waste: This approach forces a review of all expenditures, helping to eliminate unnecessary spending and promoting efficiency.
  • Alignment with Strategic Goals: ZBB aligns budgeting with current strategic goals, ensuring resources are allocated to the most critical areas of need.
  • 20 Marks

IMAC – JULY 2023 – L1 – Q2 – Budgeting | Marginal Costing and Absorption Costing

Explain types of budgeting and prepare a flexible budget for cost control, including variance analysis.

a) Explain the following:
i) Incremental Budgeting (2 marks)
ii) Zero-Based Budgeting (2 marks)
iii) Activity-Based Budgeting (2 marks)

b) Cox Ltd is a manufacturing company that produces a body shaping drink for the African market. The company employs a marginal costing system as an integral part of its reporting systems. During the reporting period, there was no opening or closing inventory. The company produces its budgeted and actual results for December 31, 2022, as follows:

Budget Actual
Production/sales (units) 2,000 1,400
Sales (GH¢) 60,000 42,400
Variable Costs:
Direct material (GH¢) (20,000) (13,200)
Direct labour (GH¢) (10,000) (7,600)
Variable overhead (GH¢) (6,000) (4,400)
Contribution (GH¢) 24,000 17,200
Fixed cost (GH¢) (20,000) (20,800)
Net profit/loss (GH¢) 4,000 (3,600)

Required:
Prepare a budget that will be useful for management cost control purposes and briefly comment on the company’s performance in December 2022. (14 marks)

a)
i) Incremental Budgeting:
This is the system of budgeting where the previous period’s or year’s budget is used as a basis for preparing the current period’s budget by making incremental adjustments influenced by factors such as inflation, expansion needs, and growth. It is simple to apply in practice because you need not develop a decision package or justify the inclusion of the cost of an item into the budget. However, this method perpetuates past inefficiencies and does not lead to optimal and efficient allocation of budgetary resources. (2 marks)

ii) Zero-Based Budgeting:
This is a process of budgeting whereby all activities contained in the budget are re-evaluated each time the budget is prepared. Every item of expenditure must be justified in its entirety to be included in the next year’s budget. This approach adds a psychological impetus to employees to avoid wasteful expenditure, but it creates extra paperwork as the process of preparing the decision packages under Zero-Based Budgeting can be repetitive and cumbersome. (2 marks)

iii) Activity-Based Budgeting:
This is a method of budgeting based on an activity framework and the utilization of cost driver data in the budget-setting and variance feedback process. It involves defining activities that drive costs and using the level of activity to decide how much resource should be allocated and to determine how well an activity is being managed and to explain variances from the budget. While it helps managers to identify the cost of an activity and facilitate cost reduction, it can sometimes be difficult to trace objectively the cost of an activity to a product. (2 marks)

b)
Cox Limited – Cost Card

Cost Element Calculation GH¢
Selling price (GH¢60,000 / 2,000 units) 30
Direct material (GH¢20,000 / 2,000 units) 10
Direct labour (GH¢10,000 / 2,000 units) 5
Variable overhead (GH¢6,000 / 2,000 units) 3
Budgeted production cost 18
(2 marks)

Flexible Budget for the Month, 31 December 2022

Performance Area Fixed Budget Flexible Budget Actual Result Variance
Production/Sales 2,000 units 1,400 units 1,400 units
Sales (GH¢) 60,000 42,000 42,400 400F
Variable Costs:
Direct material (GH¢) 20,000 14,000 13,200 800F
Direct labour (GH¢) 10,000 7,000 7,600 600A
Variable overhead (GH¢) 6,000 4,200 4,400 200A
Total variable cost (GH¢) (36,000) (25,200) (25,200) 0.00
Contribution (GH¢) 24,000 16,800 17,200 400F
Fixed cost (GH¢) (20,000) (20,000) (20,800) 800A
Net profit/loss (GH¢) 4,000 (3,200) (3,600) 400A
(Marks are evenly spread for flexible budget and variance = 10 marks)

Commentary:
Sales variance was GH¢400F. This means that budgeted selling price is
(GH¢60,000/2,000units) GH¢30 and actual selling price is (GH¢42,400/1,400 units)
GH¢30.285. The overall performance is GH¢400 worse than budgeted. That is, the
flexible budget is GH¢3,200 compared with actual loss of GH¢3,600. Control of
direct material cost has been very good as this has been GH¢800 better than
expected. Direct labor cost is overspent as does fixed overhead by GH¢600 and
GH¢200 respectively.
(2 marks)

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