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PAST EXAM
QUESTION AND ANSWER
P5 Answer - Question 2
Text reference. Different approaches to budgeting are discussed in Chapter 2 of the BPP
Study Text.
Top tips.
Part (a): A sensible approach to this question might be to think about the benefits and
drawbacks of incremental budgeting in general terms, and then think how these would affect
its suitability for each of the different divisions. For example, the scenario identifies that F is
growing quite rapidly, so how would this affect the suitability of incremental budgeting in F?
The question specifically asks about its suitability at ‘each division’ so it is important that you
deal with the different divisions in turn, although the similarities between S and H mean you
could look at them together.
Part (b): Up to 6 out of the 8 marks available here were for calculations, so this part of the
question should have offered you some easy marks. However, it is important you apply the
information given in the scenario correctly; for example, noting that administrative costs are
fixed, although cost of sales and distribution costs are variable.
Also, remember that because you now have actual figures for Quarter 1 of the current year,
the rolling budget should include budgeted figures for Quarter 1 of the next year.
Finally, note that not all the marks in this part of the question are available for calculations;
so you still need to comment on the potential benefits (or drawbacks) of using rolling budgets
for F.
Part (c): One of the key issues highlighted in the scenario is that the managers of the
manufacturing divisions are very doubtful about the value which M adds. Therefore, to try to
remove these doubts, the approach to budgeting in M needs to be one which challenges
and justifies any proposed expenditure before it is approved. On this basis, zero-based
budgeting would seem to be appropriate.
Part (d): The context of this question is the contrast between top-down budgeting (with little
participation) and bottom-up budgeting (which involves much greater participation).
However, a useful way to approach this part of the question could be to think how the degree
of participation changes in the different types of budget you have considered in parts (a), (b)
and (c).
DG’s current (incremental) approach, appears to be essentially a top-down process with little
participation from the divisions. This could provide your analysis of the current level of
participation; (and if DG decides to retain incremental budgeting in the S and H divisions, a
top-down approach could remain appropriate there.)
But could DG successfully introduce rolling budgets or zero-based budgeting (in F and M
respectively) without having a greater degree of involvement from divisional managers?
Consequently, what level of participation will be appropriate at DG in the future?
Marking scheme
Marks
(a)
Evaluation of the advantages and disadvantages of
incremental budgeting in general – 1 mark per relevant
point
Up to 5
Recommendations about the suitability of incremental
budgeting in S and H division – 1 mark per relevant point
Discussion about the suitability of incremental budgeting
for F – 1 mark per relevant point
Discussion about the suitability of incremental budgeting
for M – 1 mark per relevant point
Up to 3
Up to 3
Up to 3
8
Marks
(b)
Explanation of the rolling budget process – 1 mark per
relevant point
Calculations (up to 6 marks in total for calculations):
Actual figures in Q1
Revenue; Cost of Sales; Distribution costs; Administration
costs; Operating profit – 1 mark for correct figures for each
line in the budget
Budgeted figures for Q1 in the next year
Comments on the use of rolling budgets at F – 1 mark per
relevant point
Up to 2
1
Up to 4
1
Up to 3
8
(c)
(d)
Recommendation of an appropriate method (1 mark), plus
1 mark per valid point justifying the choice of method
Explanation of top-down vs bottom-up budgeting – 1 mark
per relevant point
Evaluation of use of bottom-up control at DG, and its
impact on current processes
3
3
Up to 2
Up to 6
6
Total = 25
(a)
Incremental budgeting
Advantages
Not too time-consuming – DG currently uses incremental budgets. One of the main
advantages of incremental budgets is that they are relatively quick and easy to
prepare. This is a general advantage at DG given the time constraints which the
finance department is currently experiencing in relation to the Information Systems
implementation.
Stable environment – Incremental budgets are also appropriate for stable
environments, where current or historic figures can provide a reliable basis for
projecting future figures, and where only small changes are required to those figures.
Disadvantages
Accepts inefficiencies – A major problem with incremental budgets is that, by their
nature, they reinforce existing practices. The fact that the FD has identified that the
most promising area for performance improvement lies in better internal control
practices suggests that there are inefficiencies in DG’s current processes, which are
likely to be reflected in its current figures. However, by basing future years’ budget on
the current figures, these inefficiencies will be perpetuated rather than challenged.
Consequently, for example, DG may miss opportunities to make cost savings.
Can encourage spending – Similarly, managers may feel they have to spend the full
amount of their current year’s budget in order to preserve the same level of budget
next year, even though the expenditure may not actually be required at the moment.
Once again, such an approach could lead to DG’s costs being unnecessarily high.
H and S divisions
Stable markets – Both H and S divisions are in stable markets. The fact that sales
growth is unlikely suggests that incremental budgeting could be appropriate for them.
Moreover, such an approach would fit with the managers’ preference for maintaining
existing practices rather than changing them.
Margin improvements – Because H and S have limited opportunities to increase
revenues, in order to increase their profitability they will need to improve their margins.
However, incremental budgeting will not be suitable to help them do this.
In order to improve their margins, the divisions will need to challenge and reduce their
costs. However, by basing future budgets on current figures, an incremental approach
will not provide the stimulus for continuous improvement which is required.
F division
Rapid growth – F’s rate of growth means an incremental approach is unlikely to be
suitable for it. Its rapid growth means that budgets based on current results will quickly
become out of date.
The customer complaints and the managers’ complaints could both be symptoms of
the constraints which incremental budgets have placed on the business. For example,
the complaints about late deliveries and poor quality could result from F trying to
satisfy rapidly increasing demand and in the face of budgetary constraints – which
mean it either doesn’t have sufficient capacity to keep pace with demand or it has to
use poorer quality materials in order to reduce material costs.
The managers’ complaints pick up on this point further. If the cost budgets have been
set in line with current levels of demand, they are unlikely to be sufficient to cope with
the higher levels of demand.
M division
Justifying costs – The managers of the manufacturing divisions are sceptical of the
need for a marketing department and using an incremental budget will not do anything
to change their opinion of this.
The current budgetary approach at M (simply adding a percentage to the current
year’s expenditure) doesn’t require M to justify its spending. Until it does this, however,
it seems unlikely that M will be able to change the other division’s perceptions of it.
Perhaps more importantly though, simply adding a percentage to the current year’s
spend could lead to unjustified expenditure. For example, if the marketing division
commits some expenditure this year on the basis that it is currently within budget
rather than the expenditure will add value for DG, next year’s budget will be uplifted
from the higher figure. Under such circumstances, the budget will continuously be
higher than it needs to be. Again, this would justify the other managers’ scepticism
about the amount of value M adds to the company.
(b)
Under a rolling budget, another accounting period is added to the budget when the
most recent one finishes. The budget is then recalculated using the actual data from
the most recent period as a basis.
Because Fizzy (F) division’s budget is based on a quarterly basis, the rolling budget
will include actual figures for Quarter 1 of the current year, and then forecasts for
Quarters 2 – 4 of the current year, along with Quarter 1 of the following year.
Based on the assumption that cost of sales and distribution costs increase in line with
sales, and that administration costs remain fixed as in the original budget, F’s rolling
budget would be as follows:
Revenue
Cost of sales
Gross profit
Distribution costs
Administration
costs
Operating profit
Q1
$'000
Actual
Q2
Q3
Q4
TOTAL
Q1
$'000
$'000
$'000
$'000
$'004
Forecast Forecast Forecast Forecast Forecast
17,932
(9,863)
8,069
(1,614)
18,470
(10,159)
8,311
(1,662)
19,024
(10,464)
8,560
(1,712)
19,595
(10,778)
8,817
(1,764)
75,021
(41,264)
33,757
(6,752)
20,183
(11,101)
9,082
(1,817)
(4,214)
2,241
(4,214)
2,435
(4,214)
2,634
(4,214)
2,840
(16,856)
10,149
(4,214)
3,051
As we noted in part (a), F is growing rapidly, and the rolling budget enables F’s
managers scope to increase their variable costs to reflect that growth, rather than
being constrained by the original budget.
As a result, F should be better able to sustain its growth, and the level of complaints
about late deliveries and poor quality (which could otherwise jeopardise its growth)
should be reduced.
Moreover, the rolling budget should provide managers with more realistic targets
against which to compare actual performance. In this way, the rolling budget provides
a more effective control mechanism than an annual budget, which could potentially be
disregarded as being out of date.
It is likely that additional resources in the finance department will be required to
prepare rolling budgets, because updated budgets will need to be prepared each
quarter rather than on an annual basis as they currently are. However, the benefits
which F’s managers would derive from having rolling budgets should outweigh the
additional costs incurred to prepare them.
(c)
Justifying expenditure – The scepticism from the managers of the manufacturing
divisions about the need for a marketing department (M), in conjunction with the
Board’s requirement that M’s costs should be carefully controlled, suggests that an
incremental budget may not provide a robust enough framework for M.
Zero based budgeting – By contrast, a zero-based budgeting approach may be
appropriate, and this is the approach recommended for M.
As each marketing campaign is run as an individual project, it seems more appropriate
M to budget for the campaigns on a project-by-project basis. A zero-based budget
approach would provide a suitable framework for doing this, with the cost of each
campaign having to be justified at the start before the campaign is approved.
Under a zero-based budget, M would need to justify every cost which is required for a
specific marketing campaign. If a cost element cannot be justified, then no resources
will be allocated to it in the budget.
Tighter control - Such an approach should also appease the managers of the
manufacturing divisions because it will mean that marketing expenditure is being much
more tightly controlled.
(d)
Top-down budgeting
In a top-down budgeting environment, budget figures are essentially imposed on
operational managers and other budget holders by senior management. Operational
managers have very little participation in the budgeting process.
Limited participation – The divisional managers at DG do appear to have some input
into the budget process because they discuss the market growth estimates with the
head office finance managers before the budgets are prepared.
However, the budgeting process still appears essentially top-down, and this appears to
be causing resentment about the divisional managers – particularly the F managers
who want to be less controlled by constraints “imposed” by the Board.
Bottom-up control
In contrast to top-down budgeting, a bottom-up approach would allow divisional
managers much greater participation in preparing and setting their own budgets.
This would appear to be the approach which the F managers want, because their
greater participation in setting the budgets should mean they feel “less controlled” by
the Board.
Improved motivation – If the divisional managers have a greater sense of ownership
of the budgets, this should also increase their motivation to achieve the budget targets.
Accountability - Equally, if managers are going to be held accountable for their
performance against budget targets, it seems fair that they should have some input
into setting those targets; for example, so that they think they are realistic.
Improved decision-making – Moreover, the divisional managers at DG should have
a more detailed knowledge of their markets than the Board. Therefore, by allowing the
managers to participate in the budgeting process, the quality of decision-making and
budgeting may also be improved. In this respect, a bottom-up approach would benefit
DG as a whole, not just the divisional managers.
Similarly, if the divisional managers do more of the work to prepare the budgets, this
means the budgeting process is less onerous for the senior management team, which
allows them more time to spend on other matters.
Levels of participation
Overall control – At DG, the budget system in each business is the main method of
central control. Therefore the Board needs to ensure that the budgets remain in line
with overall corporate objectives, and are not too easily achieved.
Consequently, it appears that an approach which combines aspects of both top-down
and bottom-up budgeting would appear to be most appropriate for DG.
It is important that the managers are involved in the budget-setting process, because
their own personal targets are set around achieving the relevant budget numbers.
Equally, however, it is important that head office should also be involved, to ensure
that the budgets fit with DG’s overall strategic objectives and that budget targets
remaining challenging.
Also, it is debatable how far the managers of H and S division will voluntarily drive
down costs without close monitoring from the head office. In this respect, the Board
may decide that the control which is imposed by a top-down approach is still required
in relation to these two divisions, and therefore the level of participation for these two
divisions will be lower than for the other two divisions.
Rolling budgets – If DG introduces rolling budgets for F, the process of preparing
these budgets should be delegated to the divisional managers. On the one hand this is
due to the resource constraints within the finance department, but on the other it is
because the divisional managers should be more aware of changes in the market
which need to be reflected in the updated figures. However, senior finance staff should
still review the budgets, and the underlying assumptions behind them, to ensure they
seem reasonable.
Zero-based budgeting – If M adopts zero-based budgeting, divisional managers will have a
crucial role to play in the budgeting process, because they will need to assess what activities
and expenditure are required to support each campaign.