Incremental budgeting is a simple, straight-forward approach which uses either last year’s budget or actual results as the starting base for the next year’s budget, only making adjustments for new assumptions, for example, the estimated change in sales, raw material price inflation, or other incremental factors. Whilst this approach might be useful in a predictable, static environment, it comes with drawbacks.
First, a cost centre manager might include ‘slack’ in their budget proposal – this means ‘adding a little extra,’ to cushion their budget. Last year’s budget might also include outdated assumptions which would be carried forward into the new budgeting period using incremental budgeting. Managers may also be motivated to spend everything in their budget towards the end of the year to ensure they receive the same amount, or more, in the following year.
Zero-based budgeting was developed in response to the issues surrounding incremental budgeting.
Zero-based budgeting is an approach to budgeting where all expenses must be justified at the start of each new budgeting period. This process starts at a ‘zero-base,’ and every organisational function is analysed for their needs and costs before an item is included in the budget.
First, ‘decision units’ can be defined as business units, departments or programmes. Managers of each decision unit then evaluate the activities and processes they need to achieve their objectives. This information is recorded in a ‘decision package’ detailing information on costs, resources required and different levels of output.
After the decision packages are generated, they are ranked, and a budget is created by allocating funds to the most attractive decision packages. Under zero-based budgeting, there is now a business justification for each item in the budget.
Zero-based budgeting focuses the budgeting process on the objectives of the organisation by linking decision packages to organisational objectives. As it requires active involvement from managers and staff in preparing decision packages, their understanding of cost behaviours will be improved. This approach can result in better resource allocation and overall lower costs. Also, obsolete activities and processes will be cut out of the budget.
However, zero-based budgeting can be time-consuming. Data will need to be gathered for each decision package and some unknown information may need to be estimated. Zero-based budgeting also requires extensive document creation and management time when evaluating decision packages. Conflicts might arise in setting criteria for the ranking of decision packages, and more budgeting skills are needed by managers. The budgeting cycle is annual, so short-term goals may be prioritised instead of long-term goals.
Plainfield County Public Authority (PCPA) is a local public agency which provides services to the community, including a public library. PCPA is funded primarily from local tax revenues.
PCPA has recently moved from an incremental budgeting to a zero-based budgeting (ZBB) system. The central budget office now provides decision unit managers with PCPA’s strategic plan, guidelines for budgeting and other support, and gives managers autonomy in how to develop their decision packages.
In the past, the library manager adjusted the budget to account for inflation and operational assumptions. Some of the costs the library currently incurs are as follows:
The number of library visitors is expected to increase next year, increasing the workload for librarians. This will in turn increase staff costs by 15% due to overtime payments.
Despite the increase in the number of library visitors, the library has come under criticism for being ‘old-fashioned’, and the library manager wishes to respond to this. He is considering two projects for inclusion in his budget:
Decision package 1: Computer upgrade
With this proposal, only the computers will be replaced. The total cost for this upgrade will be $45,000. Annual IS maintenance costs will fall slightly to $9,000 as the new computing environment will require less support. Annual website costs will remain constant, and staff costs are expected to grow as projected above. This upgrade will not substantially change library operations.
Decision package 2: Computer upgrade and integrated library system
Under this proposal, new computers plus additional hardware and software will be purchased which automates the core library processes. The combined cost of the new system will be $98,500. This improvement will allow ‘self-service’ borrowing of books. Members of the public will scan books when borrowing and returning them, eliminating the need for interaction with a librarian. The new system will allow the library to reduce staff members to 4, still earning the same average annual salary while avoiding additional overtime payments. Annual IS maintenance costs will increase to $22,000, and annual website costs will increase to $3,000.
The new system will use a dynamic website that lets library members see, in real-time, what books are available at the library and then reserve them online.
Requirements:
(a) Determine the cost of each decision package for the first year (ignore time value of money) and choose between the two options from both financial and non-financial perspectives.
(b) Discuss the advantages and disadvantages of moving to ZBB for the library.
Suggested solution:
(a)
|
$ |
Computer upgrade |
45,000 |
Annual IS maintenance costs |
9,000 |
Website hosting |
1,750 |
Staff costs ($140,000 x 1.15) |
161,000 |
|
216,750 |
|
$ |
Computer upgrade including integrated library system |
98,500 |
Annual IS maintenance costs |
22,000 |
Website hosting |
3,000 |
Staff costs ($140,000 x 4/5 staff members) |
112,000 |
|
235,500 |
Information for the quarter:
Financial perspective
Decision package 2 is the more expensive option by $18, 750, or 8.7%. However, if the annual operating costs are considered, assuming the initial IT investment costs will be amortised, decision package 2 will bring annual savings of $34,750 (The difference between decision package 1 $171, 750 and decision package 2 $137, 000).
Non-financial perspective
Decision package 2 is the more innovative solution and addresses the criticism of the library being old-fashioned. This system will save community members’ time as they will be able to search for and reserve books online without visiting the library. Also, the community and staff will have access to accurate and real-time information about what books are available. Automation of library tasks means librarians can be more focused on the needs of library visitors and allows for reducing the number of librarians in the future once the system is up and running. Satisfied visitors may also boost the library’s reputation with positive comments and feedback on social media.
Even though the initial cost for decision package 2 is higher than decision package 1, it seems like the best option as it will reduce longer-term operational costs, improve efficiency, and improve the public’s ability to access and use library resources.
(b)
Move to ZBB
Under ZBB, the library manager is more focused on the objectives and needs of the community when preparing their budget. Decision packages can be evaluated by the value for money provided for the community, not just by cost savings. The library manager is now more involved in the budgeting process and has found operational efficiencies and quality improvements in the process.
However, ZBB may be time-consuming for the library manager and can distract him from other important responsibilities. We also don’t know if he has the appropriate skills to manage the budgeting process. As ZBB is an annual process and focused primarily on next year’s budget, short-term objectives might take precedence over long-term benefits. For example, the new library system is more expensive in the short-term but leads to long-term cost savings and benefits – the ZBB approach does not highlight these long-term advantages.
Written by Steve Willis, finance and accountancy trainer