the meaning and use of incremental budgets, flexible budgets and zero budgeting

5.5 Budgets – Meaning, Purpose and Types

5.5.1 Meaning and Purpose of Budgets

A **budget** is a detailed financial plan that estimates the expected income, expenditure and cash‑flows for a defined period (normally one year). In the Cambridge syllabus a budget is described as a tool that helps an organisation to plan, coordinate, control and measure performance.

• Planning – sets quantitative targets for revenue, costs and profit.
• Coordination – links the objectives of different departments, projects or activities.
• Control – provides a benchmark against which actual results are compared.
• Performance measurement – the difference between actual and budgeted figures is a budget variance, which is used to assess efficiency, effectiveness and to motivate staff.

Budgets as Performance‑Measurement Tools

When the period ends, the organisation calculates:

Variance = Actual – Budgeted

• For costs a **favourable** variance occurs when the actual cost is lower than budgeted; an **adverse** (unfavourable) variance occurs when the actual cost is higher.
• For revenues a **favourable** variance occurs when the actual revenue exceeds the budget; an **adverse** variance occurs when it falls short.
• Variance analysis enables managers to identify the cause (price, volume, efficiency or external factor) and to take corrective action.

5.5.2 Overall Benefits and Drawbacks of Budgets

Benefits	Drawbacks
Provides a clear financial target for the whole organisation. Facilitates resource allocation and prioritisation. Improves coordination between departments. Enables performance monitoring through variance analysis. Motivates staff by linking rewards to achievement of targets.	Time‑consuming to prepare, especially for large firms. Can become a rigid “rule‑book” if not regularly reviewed. Risk of “budgetary slack” – managers may under‑estimate activity to make targets easier. May focus attention on short‑term financial targets at the expense of long‑term strategy.

5.5.3 Types of Budgets

Three approaches are highlighted in the Cambridge syllabus:

1. Incremental budgeting
2. Flexible budgeting
3. Zero‑budgeting (including the related Zero‑Based Budgeting method)

1. Incremental Budgeting

Preparation starts from the previous year’s actual results; each line item is then increased or decreased by a set percentage or amount to reflect expected changes (inflation, growth, new projects, etc.).

Aspect	Details
Typical adjustment	+/- % for inflation, sales growth, new product launch, etc.
Advantages	Simple and quick to prepare. Provides stability – departments know what to expect. Useful where the external environment is relatively stable.
Disadvantages	May lock in past inefficiencies. Little incentive for managers to seek cost reductions. Not responsive to major market or technological changes.
Numerical example	Last year sales = £500 k. Management adds 5 % for expected growth → budgeted sales = £525 k.

2. Flexible Budgeting

A flexible budget adjusts the original (static) budget to the actual level of activity, usually expressed as a function of a cost driver such as output volume.

Total Cost = F + c × Q

• F = fixed cost (does not change with activity)
• c = variable cost per unit
• Q = actual activity level (e.g., units produced)

Aspect	Details
Preparation	Develop a budget for a range of activity levels (e.g., 0, 5 000, 10 000 units).
Use	After the period, adjust the budget to the actual output and compare actual costs with the flexible budget.
Advantages	Separates the effect of volume changes from efficiency issues. Provides a more meaningful basis for variance analysis. Ideal for businesses with fluctuating demand.
Disadvantages	Requires identification of reliable cost drivers. More complex than a static (incremental) budget.
Numerical example	Fixed costs = £20 k, variable cost = £5 per unit, actual output = 8 000 units. Flexible‑budget cost = £20 k + (£5 × 8 000) = £60 k.

3. Zero‑Budgeting (and Zero‑Based Budgeting)

Zero‑budgeting starts each budgeting cycle from a **zero base** – no cost is carried forward automatically. Every expense must be justified for the upcoming period, regardless of past spending.

• Often used by start‑ups, new divisions, or organisations undergoing major restructuring.
• Ensures that each cost is linked to current strategic objectives.

Zero‑Based Budgeting (ZBB)

ZBB is the systematic methodology that implements the zero‑budgeting principle. It requires:

1. Identification of all activities (decision packages).
2. Estimation of the cost of each activity.
3. Ranking of packages according to their contribution to organisational goals.
4. Allocation of resources to the highest‑ranked packages.

Aspect	Zero‑Budgeting	Zero‑Based Budgeting (ZBB)
Starting point	All items begin at zero each period.	All items begin at zero and are justified & ranked as decision packages.
Typical use	New businesses, divisions, or after a major change.	Large organisations seeking thorough cost‑review and strategic re‑allocation.
Complexity	Low‑medium – justification required but no detailed ranking.	High – extensive analysis, ranking and documentation.
Motivation for cost control	Strong – every cost must be defended.	Very strong – resources allocated only to justified, high‑value activities.

5.5.4 Budget Variances – Calculation and Interpretation

Variance type	Formula	Interpretation (costs)	Interpretation (revenues)
Favourable	Actual – Budget < 0 (costs) / Actual – Budget > 0 (revenues)	Cost lower than expected – positive outcome.	Revenue higher than expected – positive outcome.
Adverse	Actual – Budget > 0 (costs) / Actual – Budget < 0 (revenues)	Cost higher than expected – problem to investigate.	Revenue lower than expected – problem to investigate.

Illustrative calculations

• Budgeted sales = £100 k; Actual sales = £115 k.
  Variance = £115 k – £100 k = +£15 k → **Favourable** revenue variance.
• Budgeted production cost = £60 k; Actual cost = £68 k.
  Variance = £68 k – £60 k = +£8 k → **Adverse** cost variance.

After calculating variances, managers should ask:

1. Is the variance due to volume, price, efficiency or an external factor?
2. What corrective action is required (e.g., renegotiating supplier terms, revising sales strategy)?
3. How can the budgeting process be improved for the next cycle?

5.5.5 Comparison of the Three Budgeting Approaches

Aspect	Incremental Budget	Flexible Budget	Zero‑Budgeting
Basis of preparation	Previous year’s actuals + adjustments	Original static budget adjusted for actual activity level	All items start from zero; each cost must be justified
Complexity	Low	Medium – requires cost‑driver analysis	Medium‑high – justification of every line item (higher for ZBB)
Responsiveness to change	Low – changes only through predetermined adjustments	High – reflects actual volume and can highlight efficiency issues	High – aligns spending with current strategic priorities
Motivation for cost control	Limited – budgets are largely carried forward	Moderate – variance analysis points out inefficiencies	Strong – every expense must be defended
Typical use	Stable environments, routine operations	Businesses with variable demand (manufacturing, retail, services)	Start‑ups, new divisions, organisations undergoing major restructuring

5.5.6 Practical Guidance for Choosing a Budgeting Approach

• Market volatility – highly variable demand favours flexible or zero‑budgeting.
• Strategic focus – if cost‑containment and alignment with new objectives are priorities, consider zero‑budgeting/ZBB.
• Resource availability – limited time or expertise may make incremental budgeting more realistic.
• Organisational culture – cultures that value autonomy and innovation respond well to flexible or zero‑budgeting; highly hierarchical cultures may prefer the predictability of incremental budgets.
• Performance measurement needs – where detailed variance analysis is required, a flexible budget provides the most useful benchmark.

5.5.7 Key Take‑aways

• Budgets are essential for planning, coordination, control and performance measurement.
• Incremental budgeting is quick and stable but can perpetuate past inefficiencies.
• Flexible budgeting links costs to activity levels, giving a realistic basis for variance analysis.
• Zero‑budgeting forces a fresh justification of all expenses, supporting strategic alignment but requires more effort.
• Understanding and interpreting variances is central to effective control and continuous improvement.