Transport Operator (Professional Carrier)
Hot Topic 3
Professional Approach to Transport Budgeting (Part-1)
Get it wrong and it will cost you a lot of money
Transport budgeting has been chosen as Topic 3 in Professional Carriers Conversations
As “demand-driven” service providers, road transport operators (RTOs) are particularly vulnerable in a stalled-growth SA economy as demand falls and rates begin to tumble. Apart from these challenges, the industry is heavily dependent upon imported equipment and consumables in the areas of vehicles, parts, tyres and fuel.
Reference to the change in the ZAR/USD exchange rate chart is evidence of the extremely severe situation driving the dilemma Carriers face – it could quickly worsen to the point of financial disaster for this capital-intensive industry, especially sparsely funded privately-owned Emerging Operators.
Value of the South African rand to the United States dollar from 1975 to 2015 by the blue columns: The percentage rate of change year-on-year is shown by the black line.
Damaged international confidence in the country resulted in significant exchange volatility throughout much of January 2016, reaching an all-time low of R 17.9169 to the US dollar on the 9 January 2016 before rebounding to R 16.57 later the same day.
Budgeting should involve the whole organisation - not just the company financial manager
With this in mind we begin Topic 3
(Part - 1)
Address budgeting with a view to assisting Carriers better understand this very contentious subject from descriptive alternatives presented by various academic approaches to basic but critical budgeting techniques.
(Part - 2) (to follow)
We then move on to explain some of the more common errors found in transport management budgets, and how to avoid them. However, as you will see, budgeting is not to be confused with Operating Cost Estimates (OCEs).
The following extracts are taken from some informed budgeting dissertations
It’s an itemized summary of expected income and expenditure of a country, company, etc., over a specified period, usually a financial year
Budgeting is a math exercise in number crunching.
A budget is a quantitative expression of a plan for a defined period of time. It may include planned sales volumes and revenues, resource quantities, costs and expenses, assets, liabilities and cash flows. It expresses strategic plans of business units, organizations, activities or events in measurable terms.
Budgeting Techniques - Review
A budget is basically a plan of action for the forthcoming business period and budget planning should involve the whole organisation. The ability to budget effectively is crucial both in terms of performance and profitability as, without having an awareness of costs relative to income it’s all too easy to spiral down into losses over a period of time.
There are three main budgeting techniques:
What is Incremental Budgeting?
The incremental approach to budgeting combines the costs identified from the previous accounting period with percentage additions. These percentage additions are utilised to cover two key areas which include:
Cost increases as a result of inflation or,
Greater purchasing expenditure associated with increases in both costs and income as a result of business volume predictions.
A key limitation of the Incremental Budgeting system is the manner in which percentages are added in a blanket fashion, resulting in the likelihood of higher overall costs in the long-term. This may then also result in a business having to increase sale prices to a level that is no longer competitive.
What is Zero-Based Budgeting?
The clue is in the title as the zero-based budgeting system requires budgeting to commence with the assumption that every cost has a zero base. Next, each item relating to expenditure is worked through, and decisions are made as to whether the purchase is completely essential. Then, different purchasing options associated with each specific item is explored as a means of ensuring the item is obtained as cost-effectively as possible.
One of the main limitations of the zero-budgeting system is that it can take an awful lot of time to work through each individual cost in this manner. However, it is fair to add that utilising this approach will then provide an extremely useful database containing valuable, time-saving information for the years to come.
What is Flexed Budgeting?
As with zero-based budgeting, the flexed budgeting system involves ‘flexing’ the normal budget. The benefits of flexed budgeting are that it is likely to be considerably more accurate as the budget is adapted to suit various external changes. Within this approach managers are able to provide key information resulting in an achievable budget - pessimistic budget or optimistic budget.
Through undertaking the process of flexed budgeting, managers are better able to make important decision relating to risk and expenditure, having gained a wider perspective on best and worst outcomes.
As highlighted above, there are three main categories associated with budgeting which include incremental, zero-based and flexed budgeting. Each of these approaches has various strengths and limitations with the latter approach being able to provide more accurate information.
(Source: Brown, B. (2009) Successful Finance Surrey: Crimson)
Another Perspective (Comparing Budgeting Techniques - Incremental V Z-BB)
The budgeting process is an essential component of management control systems, as it provides a system of planning, coordination and control for management. It is often an arduous process, however, and often strikes dread in the hearts of those involved in budget preparation.
For example, a private company's objectives may be to maximise profit. The meeting of this objective can then be set out in the budget by aiming for a percentage increase in sales and perhaps the cutting of various costs.
Incremental budgeting is the traditional budgeting method whereby the budget is prepared by taking the current period's budget or actual performance as a base, with incremental amounts then being added for the new budget period. These incremental amounts will include adjustments for things such as inflation, or planned increases in sales prices and costs.
It is a common misapprehension of students that one of the biggest disadvantages of incremental budgeting is that it doesn't allow for inflation. Of course it does; by definition, an 'increment' is an increase of some kind. The current year's budget or actual performance is a starting point only.
Benefits of incremental budgeting
As indicated above, it is easy to prepare and is therefore quick. Since it is easy to prepare, it is also easily allocated to less senior members of staff:
As well as being easy to prepare, it is easy to understand.
Less preparation time leads to lower preparation costs.
It prevents conflict between departmental managers since a consistent approach is adopted throughout the organisation.
The impact of change can be seen quickly.
Drawbacks of incremental budgeting
It assumes that all current activities and costs are still needed, without examining them in detail. By its very nature, incremental budgeting looks backwards rather than forwards. While this is not such a problem in fairly stable businesses, it will cause problems in rapidly changing business environments.
There is no incentive for departmental managers to try and reduce costs and in fact, they may end up spending money just for the sake of it, knowing that if they don't spend it this year; they won't be allocated the cash next year, since they will be deemed not to need it.
Performance targets are often unchallenging, since they are largely based on past performance with some kind of token increase. Therefore, managers are not encouraged to challenge themselves and inefficiencies from previous periods are carried forward into future periods.
With zero-based budgeting, the budgeting process starts from a base of zero, with no reference being made to the prior period's budget or actual performance. All of the budget headings, therefore, literally start with a balance of zero, rather than under incremental budgeting, when they all start with a balance at least equal to last year's budget or spend. Every department function is then reviewed comprehensively, with all expenditure requiring approval, rather than just the incremental expenditure requiring approval.
Zero-based budgeting tries to achieve an optimal allocation of resources to the parts of the business where they are most needed. It does this by forcing managers to justify every activity in their department as they know that, until they do this, the budget for their department is zero. If they are unable to do this, they aren't allocated any resources and their work therefore stops (as does their employment within the organisation, at this point, presumably). In this way, all unjustifiable expenditure theoretically ceases. A questioning attitude is developed by management, who are constantly forced to ask themselves questions such as:
Is the activity really necessary at all?
What happens if the activity ceases?
Is the current level of provision adequate?
What other ways are there of carrying out the activity?
How much should the activity cost?
Do the benefits to be gained from the activity at least match the costs?
All of these questions are largely answered by breaking the budgeting process down into three distinct stages, as detailed below.
Stages in Zero-based budgeting
1) Activities are identified by managers. Managers are then forced to consider different ways of performing the activities. These activities are then described in what is called a 'decision package', which:
analyses the cost of the activity
states its purpose
identifies alternative methods of achieving the same purpose
establishes performance measures for the activity
It assesses the consequence of not performing the activity at all or of performing it at different levels.
As regards this last point, the decision package may be prepared at the base level, representing the minimum level of service or support needed to achieve the organisation's objectives. Further incremental packages may then be prepared to reflect a higher level of service or support.
While some form of cost-benefit analysis may be useful at this stage, a degree of quantitative analysis must also be incorporated. Simple cost-benefit analysis would find it difficult to incorporate the financial effect of such considerations.
2) Management will then rank all the packages in the order of decreasing benefits to the organisation. This will help management decide what to spend and where to spend it. This ranking of the decision packages happens at numerous levels of the organisation. The resources are then allocated based on order of priority up to the spending level.
Benefits of Z-BB
The benefits of Z-BB are substantial. They would have to be otherwise no organisation would ever go to the lengths detailed above in order to implement it. These benefits are set out below:
Since Z-BB does not assume that last year's allocation of resources is necessarily appropriate for the current year, all of the activities of the organisation are re-evaluated annually from a zero base. Most importantly therefore, inefficient and obsolete activities are removed, and wasteful spending is curbed. This has got to be the biggest benefit of zero-based budgeting compared to incremental budgeting and was the main reason why it was developed in the first place.
By its nature, it encourages a bottom-up approach to budgeting in order for Z-BB to be used in practice. This should encourage motivation of employees:
It challenges the status quo and encourages a questioning attitude among managers.
It responds to changes in the business environment from one year to the next.
Overall, it should result in a more efficient allocation of resources.
Drawbacks of Z-BB
Departmental managers may not have the necessary skills to construct decision packages. They will need training for this and training takes time and money. In a large organisation, the number of activities will be so large that the amount of paperwork generated from Z-BB will be unmanageable.
Ranking the packages can be difficult, since many activities cannot be compared on the basis of purely quantitative measures. Qualitative factors need to be incorporated but this is difficult. Top level management may not have the time or knowledge to rank what could be thousands of packages. This problem can be somewhat alleviated by having a hierarchical ranking process, whereby each level of managers rank the packages of the managers who report to them.
The process of identifying decision packages and determining their purpose, costs and benefits is massively time consuming and costly. One solution to this problem is to use incremental budgeting every year and then use Z-BB every three to five years, or when major change occurs. This means that an organisation can benefit from some of the advantages of Z-BB without an annual time and cost implication. Another option is to use Z-BB for some departments but not for others. Certain costs are essential rather than discretionary and it could be argued that it is pointless to carry out Z-BB in relation to these.
Since decisions are made at budget time, managers may feel unable to react to changes that occur during the year. This could have a detrimental effect on the business if it fails to react to emerging opportunities and threats.
3) The organisation's management information systems might be unable to provide the necessary information.
Since Z-BB requires all costs to be justified, it would seem inappropriate to use it for the entire budgeting process in a commercial organisation. Why take so much time and resources justifying costs that must be incurred in order to meet basic production needs? It makes no sense to use such a long-winded process for costs where no discretion can be exercised anyway.
Incremental budgeting is, by comparison, quick and easy to do and easily understood. However, the use of incremental budgeting indisputably gives rise to inefficiency, inertia and budgetary slack.
In conclusion, neither budgeting method provides the perfect tool for planning coordination and control. However, each method offers something positive to recommend it and one cannot help but think that the optimal solution lies somewhere between the two.
(Written by a member of the (ACCA) Performance Management examining team
Last updated: 27 Jun 2017)
Where to now?
Having reviewed extracts from these two dissertations, it becomes obvious that there is a great deal more to smart budgeting than simply guess work. However it should be noted that all budget projections are subject to pure speculation based on how one interprets the budget period some three months ahead of implementation. And, right now it’s more than pretty gloomy and totally unpredictable.
In any event, how one sees a budget year is extremely subjective – especially regarding fleet replacements and additions, particularly given the current political and economic uncertainty. So now, more than ever, it essential to base future management decisions on intelligent interpretations of the local and foreign Macro and Micro-environmental trends.
Appeal to readers
We would be appreciative of your Thoughts/Questions on this important Topic before continuing with Part-2 which addresses the pitfalls of many fleet managers in regard to common errors in compiling a workable and cost-effective budget commitment.