Question

Pretorious Manufacturing has just hired a new controller, Diana Metcalf. During her first week on the job, Diana was asked to establish a budget for operating expenses in 2014. Since Diana was not yet familiar with the operations of Pretorious Manufacturing, she decided to budget these expenses using the same procedures as the prior controller. Therefore, in order to establish a budget for operating expenses, Diana started with actual operating expenses incurred in 2013 and added 4.3 percent. Diana based this percentage on inflation as measured by the consumer price index.

Comment on the effectiveness of Diana’s budgeting strategy.

Answer 1

Diana’s budgeting strategy is not an effective strategy at all. The basis is the figures for last year and so Diana is using an incremental budget for 2014. This method of budgeting is not appropriate due to several reasons:

Firstly Diana has based her estimates on the actual operating expenses incurred during last year i.e. in 2013. This is not a correct approach as this approach is clearly ignoring the impact of volume changes in 2014 compared to 2013. Volume changes will clearly affect operating expenses and an increase in volumes will cause the operating expenses to increase and vice versa. Thus the assumption that the activities and methods of working in 2014 will continue in the same way as in 2013 is a faulty assumption.

Secondly in 2014 there might be certain changes in operations of Pretorious Manufacturing. Hence Diana will have to clearly differentiate fixed operating costs and variable operating costs while preparing the budget. This differentiation will enable her to develop a precise budget for 2014.

The effective strategy for Diana would have been to use a zero based budgeting. Under this method she will have to justify all the operating expenses for 2014 and for subsequent new periods for which budget will be prepared.