Module-3 BUDGET AND BUGETARY CONTROL

BUDGET AND BUGETARY CONTROL

• [Link], “A budget is a written plan covering projected activities of a firm

for a definite time period.”
• Budgetary Control: Budgetary Control is a method of managing costs through
preparation of budgets. Budgeting is thus only a part of the budgetary control.

Features of Budgetary Control

1. Setting financial goals and targets: Budgetary control involves setting specific
financial goals and targets for the organization to achieve. These goals are usually
based on the company's overall strategic objectives and are used as a benchmark
for performance evaluation.
2. Monitoring and tracking financial performance: Budgetary control involves the
regular monitoring and tracking of financial performance against budgeted targets.
This allows management to identify variances and take corrective action if
necessary.
3. Cost control and reduction: Budgetary control helps in controlling and reducing
costs by providing a framework for monitoring and controlling expenses.
4. Resource allocation: Budgetary control assists in the efficient allocation of
resources by providing a framework for planning and allocating resources based on
the organization's priorities and financial capabilities.
5. Decision-making: Budgetary control provides management with the necessary
information to make informed decisions about resource allocation, investment
opportunities, and strategic planning.
6. Performance evaluation: Budgetary control enables management to evaluate the
performance of different departments and units within the organization based on
their budgetary performance.
7. Forecasting and planning: Budgetary control involves forecasting and planning for
future financial performance based on past performance and market conditions.
8. Accountability and responsibility: Budgetary control helps in creating a culture of
accountability and responsibility within the organization by assigning specific
financial targets to different departments and individuals.

Objectives of Budgetary Control

• Planning
• Co ordination
• Measurement of Success
 • Motivation
• Communication
• Control

Advantages of Budgetary Control

1. Better decision-making: Budgetary control helps organizations make better

financial decisions by providing a clear picture of the organization’s financial
situation. This helps in determining the allocation of resources and setting financial
goals.
2. Cost control: Budgetary control helps in controlling and monitoring costs, which
can help organizations in managing their cash flow and ensuring that resources are
used efficiently.
3. Performance evaluation: Budgetary control helps in evaluating the performance of
different departments and individuals, identifying areas of improvement, and
holding people accountable for their financial performance.
4. Goal setting: Budgetary control helps in setting financial goals for the organization,
which can help in aligning the efforts and resources of the organization towards
achieving those goals.
5. Forecasting: Budgetary control helps in estimating future financial needs and
identifying potential problem areas, which can assist in planning for future
scenarios and ensuring that the organization is prepared for potential financial
challenges.
6. Communication and coordination: Budgetary control encourages better
communication and coordination among different departments and individuals, as
it provides a framework for everyone to work towards common financial goals.
7. Motivation and incentive: Budgetary control can help in motivating employees by
setting clear financial targets and providing incentives for achieving them. This can
encourage better performance and commitment to financial goals.

Limitations of Budgetary Control

1. Inflexibility: Budgetary control can be inflexible, making it difficult to make

changes to the budget when unexpected events or financial challenges arise.
2. Time-consuming: Constructing and monitoring budgets can be time-consuming,
leading to a heavy administrative burden on the organization.
3. Lack of accuracy: Budgetary control relies on predicting future revenues and
expenses, which can be difficult to do accurately, especially in uncertain economic
conditions.
 4. Unrealistic targets: Budgetary control can lead to unrealistic financial targets
being set, which can demotivate employees and create a negative work
environment.
5. Focus on short-term goals: Budgetary control can encourage a focus on short-
term financial performance at the expense of long-term strategic goals and
investments.
6. Resistance to change: Budgetary control can lead to resistance to change within
the organization, as employees may be hesitant to deviate from the established
budget.
7. Limited scope: Budgetary control may only focus on financial aspects, neglecting
other important non-financial factors that impact performance.
8. Rigid hierarchies: Budgetary control can reinforce hierarchical management
structures and limit empowerment and decision-making at lower levels of the
organization.

Essentials of Effective Budgeting

• Support of top management
• Team Work
• Realistic Objectives
• Excellent Reporting System
• Structure of Budget team
• Well defined Business Policies
• Integration with Standard Costing System
• Inspirational Approach

TYPES OF BUDGETS

COVERAGE
• Functional
• Master
CAPACITY
• Fixed
• Flexible
CONDITION
• Basic Budget
• Current Budgets
PERIOD
• Long Term
• Short Term
FUNCTIONAL BUDGETS
• Sales
• Production
• Cash
• Purchase

PRODUCTION BUDGET

The production budget is prepared on the basis of estimated production for budget period.
Usually, the production budget is based on the sales budget. At the time of preparing the
budget, the production manager will consider the physical facilities like plant, power,
factory space, materials and labour, available for the period. Production budget envisages
the production program for achieving the sales target. The budget may be expressed in
terms of quantities or money or both. Production may be computed as follows:

Units to be produced = Desired closing stock of finished goods + Budgeted sales –

Beginning stock of finished goods.

PRODUCTION COST BUDGET

This budget shows the estimated cost of production. The production budget demonstrates
the capacity of production. These capacities of production are expressed in terms of cost
in production cost budget. The cost of production is shown in detail in respect of material
cost, labour cost and factory overhead. Thus production cost budget is based upon
Production Budget, Material Cost Budget, Labour Cost Budget and Factory Overhead.

PURCHASE BUDGET

Strategic planning of purchases offers one of the most important areas of reduction cost in
many concerns. This will consist of direct and indirect material and services. The
purchasing budget may be expressed in terms of quantity or money.

The main purposes of this budget are:

• It designates cash requirement in respect of purchase to be made during budget

period
• It is facilitates the purchasing department to plan its operations in time in respect of
purchases so that long term forward contract may be organized.
SALES BUDGET

• The sales budget is an estimate of total sales which may be articulated in financial
or quantitative terms. It is normally forms the fundamental basis on which all other
budgets are constructed.

In practice, quantitative budget is prepared first then it is translated into economic terms.
While preparing the Sales Budget, the Quantitative Budget is generally the starting point in
the operation of budgetary control because sales become, more often than not, the
principal budget factor.

The factor to be consider in forecasting sales are as follows:

• Study of past sales to determine trends in the market.

• Estimates made by salesman on various markets of company products.
• Changes of business policy and method.
• Government policy, controls, rules and Guidelines etc.
• Potential market and availability of material and supply.

CASH BUDGET

The cash budget is a sketch of the business estimated cash inflows and outflows over a
specific period of time. Cash budget is one of the most important and one of the last to be
prepared. It is a detailed projection of cash receipts from all sources and cash payments
for all purposes and the resultants cash balance during the budget. It is a mechanism for
controlling and coordinating the fiscal side of business to ensure solvency and provides the
basis for forecasting and financing required to cover up any deficiency in cash. Cash
budget thus plays a vital role in the financing management of a business undertaken. Cash
budget assists the management in determining the future liquidity requirements of the
firm, forecasting for business of those needs, exercising control over cash. So, cash budget
thus plays a vital role in the financial management of a business enterprise.

Function of Cash Budget

• It makes sure that enough cash is available when it is required.

• It designates cash excesses and shortages so that steps may be taken in time to
invest any excess cash or to borrow funds to meet any shortages.
• It shows whether capital expenditure could be financed internally.
• It provides funds for standard growth.
• It provides a sound basis to manage cash position.
Advantages of Cash Budget

1. Usage of Cash: Management can plan out the use of cash in accord with the
changes of receipt and payment. Payments can be planned when sufficient cash is
available and continue the business activity with the minimum amount of working
capital.
2. Allocation for Capital Investment: It is dual benefits such as capital expenditure
projects can be financed internally and can get an idea for cash availability of
capital investment.
3. Provision of Excess Funds: It reveals the availability of excess cash. In this regard
management can decide to invest excess funds for short term or long term
according to the requirements in the business.
4. Pay out Policy: This budgetary system may help the management for future pay out
policy in the form of dividend. In case the cash budget liquid position is not
favourable, the management may reduce the rate of dividend or maintain dividend
amount or skip dividend for the year.
5. Provision for acquiring Funds: It gives the top level management ideas for
acquiring funds for particular time duration and sources to be explored.
6. Profitable Use of Cash: Business person can take decision for the best use of
liquidity to make more profitable transaction. It can be used at the time of bulk
purchase payments and one get the benefit of discount.

Limitation of Cash Budget

1. Complex Assumption: Business is full of uncertainties, so it is very difficult to have

near perfect estimates of cash receipts and payments, especially for a longer
duration. It can be predicted for short duration such as of three to four months.
2. Inflexibility: If the finance manager fails to show flexibility in implementing the cash
budget, it will incur adverse effects. If the manager follows strictly adheres to the
estimates of cash inflow, it may negatively result in losing customers. Likewise,
loyalty in payments may lead to deterioration of liquid position.
3. Costly: Application of this technique necessitates collecting of statistical
information from various sources and expert personnel in operation research would
be the costliest deal. It becomes expensive which may not be affordable to small
business houses.

In addition, finding out experts is not always possible. In this situation the long term
predictions do not prove correct.
Methods

1. Receipt and payment: It is most popular and is universally used for preparing cash
budget. The assumption of statistical data is arrived at calculated on the basis of
requirements like monthly, weekly or fortnightly. On account of elasticity, this
method is used in forecasting cash at different time periods and thus it helps in
controlling cash distributions. (a) Cash receipts from customers are based on sales
forecast. The term of sale, lag in payment etc., are generally taken into
consideration. (b) Cash receipts from other sources, such as dividends and interest
on trade investment, rent received, issue of capital, sale of investment and fixed
assets. (c)Cash requirements for purchase of materials, labour and salary cost and
overhead expenses based on purchasing, personnel and overhead budgets. (d)
Cash requirements for capital expenditure as per the capital expenditure budget. (e)
Cash requirements for other purposes such as payment of dividends, income tax
liability, fines and penalties.
a) Estimating Cash Receipts: Generally main sources of cash receipts are sales,
interest and dividend, sales of assets and investments, capital borrowings etc. The
Company estimates time lag on the basis of past experience of cash receipts on
credit sales while cash sales can be easily determined.
b) Estimating Cash Payments: It can be decided on the basis of various operating
budgets prepared for the payment of credit purchase, payment of labour cost,
interest and dividend, overhead charges, capital investment etc.
2. Adjusted Profit and Loss Account: This method is based on cash and non cash
transactions. This method estimates closing cash balance by converting profit into
cash. The hypothesis of this method is that the earning of profit brings equal amount
of cash into the business. The net profit shown by profit and loss account does not
signify the actual cash flow into the business. This also leads to another
assumption, that is the business will remain static, i.e. there will be no wearing out
or increase of assets and changes of working capital so that the total cash on hand
for the business would be equal to the profit earned.
3. Budgeted Balance Sheet Method: This method looks like the Adjusted Profit and
Loss Account method only, except that in this method a Balance sheet is projected
and in that method Profit and loss Account is adjusted. In this method Balance
sheet is prepared with the projected amount of all assets and liabilities except cash
at the end of budget period. The cash balance will find out balancing amount. If
assets side is higher than liability side it would be the bank overdraft while liability
side is higher than assets side it gives bank balance. This method is used by the
stable business houses.
 4. Working Capital Differential Method: It is based on the estimate of working
capital. It begins with the opening working capital and is added to or deducted from
any changes made in the current assets except cash and current liabilities. At the
end of the budget period balance shows the real cash balance. This method is quite
similar to the Balance Sheet method.

FIXED BUDGET

Budget which is designed to remain unchanged irrespective of the volume of output.

FLEXIBLE BUDGETS

This is a dynamic budget. In comparison with a fixed budget, a flexible budget is one “which
is designed to change in relation to the level of activity attained.” An equally accurate use of
the flexible budgets is for the purposes of control. Flexible budgeting has been developed
with the objective of changing the budget figures so that they may correspond with the
actual output achieved. It is more sensible and practical, because changes expected at
different levels of activity are given due consideration. Thus a budget might be prepared for
various levels of activity in accord with capacity utilization.

Flexible budget may prove more useful in the following conditions:

• Where the level of activity varies from period to period.
• Where the business is new and as such it is difficult to forecast the demand.
• Where the organization is suffering from the shortage of any factor of production.
For example, material, labour, etc. As the level of activity depends upon the
availability of such a factor.
• Where the nature of business is such that sales go on changing.
• Where the changes in fashion or trend affects the production and sales.
• Where the organization introduces the new products or changes the patterns and
designs of its products frequently.
• Where a large part of output is intended for the export.

Uses of Flexible Budget

1) Performance Evaluation: Flexible budgets allow for comparison of actual results

with budgeted amounts based on the actual level of activity. This helps in evaluating
the performance of a business unit or department.
2) Cost Control: Flexible budgets can help in controlling costs by providing a
benchmark to compare actual expenses with budgeted amounts at various levels of
activity. This can help in identifying and addressing variances in a timely manner.
 3) Resource Allocation: Flexible budgets can assist in determining the optimal
allocation of resources based on the actual level of activity. This can help in making
informed decisions regarding resource allocation to different areas of the business.
4) Decision Making: Flexible budgets can be used as a tool for decision making, such
as determining the profitability of new projects or the impact of changes in the level
of activity on costs and revenues.
5) Forecasting: Flexible budgets can be used as a basis for forecasting future
performance based on different levels of activity. This can help in predicting the
financial impact of changes in the business environment.
6) Planning and Budgeting: Flexible budgets can help in the planning and budgeting
process by allowing for adjustments based on changes in the level of activity. This
can help in developing more realistic and achievable budgets.
7) Communication: Flexible budgets can be used to communicate financial targets
and expectations to managers and employees at different levels of the organization.
This can help in aligning efforts with the overall financial goals of the business.

Preparation of a Flexible Budget

The preparation of a flexible budget requires the analysis of total costs into fixed and
variable components. This analysis of course is, not unusual to the flexible budgeting, is
more important in flexible budgeting then in fixed budgeting. This is so because in flexible
budgeting, varying levels of output are considered and each class of overhead will be
different for each level. Thus the flexible budget has the following main distinguishing
features:

• It is prepared for a range of activity instead of a single level.

• It provides a dynamic basis for comparison because it is automatically related to
changes in volume. The formulation of a flexible budget begins with analyzing the
overhead into fixed and variable cost and determining the extent to which the
variable cost will vary within the normal range of activity.

There are two methods of preparing such a budget

1. Formula Method / Ratio Method: This is also known as the Budget Cost
Allowance Method. In this method the budget should be prepared as follows:
a) Before the period begins:
• Budget for a normal level of activity,
• Segregate into fixed and variable costs,
• Compute the variable cost per unit of activity
b) At the end of the period:
 • Ascertain the actual activity
• Compute the variable cost allowed for this level, add the fixed
cost to give the budget cost allowance. The whole process is
expressed in the formula: Allowed cost = Fixed cost + (Actual
units of activity for the period) (Variable cost per unit of
activity)
2. Multi Activity Method:
• This method involves computing a budget for every major level of activity. When the
actual level of activity is known, the allowed cost is found “interpolating” between
the budgets of activity levels on either side.
• Different levels of activity are expressed in terms of either production units or sales
values. The levels of activity are generally expressed in production units or in terms
of sales values.
• The fixation of the budget cost gives allowance for the budget centres. According to
CIMA London, the budget cost allowance means, “the cost which a budget centre is
expected to incur during a given period of time in relation to the level of activity
attained by the budget centre.“
• The determination of the different levels of activity for which the flexible budget is to
be prepared.
❖ Graphic Method: In this method, estimates of budget are presented graphically. In
this costs are divided into three classes, viz., fixed, variable and semi variable cost.
Values of costs are obtained for different levels of production. These values are
signified in the form of a graph.

ZERO BASE BUDGET

• The ‘Zero Base’ refers to a ‘nil budget’ as the starting point. It starts with a
presumption that the budget for the next period is ‘zero’ until the demand for a
function, process, or project is not justified for single penny. The assumption is that
without such justification, no expenditure will be allowed. In effect, each manager
or functional head is required to carry out cost benefit analysis of each of the
activities, etc. Under his control and for which he is responsible. The method of ZBB
suggests that the business should not only make decision about the proposed new
programmes but it should also, regularly, review the suitability of the existing
programmes. This approach of preparing a budget is called incremental budgeting
since the budget process is concerned mainly with the increases or changes in
operations that are likely to occur during the budget period.
• This method for the first time was used by the department of Agriculture, U.S.A. in
the 19th century. Other State Governments of the U.S.A. found this method helpful
 and so almost all the states took deep interest in the ZBB method. A number of
states of America use this technique even today. The ICAI has brought out a
research in the form of a monograph showing the application of the ZBB method
that worries in tandem with the concerns for national environment and its
requirements. In India, however, the ZBB approach has not been fully accepted and
actualized. “ZBB is a management tool, which provides a systematic method for
evaluating all operations and programmes, current or new, allows for budget
reductions and expansions in a rational manner and allows re allocation of sources
from low to high priority programmes.” David Lieninger.
• ZBB is a planning, resource allocation and control tool. It, however, presupposes
that
a. There is an efficient budgeting system within the enterprise.
b. Managers can develop quantitative measures for use in performance evaluation.
c. Among the new suggestions and programmes, along with old ones are put to a strict
scrutiny.
d. Funds are diverted from low priority suggestions to high priority suggestions.

Procedure of Zero Base Budgeting:

1) Determination of the objective: This is an initial step for determining the objective
to introduce ZBB. It may result into the decreased cost in personnel overheads or
debunk the projects which do not fit in the business structure or which are not likely
to help accomplish the business objectives.
2) Degree at the ZBB is to be introduced: It is not possible every time to evaluate
every activity of the whole business. After studying the business structure, the
management can decide whether ZBB is to be introduced in all areas of business
activities or only in a few selected areas on the trial basis.
3) Growth of Decision units: Decision units submit their data as to which cost benefit
analysis should be done in order to arrive at a decision that helps them decide to
continue or abandon. It could be a functional department, a programme, a product
line or a sub line.
4) Growth of Decision packages: Decision units are to be identified for preparing data
relating to the proposals to be included in the budget, concerned manager analyzes
the activities of his or her own decision units.
5) Assessment and Grading of decision packages: These packages invented and
formulated are submitted to the next level of responsibility within the organization
for ranking purposes. Ranking basically decides as to whether or not to include the
proposals in the budget.
 6) Allotment of money through Budgets: It is the last step engaged in the ZBB
process. According to the cost benefit analysis and availability of the funds,
management has ranks and thereby a cut off point is established. Keeping in view
reasonable standards, the approved designed packages are accepted and others
are rejected.

Advantages of Zero Base Budget

1) Elimination of wasteful spending: By requiring departments to justify all expenses

from scratch, zero-based budgeting can help identify and eliminate unnecessary
and wasteful spending.
2) Focus on efficiency: Zero-based budgeting provides an opportunity to re-evaluate
existing processes and programs, encouraging a focus on efficiency and
effectiveness in resource allocation.
3) Alignment with organizational goals: Since every item in the budget is justified
based on its contribution to organizational goals, zero-based budgeting ensures that
resources are allocated in a way that aligns with the overall objectives of the
organization.
4) Increased accountability: Zero-based budgeting promotes greater accountability
as it requires departments to provide detailed justifications for all expenses,
fostering a culture of responsible budget management.
5) Enhanced transparency: The detailed analysis and justification of each expense in
zero-based budgeting leads to increased transparency in budgeting processes,
enabling stakeholders to understand how and why resources are being allocated.
6) Flexibility: Zero-based budgeting allows for a flexible allocation of resources,
enabling organizations to adapt to changing circumstances and prioritize the most
critical needs.
7) Encouragement of innovation: By re-evaluating all expenses from zero, zero-based
budgeting encourages departments to seek new and innovative ways to deliver
services and programs, leading to improvements in creativity and problem-solving.

Disadvantages of Zero Base Budget

1) Time-consuming: Zero-based budgeting requires a significant amount of time and

effort to create and implement, as it involves the complete re-evaluation of every
budget line item.
2) Resource-intensive: Zero-based budgeting can be demanding in terms of human
resources, as it requires the involvement of various departments and individuals in
the budgeting process.
 3) Lack of historical perspective: Zero-based budgeting does not take into account
historical spending patterns and may not consider long-term trends, which can lead
to short-term cost-cutting at the expense of long-term goals.
4) Potential for resistance: Zero-based budgeting may face resistance from
managers and employees who are accustomed to traditional budgeting methods
and may be skeptical of the need for a complete overhaul of the budgeting process.
5) Complexity: The process of evaluating each budget line item from scratch can be
complex and may require specialized knowledge and skills, making it challenging for
some organizations to implement.
6) Risk of overlooking essential expenses: Zero-based budgeting may lead to the
omission of essential expenses that are not immediately apparent, potentially
compromising the organization's operations and future growth.

PERFORMANCE BUDGET

• A budget performance report is a management report that compares the actual

revenues and costs for a period with the budgeted revenues and costs based on the
actual sales volume. In other words, it’s a report that shows the difference between
the actual company performance and the budgeted performance.
• Performance-based budgeting is the practice of developing budgets based on the
relationship between program funding levels and expected results from that
program. The performance-based budgeting process is a tool that program
administrators can use to manage more cost-efficient and effective budgeting
outlays.

RESPONSIBILITY ACCOUNTING

• Responsibility accounting is a controlling system under management accounting

where responsibilities are assigned to control unnecessary costs. Controlling costs
begins with delegating the proper authority to the individuals capable of performing
work with the standards.
• Responsibility accounting is a management control system used to evaluate the
performance of individual managers or departments within an organization. This
involves assigning specific responsibilities to managers or departments and then
holding them accountable for the results of their actions.
• The key components of responsibility accounting include:-

1. Establishing clear and specific performance objectives for each manager or

department.
 2. Allocating financial resources to each manager or department based on their
responsibilities and expected performance.
3. Measuring and evaluating the performance of each manager or department
using key performance indicators (KPIs) and other metrics.
4. Holding managers or departments accountable for their performance
through rewards or consequences.

Responsibility accounting helps to improve the overall performance of an organization by

ensuring that individual managers or departments are focused on achieving their specific
objectives and are held accountable for their results. It also provides a framework for
evaluating and rewarding individual performance within the organization.