Chapter 2 MANAGEMMENT CONTROL SYSTEMS PROCESS

BUDGET PREPARATION AND CONTROL

Determination of objectives and goals of an organization are a primary steps taken by any management. Such
objectives must be clearly defined. Objectives may be short term or long term. However, it is necessary to prepare
a comprehensive plan to transform these objectives into reality. Thus, there is a need for precise planning
mechanism and thorough control systems to fulfill the pre-determined objectives. Planning facilitates systematic
work towards achieving the objectives and controlling helps to review the progress made and to monitor whether
the work is progressing as per the plan or not. Budgeting is a technique that helps in planning as well as
controlling. It is a technique of cost accounting with the twin objectives of facilitating planning and ensuring
controlling.

BUDGET:
The Chartered Institute of Management Accountants, London, defines a budget as ‘a financial and/or
quantitative statement prepared prior to a defined period of time, of the policy to be pursued during that
period for the purpose of achieving a given objective.’ Thus, a budget is a detailed plan of operations for some
specific future period. It is an estimate prepared in advance of the period to which it applies.

Features of a Budget:
a) A budget is prepared in advance and is based upon a future plan of actions. E.g. budget for next quarter, next
year etc.
b) A budget is a prepared either in money terms and/ or physical units. E.g. sales budget in sales units and
revenue expected.
c) A budget is prepared for the definite future period. E.g. budget for FY 2015-16 etc.
d) The policy to be followed must be clear and definite and it must be laid down before the budget is prepared.
e) All departments of an organization co-operate and coordinate to prepare the budgets.
f) A budget is a written document.
g) A budget needs to be updated and corrected at every instance of change in circumstances. This it is a
continuous process.
h) Budgets help in planning, coordination and control.

BUDGETARY CONTROL:
The Charted Institute of Management Accountants, London defines Budgetary Control as “ the establishment of
budgets, relating the responsibilities of executive to the requirements of a policy and the continuous
comparison of actual with budgeted results either to secure by individual action the objectives of that
policy or to provide a firm basis for its revision”. It is a system of management control and accounting in
which all the operations are forecasted and planned in advance and results are compared with actual outcome.

Steps of Budgetary Control:

1. Study the environment (internal & external) and forecasting,
2. Establish Budgets, for various functions and operations,
3. Collecting and systematically recording actual performance,
4. Compare actual outcome with budgeted data,
5. Fix responsibilities for under-achievement and take corrective action,
6. Revise budgets, if necessary.

We can say that budgeting is the art of planning and budgetary control is the act of sticking to the plan. In fact,
budgetary control involves continuous comparison of actual results with the budgets and taking appropriate
remedial action promptly. The success of budgetary control depends on proper basis of measurement to evaluate
performance and efficiency.

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Objectives of Budgetary Control:

1. Planning – a well defined plan helps an organization to use the scarce resources in an efficient manner and
thus achieving the predetermined targets becomes easy.
2. Co-ordination – to co-ordinate different levels of management for achievement of the objectives, e.g. sales
manager will consult the production manager before committing any deadlines to the customer.
3. Control – budgets facilitate centralized control with delegated authority and responsibility. Budgets provide a
basis for controlling through comparison of actual with budgeted performance.
4. Profitability – to achieve maximum profitability by proper planning and ensuring economic use of available
resources.
5. Assessment – by laying down responsibilities of executives and other personnel so that everyone knows what
is expected of him and how he will be judged. Budgetary control is a technique for an objective assessment of
executives.
6. Loss reduction – to reduce losses and wastages to the minimum, through adequate planning and control.
7. Focus – to see that the firm is not diverted from its long term objectives and focused on its targets.

Advantages of Budgetary Control:

1. Budgetary control aims at maximization of profits through effective planning and control.
2. Budgetary control ensures the smooth functioning of various departments of an organization.
3. There is a planned approach to expenditure and financing of the business. This facilitates best utilization of
funds and reduces wastages and losses. It is a powerful tool for controlling expenditure.
4. Budgets provide a clear definition of the objective and policies of the concern.
5. Better managerial co-ordination is facilitated through budgetary control.
6. There is effective and efficient utilization of men, materials and resources, since each level of management is
aware of their authority and responsibilities.
7. Reporting is done on a periodical basis for continuous control. Thus, it facilitates the principles of
Management by Exception. The concerned managerial personnel are involved only in deviations from
budgets showing the weak spots and inefficiencies.
8. Budgeting encourages the habit of forward thinking, making careful study of future problems and taking
decisions.
9. The method of evaluating performance against budgets provides a suitable basis for establishing incentive
system of remuneration by results as also spotting people with exceptional qualities of leadership and
management.

FORECAST
A budget typically includes forecasts of expected revenues, expenses, and other financial aspects for a specific
period, such as a fiscal year. It helps managers to plan for the future. Given uncertainty about the future, however,
it is quite likely that a budget will become outdated as events occur and so the budget will cease to be a realistic
forecast. New forecasts might be prepared that differ from the budget. While a forecast is what is likely to happen;
a budget is what an organisation wants to happen. There is significant difference between the two concepts. The
differences are categorised below:

Forecasts Budget
Forecasts is mainly concerned with anticipated or Budget is related to planned events.
probable events
Forecasts may cover for longer period (often in excess Budget is planned or prepared for a shorter period.
of a year).
Forecast is only a tentative estimate. Budget is a target fixed for a period.
Forecast results in planning. Result of planning is budgeting.
The function of forecast ends with the forecast of The process of budget starts where forecast ends and
likely events. converts it into a budget.
Forecast usually covers a specific business function. Budget is prepared for the business as a whole.
Forecasting does not act as a tool of controlling Purpose of budget is not merely a planning device but
measurement. also a controlling tool.

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INSTALLATION OF BUDGETARY CONTROL:

Budgetary Control is extremely useful for planning and controlling the business operations. But, for successful
implementation of a budgetary control system, certain preparations or pre-requisites are to be fulfilled. They are
summarized below:

A) Organizational Chart
There should be an organization chart laying out in clear terms the responsibilities and duties of each level of
executives and the delegation of authority to the various levels. The organization chart will define clearly the
functions to be performed by each executive relating to the budget preparation and his relationship with other
executives. The organization chart may have to be adjusted to ensure that each budget is controlled by an
appropriate member of the staff.

B) Budget Centre
A budget centre is a group of activities or section of an organization for which budget can be developed. For
example – manpower planning budget, R & D budget, labour hours budget, production cost budget etc.
Budget centres should be clearly defined so that budget preparation becomes easy. Budget centre is established
for cost control and all the budgets should be related to cost centres.

C) Budget Committee
The budget committee is a group of representatives of various functions in an organization. The committee
consists of Chief Executives or Head of Dept. of various functions. The main function of a budget committee
–
i. to receive estimates and forecasts,
ii. to prepare budgets,
iii. scrutinize these budgets,
iv. to lay down broad policies regarding the preparation of budgets,
v. to approve the budgets,
vi. to suggest for revision,
vii. to monitor the implementation,
viii. to recommend the action to be taken in a given situation

D) Budget Period
A budget is always prepared prior to a definite period of time. According to C.I.M.A London, budget period is
defined as “the period for which a budget is prepared and used, which may then the sub-divided into control
periods”. It refers to the period of time covered by a budget. In deciding the length of the budget period
certain factors should be considered such as production cycle, seasonal nature, availability of funds,
production methods, reporting durations etc.
A budget period is a period for which budget is prepared while a control period is the periodical interval for
preparation of reports and sending them to the management for review, interpretation and corrective action.

E) Budget Manual
A budget manual is a document that lays down the responsibilities of persons engaged in budgetary control.
The manual is in the form of a booklet explaining the procedures, formats and records relating to the
preparation and use of budgets and instructions to be followed. A typical budget manual contains the
following:
i. Objectives and managerial policies of the organization,
ii. Structure of authority and responsibility,
iii. Functions of budget committee,
iv. Submission due dates of preliminary forecasts,
v. Budget period,
vi. Forms in which various reports are to be prepared, their periodicity, personnel to whom reports are to be
sent;
vii. The matters on which action may be taken only with the approval of top management.
viii. Follow up procedures
The main purpose of the budget manual is to inform the executives in advance about procedures to be
followed rather than issuing frequent instructions.

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F) Budget Controller
A Budget Controller is appointed to monitor the various functions of Budget Committee and to co-ordinate
their efforts for preparation of target figures. The Budget Controller does not control, he is staff man and a
link between various functional departments. His duties will comprise mainly of:
i. Helping in preparation of the various budgets and their coordination and compilation into the master
budget.
ii. Compiling of information about actual performance on a continuous basis comparing it against the budget
figures, ascertaining causes of deviation, and preparing reports based thereon and sending them to the
appropriate executive.
iii. Bringing to the notice of the management the need for revision of budgets are assisting them in the task;
and
iv. Compiling information of all types for the purpose of efficient preparation of budgets and proper
reporting.

G) Budget Key Factor

A budget key factor or principal budget factor is defined as ‘a factor which will limit the activities of an
undertaking and which is taken into account in preparing budgets’. A key factor is also known as limiting
factor which would restrict the activities of an organization. Thus, a key factor has to be considered while
preparing budgets. Examples of budget key factor are sales demand, shortage of raw materials, lack of skilled
labour or inadequate machine capacity etc. The management should verify the influence of the key factor on
the budget. If the sales demand is only 50,000 units, it is no use of producing 100,000 units. Also, if
production capacity is 50,000 units, a sales potential of 100,000 units is of no importance. Decisions will have
to be taken resulting in optimum production keeping in view the different limiting factors. Thus, we can say
that a key factor is the starting point in process of budget preparation.
The following is a list of principal budget factors which will influence the targets:
i. Sales - customer demand, pricing policy, shortage of sales staff, inadequate advertising budget
ii. Material – supply of raw material, restrictions on imports
iii. Plant capacity – availability of free machine hours, no. of machines etc.
iv. Labour - availability of skilled labour, as well as casual, unskilled labour, wages etc.
v. Funds – long term and short term capital available at a low cost,
vi. Governmental restrictions etc.

H) Budget Reports
It is essential that the accounting system should be able to record and analyze the transactions involved.
Performance evaluation and reporting of variances is an integral part of all control systems. Thus, budget
reports showing the comparison between the actual and budgeted expenditure should be presented
periodically and promptly. The report should be prepared to give complete reasons for the differences so that
proper corrective action may be taken. The variations / deviations from budgets are analyzed for each item, so
as to locate the responsibility and facilitate corrective action. To prepare an effective budget report, it must be:
i. Simple to understand, containing a suitable heading and budget period,
ii. Regularly and promptly presented,
iii. Should avoid unnecessary details,
iv. Quantitative data analysis,
v. Free from personal bias of the person preparing it; and
vi. Dated and signed by those who prepare and check it.

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BUDGET PREPARATION PROCESS

Types of budgeting process This budgeting process involves preparing the budget by the company’s senior
management based on the company’s objectives. The departmental managers are assigned the responsibility for its
successful implementation. Every department can opt to create its own budget based on the company’s broader
budget allocation and goals. The following are the four budgeting processes which are classified on the basis of the
participation of the budget holders.
 Bottom-Up Budgeting – this is the budgeting process where all budget holders have the opportunity to
participate in setting their own budgets.
 Imposed/Top-Down Budgeting – this is the budgeting process where budget allowances are set without
permitting ultimate budget holders the opportunity to participate in the process.
 Negotiated Budget – this is the budgeting process in which budget allowances are set largely on the basis of
negotiations between budget holders and those to whom they report.
 Participative Budgeting – Participative budgeting involves employees from lower levels who give their
input about the cost allocation. It allows lower-level employees to feel a sense of ownership and belonging to
the organisation, as they feel that they are an important part of the budgeting process. Thus, it is often reffred
as bottom – up budgeting.

STAGES OF BUDGETING PROCESS

The important stages of the budgeting process are as follows:
1. communicating details of budget policy and guidelines to those people responsible for the preparation of
budgets;
2. determining the factor that restricts output;
3. the order of preparation of budget;
4. negotiation of budgets with superiors;
5. final acceptance of budgets;
6. ongoing review of budgets.

Step One - Communicating details of the budget policy

The annual budget is only an implementation part of the long-range plan. Top management must communicate
the policy effects of the long-term plan to those responsible for preparing the current year’s budgets. Policy effects
include planned changes in sales mix, or the expansion or contraction of certain activities. Thus, preparation of the
sales budget is the starting point.

Step Two - Determining the factor that restricts performance

In every organisation there are factors that restricts performance for a given period. In the majority of
organisations this factor is sales demand. These factors that restrict performance are referred as principal budget
factor. CIMA Official Terminology1 defines the principal budget factor as factors that limits the activities of an
undertaking. The document states that identification of the principal budget factor is often the starting point in the
budget setting process. Often the principal budget factor will be sales demand but it could be production capacity
or material supply. The principal budget factor may also be machine capacity, distribution and selling resources,
the availability of key raw materials or the availability of cash. Once this factor is defined then the remainder of the
budgets can be prepared. For example, if sales are the principal budget factor then the production manager can
only prepare his budget after the sales budget is complete.

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Step Three - The Order of Budget Preparation

Assuming that the principal budget factor has been identified as being sales, the order of budget preparation is
summarised as follows:
a. The sales budget is prepared in units of product and sales value. Along with this the finished goods inventory
budget should have to be prepared simultaneously.
b. With the information from the sales and inventory budgets, the production budget is to be prepared. The
production budget will be stated in terms of units.
c. This leads on logically to budgeting the resources for production. This involves preparing a materials usage
budget, machine usage budget and a labour budget.
d. Sequentially, a materials inventory budget will have to be prepared, to decide the planned increase or decrease
in the level of inventory held. Once the raw materials usage requirements and the raw materials inventory
budget are known, the purchasing department can prepare the raw material purchases budget.
e. During the preparation of the sales and production budgets, the managers of the cost centres of the
organisation will prepare their draft the department overheads costs budgets. Such overheads will include
maintenance, stores, administration, selling and research and development.
f. From the above information a budgeted income statement has to be prepared.
g. For the preparation of budgeted statement of financial position, the capital expenditure budget (for
noncurrent assets), the working capital budget (for budgeted increases or decreases in the level of receivables
and accounts payable as well as inventories), and a cash budget have to be prepared.

Step Four - Negotiation of budgets

To implement a participative approach to budgeting, the budget should be originated at the lowest level of
management and the managers at this level should submit their budget to their superiors for approval.

Step Five - Final acceptance of the budgets

When all the budgets are in harmony with each other, they are summarized into a master budget consisting of a
budgeted profit and loss account, a balance sheet and a cash flow statement. Only when the master budget is
accepted by the top management and is in consonance with all the other budgets, the top management is nods its
final acceptance. This is possible only after sufficient negotiation has taken place over the budgets between the
budget holder and the superiors.

Step Six - Budget review

The budget process should not stop when the budgets have been agreed. Periodically, the actual results should be
compared with the budgeted results. This is a continuous process and is like the feedback loop. It can be
concluded that the most important aspect of the process is the identification of the principal budget factor or key
budget factor. If it is not stated specifically then sales are considered as the principal budget factor. On the basis of
this, the preparation stage of the process ensues with the preparation of the sales budget and ends with the
preparation of the master budget.

CLASSIFICATION OF BUDGETS:
 Functional and Master Budgets
Budgets for a period are classified according to the various activities / functions of the organization. All such
activities are interrelated. The forecasts for individual activities are prepared and then co-ordinated with other
activities. A consolidated budget is prepared to show the total effect of all the activities as a whole. Approved
targets for individual functions are known as ‘Functional Budgets’. The consolidation of all functional budgets
is known as the ‘Master Budget’. Principal functional budgets:

1. Sales Budget
The sales budget is a forecast of total sales, expressed in terms of money and quantity. A sales budget may
be prepared product-wise, territory-wise, country-wise, customer group-wise, month-wise, weekly etc. The
first step in preparation of sales budget is to forecast as accurately as possible the sales anticipated during
the budget period. Sales forecasts are influenced by various factors such as past sales figures, seasonal
fluctuations, customer preferences, level of competition, data from distributors / dealers, demography,
pricing policy, government policy etc.
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2. Production Budget
The production budget is a forecast of the production target to be achieved for budget period. A
production budget is prepared in quantity as well as monetary terms, i.e. production units’ budget and the
production cost budget. The main steps involving in the preparation of a production budget are
production planning – after considering production capacity, integration with sales forecast, inventory-
policy and management’s overall policies. Emphasis should be given to the key factor. The purpose of a
production budget is optimum utilization of productive resources of the enterprise, scheduled production
of goods, achievement of customer delivery dates etc.

3. Materials Purchases Budget

Materials Purchase Budget, commonly known as Materials Budget, facilitates the Purchase department in
suitably planning the material purchases. Production budget is the base for preparation of material budget.
If the raw material availability is the key factor, it becomes the starting point. This budget is prepared in
quantity as well as in the monetary terms and helps in planning the funds for purchases of raw materials.
Availability of storage space, financial resources, various levels of materials like maximum, minimum, re-
order and economic order quantity are taken into consideration while preparing this budget.

4. Cash Budget
Cash budget is a monthly estimate of cash which would be required and available in a future period.
Generally, this budget has two parts showing detailed estimates of cash receipts and cash payments. The
main purpose of cash budget is to predict the receipts and payments in cash so that the firm will be able to
find out the cash balance at the end of the budget period. This will help the firm to know whether there
will be surplus cash or deficit at the end of the budget period. It will help them to plan for either investing
surplus or raise necessary amount to finance the deficit. Also, decisions may be taken on controlling credit
policy, managing seasonal fluctuations etc.
Cash receipts include estimated cash-sales, collections from debtors, sale of assets, borrowings, issue of
shares, dividends received etc. Estimates of cash disbursements include cash purchases, payment to
creditors, employees’ remuneration, bonus, advances to suppliers, interest on loan, income tax, fixed asset
purchase etc.

The usefulness of cash budgets The cash budget is a very important planning tool that an organisation can
use. It acts as a cash summary and shows the cash effect of all plans made within the budgetary process.
Preparing a cash budget is an essential aspect of financial planning and control, offering valuable insights
into the organization’s cash flow dynamics and enabling proactive management of liquidity, budgetary
performance, and financial risks. The cash position and the appropriate action for each are classified
below:

i. Short term surplus – in case this is projected by the cash budget, the management may take the
following actions:
 make short term investments
 make early payments to the suppliers to obtain discount
 invest in receivables and inventories to increase sales.

ii. Short-term shortfall - in case this is projected by the cash budget, the management may take the
following actions:
 arrange for overdraft if the situation demands
 take necessary arrangements to reduce receivables
 delay payments of accounts payable to the extent possible without incurring additional costs like
forgoing of discount.

iii. Long-term surplus - in case this is projected by the cash budget, the management may be said to be in
suitable position and should take up the following actions:
 make strategic plans to expand and diversify
 the firm should make arrangements to make long term investments
 Acquisition of fixed assets can also be considered.

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iv. Long-term shortfall – in case this is projected by the cash budget, the management may be said to be in
suitable position and should take up the following actions:
 Raise long term finance by issue of equity and other long term source
 Consider shut down of operations or divestment
 Consider other retrenchment strategies.

5. Capital Expenditure Budget

Capital expenditure budget is related to purchase of fixed assets. Capital expenditure is a long-term
forecast covering over a year to five years. It is essential that capital expenditure budget be properly co-
ordinated with other functions budgets, so as to form an integral part of the overall plan. The purpose of
capital expenditure is to increase the earning capacity of the firm in the long run. Capital expenditure
results in either acquisition of fixed asset or permanent improvement in the existing fixed assets. Another
important feature of capital expenditure is that the amount involved is very heavy and such decisions are
irreversible. Hence, careful planning is required for capital expenditure.

6. Direct Labour Budget

The labour required for production process is determined in terms and grades of workers required and the
labour time for each job, operation and process. The rates of pay, allowances, bonus, etc., of each category
are then considered and labour cost to be set for each budget centre is calculated.

7. Manufacturing Overhead Budget

This budget is prepared for planning of the factory overheads to be incurred during the budget period. In
this budget the overheads should be shown department-wise so that responsibility can be fixed on proper
persons. Classification of factory overheads into fixed and variable components should also be shown in
this budget.

8. Administration Cost Budget

This budget covers the administrative (office) costs for non-manufacturing business activities. The
administrative overheads include expenses like office expenses, accounting charges, office salaries,
directors’ remuneration, legal expenses, audit fees, rent, postage, telephone, telegraph etc. These expenses
should be classified properly under different headings to determine the responsibilities regarding cost
control and reduction.

9. Selling Expenses Budget

The selling expenses include all items of expenditure on the promotion, maintenance and distribution of
finished products. This budget which is clearly related to the sales budget is the forecast of the cost of
selling and distribution, for the budgeted period. Selling and distribution expenses may be fixed or variable
with regard to the sales volume, separate budgets are usually established for fixed or variable selling and
distribution expenses.

10. Research and Development Budget

R &D budget helps management in planning the research and development activities in advance and also
the justification of the expenditure. Research and development is one of the important activities of any
firm and hence proper planning and coordination is required for effectiveness of the same.

11. Master Budget

Master budget is a consolidated summary of the various functional budgets. A master budget is the
comprehensive or summary budget incorporating all functional budgets and which is finally approved,
adopted and employed. A Master Budget shows the budgeted profit and loss account, the balance sheet of
the organization. The master budget is prepared by the budget committee on the basis of coordinated
functional budgets and becomes the target of the company during the budget period when it is finally
approved. The figures contained in master budget are the reflection of the actual intentions of the
company relating to the different areas for the forthcoming budget period.

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 On the basis of Nature / Capacity Utilization

1) Fixed Budget
A fixed budget is a budget designed to remain unchanged irrespective of the level of activity actually
attained. When a budget is prepared by assuming a fixed percentage of capacity utilization, it is called as a
fixed budget. A fixed budget is not adjusted to the level of activity achieved at the time of comparison
between the budgeted and actual costs. Obviously, fixed budgets can be established only for a small period
of time when the actual output is not anticipated to differ much from the budgeted output. However, if
there is a significant change in the business conditions a fixed budget is to be revised. Such budgets are not
suitable for cost control and hence fixed budgets are rarely used.

2) Flexible Budgets
A flexible budget is a budget that is prepared for different levels of capacity utilizations. C.I.M.A, London
defines flexible budget as a budget which ‘by recognizing different cost behaviour patterns, is designed to change as
volume of output changes’. A flexible budget recognizes the difference between fixed cost, semi-fixed cost and
variable cost and such budget changes in relation to the activity achieved. It is designed to furnish
budgeted cost at any level of capacity utilized. Thus, a flexible budget provides a reliable basis for
comparisons as it is adaptable to changes in production activity. Hence, such budget covers a range of
activity i.e. easy to change with variation in production levels and it facilitates performance measurement
and better evaluation. Flexible budget is useful for decision making in terms of selling price determination
and profit planning at different levels of capacity utilization. It facilitates deciding the discount to be given
by maintaining the same profitability.

Features of flexible budgets:

i. They are prepared for a range of activity instead of a single level.
ii. They provide a very dynamic basis for comparison because they automatically vary to changes in
volume.
iii. They provide a tailor-made budget for a particular volume.
iv. These are based upon adequate knowledge of cost behaviour pattern, i.e. fixed, semi-fixed and
variable.

Fixed Budget vs. Flexible Budget

Sr Fixed Budget Flexible Budget

.
1. It does not change with actual volume of It can be changed on the basis of
activity achieved. Thus it is rigid budget. activity level to be achieved. Thus it is
not rigid
2. It operates at one level of activity and It consists of various budgets for
under single set of conditions. different levels of activity.
3. Here, all costs are related to only one Here, analysis of variance provides
level of activity, so variance analysis does useful information as each cost is
not give useful information analysed according to its behaviour.
4. It assumes that there will be no change in It assumes that budget should be
prevailing conditions, which is unrealistic. changed as per changing conditions,
hence useful.
5. Not useful for decision making, cost Useful for decision making, cost
control not determination of selling price. control as well as selling price
determination.

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 On the basis of Time

1) Long Term
Any budget exceeding three years is known as Long Term Budget. Master Budget is normally prepared for
long term. In the modern days due to uncertainty, very few budgets are prepared for long term.

2) Short Term Budget

Any budget that is prepared for a period up to one year is known as Short Term Budget. Functional
budgets are normally prepared for a period of one year and then it is broken down month-wise.

3) Medium Term Budget

Budget prepared for a period 1-3 years is Medium Term Budget. Budgets like Capital Expenditure,
Manpower Planning are prepared for medium term.

 Zero Base Budgeting (ZBB)

Zero Base Budgeting is method of budgeting where all activities are determined each time a budget is
formulated and every item of expenditure in the budget is fully justified. Thus, ZBB involves budgeting from
scratch or zero. ZBB is also termed as ‘De-nova budgeting’ or budgeting from the beginning without any
reference to any past budgets. ZBB may be defined as ‘a planning and budgeting process which requires each
manager to justify his entire budget in detail from scratch (hence zero base). This approach requires that all
activities be analyzed and evaluated by systematic analysis and ranked in order of importance. ZBB tries to
identify alternative and efficient methods of utilizing scarce resources. Thus, ZBB facilitates effective
achievement of pre-decided objectives. Under Zero-Base Budgeting, there is a detailed analysis and evaluation
of each programme in order to justify its inclusion or exclusion from final budget. ZBB concept was
developed in U.S.A. by Peter Pyhrr in 1970 & first applied in US Govt. by President Mr. Jimmy Carter.

Steps involved in Zero Base Budgeting process –

i. Each separate activity of an organization is identified and is called as ‘decision package.’ Clear
determination and analysis of decision packages is important for management,
ii. Justification of decision packages in relation to the organizational goals,
iii. Alternatives for each decision package are considered for selection of better and cheaper options,
iv. Ranking of alternatives as per cost-benefit analysis,
v. Based on cost-benefit analysis, the resources are allocated in accordance with the ranking.

ZBB is based on the assumption that every rupee of expenditure requires justification. The traditional
budgeting approach includes previous years’ expenditure which is automatically included in new budget
proposals.

Important Features of Zero Base Budgeting:

i. Emphasis on justification of budget expenditure - “why” any particular expenditure is planned.
ii. Alternative ways are considered.
iii. Participation of all levels in decision-making.

Advantages of Zero Base Budgeting:

i. ZBB promotes operational efficiency because it requires managers to review and justify their activities or
the fund requested.
ii. For successful execution of budgetary system, responsibility at all levels of management can be ensured.
iii. ZBB is relatively elastic because budgets are prepared every year on a zero base.
iv. In this technique, inefficiencies are removed and cost of production is reduced as every budget proposal is
evaluated on the basis of cost-benefit analysis.
v. It is helpful to the management in making optimum allocation of scarce resources because a unique aspect
of ZBB is the evaluation of both current and proposed expenditure and placing it some order of priority.
vi. A lot of thinking is required for cost-benefit analysis, giving rise to many new ideas and a sense of staff
participation.

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Limitations of Zero Base Budgeting:

1. Defining the decision units and decision packages is a difficult process.
2. ZBB is a very detailed procedure involving a lot of paper work.
3. ZBB requires a lot of training for managers.
4. Cost of preparing and implementation of this system is very high.
5. Ranking of activities and decision making is a subjective process.

 Performance Budgeting
It is budgetary control system where the input costs are related to the performance i.e. the end results. This
budgeting is used extensively in the Government and Public Sector Undertakings. It is essentially a projection
of the Government activities and expenditure thereon for the budget period. This budgeting starts with the
broad classification of expenditure according to functions such as education, health, irrigation, social welfare
etc. Each of the functions is then classified into programs sub-classified into activities or projects. Objectives
of each program are ascertained clearly and then the resources are applied after specifying them clearly. The
procedure for the performance budgets include allocation of resources (funding), execution of the budget and
periodic reporting at regular intervals.

LIMITATIONS OF BUDGETARY CONTROL:

1. Based on Estimates – Budgetary control is based upon forecasting, which is merely an estimate. Therefore, the
adequacy or accuracy of budgetary control system depends upon the correctness of the estimates made.
2. Volatility – Budgets are prepared for future business conditions, however, the future scenario is constantly
changing. Thus, budget estimates may lose their usefulness under changing conditions. Rigid budget are
unsuitable for seasonal businesses.
3. Budgetary control system is based on quantitative data (units & monetary) and does not include the qualitative
factors which affect the business enterprise.
4. Installation of a budgetary control system is a costly affair and may not be useful for a small organization.
5. Co-operation at all levels of management is needed for successful implementation of budgetary control
systems. It is human nature that controls are not accepted easily. Hence, employees may resist to the
implementation of such control system.

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INTRODUCTION TO STANDARD COSTING & VARIANCE ANALYSIS

Introduction
Two vital functions of management of any organization are planning and controlling. While planning helps the
management to make systematic efforts to achieve the well-defined objectives, control enables them to review the
actual performance and locate the difference between the planned performance and actual performance. Thus for
evaluating performance, it is necessary to compare the actual performance with some pre-determined or pre
planned targets. One of the important parameters of performance is the cost of production. According to M.
Porter, for achieving sustainable competitive advantage it is necessary to establish cost leadership. For achieving
this, it is of paramount importance that the various costs are monitored closely and there is a constant comparison
of the actual costs with some pre-determined targets. Standard Costing is an important tool in the hands of
management for improving the management control by providing parameters for comparison of actual with these
parameters. The concept of standard cost, standard costing, variance analysis and other relevant aspects of the
same are discussed in this chapter in detail in the subsequent paragraphs.

Definitions
Standard Cost is defined as, ‘a pre-determined cost which is calculated from management’s standard of efficient
operation and the relevant necessary expenditure. It may be used as a basis for price fixation and for cost control
through variance analysis.’ [CIMA – UK] Standard Costing is defined as, ‘preparation and use of standard costs,
their comparison with actual costs and analysis of variances into their causes and points of incidences.’ [CIMA –
UK] From the definitions given above, the following features of standard cost and standard costing emerge.
Meaning of both the terms will be clearer by going through carefully these features.

Features of Standard Cost and Standard Costing

The following are the features of standard cost:

 Standard cost is a pre planned or pre-determined cost. This means that the standard cost is determined even
before the commencement of production. For example, if a firm is planning to launch a product in the year
2009, the standard cost of the same will be determined in the year 2008.

 Standard cost is not an estimated cost. There is a difference between saying what would be the cost and what
should be the cost. Standard cost is a planned cost and it is a cost that should be the actual cost of
production.

 It is calculated after taking into consideration the management’s standard of efficient operation. Thus
standard cost fixed on the assumption of 80% efficiency will be different from what it will be if the
assumption is of 90% efficiency.

 Standard cost can be used as a basis for price fixation as well as for exercising control over the cost. Standard
Costing is a technique of costing rather than a method and has the following features:

 Standard costing involves setting of standards for various elements of cost. Thus standards are set for material
costs, labour costs and overhead costs. Setting of standard is the heart of standard costing and so this work is
done very carefully. Setting of wrong standards will defeat the very purpose of standard costing. Standards are
not only set for costs, but also for sales and profits. The objective behind setting of standards is to have a
basis for comparison between the standard performance and the actual performance.

 Another feature of standard costing is to continuously record the actual performance against the standards so
that comparison between the two can be done easily.

 Standard costing ensures that there is a constant comparison between the standards and actual and the
difference between the two is worked out. The difference is known as ‘variance’ and it is to be analysed
further to find out the reasons behind the same.

 After the ascertaining of the variances, analyzing them to find out the reasons for the variances and taking
corrective action in order to ensure that the variances are not repeated, are the two important actions of
management. Thus standard costing helps immensely in evaluation of performance of the organization.
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 Estimated costs should not be confused with standard costs.

 Though both of them are future costs, there is a fundamental difference between the two. Estimated cost
is more or less a reasonable assessment of what the cost will be in future while on the other hand, standard
cost is a pre-planned cost in the sense it denotes what the cost ought to be.
 Estimated costs are developed on the basis of projections based on past performance as well as expected
future trends. Standard costs are pre-determined in a scientific manner through technical analysis regarding
the material consumption and time and motion study for determining labour requirements.
 Estimated costs may not help management in decision making as they are not scientifically pre-determined
costs but standard costs are decided after a comprehensive study and analysis of all relevant factors and
hence provide reliable measures for product costing, product pricing, planning, co-ordination and cost
control as well as reduction purposes.
 Under estimated costing, the cost is estimated in advance and is based on the assumption that costs are
more or less free to move and that what is made is the best estimate of the cost.
 Under standard costing, a cost is established which is based on the assumption that cost will not be
allowed to move freely but will be controlled as far as possible so that the actual cost will be close to the
standard cost as far as possible and any variation between the standard and actual cost will be capable of
reasonable explanation.

Standard costing and Management by Exception (MBE)

Standard costs are average expected unit costs, because they are only averages and not a rigid specification actual
results will vary to some extent. Standard costs can therefore be viewed as benchmarks for comparison purposes.
Variances (the differences between standard costs and actual costs) should only be reported and investigated if
there is a significant difference between actual and standard. The problem is in deciding whether a variation from
standard should be considered significant and worthy of investigation. Tolerance limits can be set and only
variances that exceed such limits would require investigation. Standard costing therefore enables the principle of
management by exception. CIMA Official Terminology1 defines management by exception as ‘the practice of
concentrating on activities that require attention and ignoring those which appear to be conforming to
expectations. Typically, standard cost variances or variances from budget are used to identify those activities that
require attention.’

Setting of Standards
The heart of the standard costing is setting of standards. Standard setting should be done extremely carefully to
ensure that the standards are realistic and neither too high nor too low. If very high standards are set, it will be
impossible to attain the same and there will be always an adverse variance. This will result in lowering the morale
of the employees. On the other hand, if standards are set too low, they will be attained very easily and the
favourable variances will create complacency amongst the employees. In view of this, the standards should be set
very carefully. The following aspects should be taken into consideration before setting the standards.

_ Type of Standard: The important aspect is that what should be the level of standard from the point of
attainment? Whether it should be very difficult to achieve or too easy to achieve? In other words whether the
standards set should be too high or too low? Thus from the standard of attainment, there can be the following
types of standards.

I. Ideal Standard: An ideal standard is a standard, which can be attained under the most favourable conditions.
The expected performance can be achieved only if all factors, such as material and labour prices, level of
performance of employees, highest output with best possible equipment and machinery, highest level of efficiency
and so on. In practice, it is very difficult to achieve this, as the combination of all favourable factors is almost
impossible. Hence the utility of this standard is that it can be used for relatively long period of time without
alteration. However, as the achievement is nearly impossible, the employee may be frustrated due to the constant
adverse variances.

II. Normal Standard: This standard is the average standard, which is attainable during the future period of time,
which may be long enough to cover one business cycle. This standard will be revised only after one business cycle
is over and thus frequent revision is not required. Normal standard may be useful for management in long term
planning.

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III. Basic Standard: Basic Standard is the standard, which is established for an unaltered use for an indefinite
period, which may be a very long period of time. Basic standards are revised very rarely, and hence the fluctuations
in the costs and prices are not reflected in this standard.

IV. Expected Standard: An Expected Standard is a standard, which, it is anticipated, can be attained during a
future specified standard period. This standard is quite attainable, it is consistent and hence fulfils all the purposes
of a good standard. It provides incentive to improve performance and get the better of the adverse conditions.
These standards are formulated after making allowance for the cost of normal spoilage, cost of idle time due to
machine breakdowns, and the cost of other events, which are unavoidable in normal efficient operations. Thus all
the normal losses are taken into consideration. These standards are most accurate and very useful to the
management in product costing, inventory valuations, estimates, analyses, performance evaluation, planning, and
employee motivation for managerial decision-making.

V. Historical Standard: This is the average standard, which has been achieved in the past. This standard tends to
be a loose standard because there is a possibility that the average past performance may include inefficiencies,
which will be passed on the new standards. However the utility of these standards is that past performance can be
used as a basis for setting of standard in future.

_ Length of the period of use: The management has to take another crucial decision about the length of the
period for which the standard will remain valid. In other words, it will have to be decided whether the standards
should be revised too frequently or after a long time. In the types of standards, we have seen that there are basic
standards, which remain unaltered for a long period of time while the current standards, and expected standards
are revised more frequently. Thus it will have to be decided as to what should be the frequency of revision.

_ Attainment Level: Before setting of standards, the management has to ascertain the level of attainment as
regards to the output. While fixing the level, due considerations should be given to the constraints if any, on the
production, level of efficiency, availability of skilled manpower, sales potential and so on.

Problems in setting standards

The standard setting process is encountered with some difficulties in the stage of implementation. The below
mentioned are some of the problems in the standard setting process:
1. Inflation needs to be incorporated into planned unit costs. The standard setting process must ensure the
inclusion of methods to mitigate the issue inflation and rising prices into the planned costs.
2. It is an important issue that a performance standard is agreed upon by all who are instrumental in working
with the performance standard which should be attainable and not too idealistic.
3. The quality of materials to be used is to be decided upon before a set of standard costs is agreed upon as a
better quality of material will cost more, but perhaps reduce material wastage.
4. Estimating materials prices where seasonal price variations or bulk purchase discounts may be significant.
5. Finding sufficient time to construct accurate standards as standard setting can be a time-consuming process.
6. Incurring the cost of setting up and maintaining a system for establishing standards.
7. Dealing with possible behavioural problems, managers responsible for the achievement of standards
possibly resisting the use of a standard costing control system for fear of being blamed for any adverse
variances.

Setting of Standard Costs

In the previous paragraphs, we have seen the establishment of standards and the care to be taken for the same.
Now we have to see the setting of standard costs for various elements of cost like material, labour and overheads
and subsequently the computation and analysis of variances. It should be remembered that setting of standard
costs is not the job of cost accounting department only, it is a task which is to be completed with the co-operation
of departments like production, sales, manpower planning, personnel, works study engineer and the cost
accounting department. Without the co-operation and active participation of all the departments, setting of
standard cost will be impossible and hence it is rightly said that techniques like standard costing and budgeting
promotes co-ordination and team work in an organization. The setting of standard costs is discussed in the
following paragraphs.

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Direct Material Cost Standard:

Direct material is an important element of cost and in several industries; the direct material cost is 50% - 55% of
the total cost. In case of industry like sugar, the material cost is nearly 65 –70 % of the total cost. In view of this,
there is a need to monitor the cost of material closely and take steps to control and reduce the same. Standard for
direct material cost is set with this particular objective. The standard direct material cost indicates as to how much
the material cost should have been and then it is compared with the actual cost to find out the difference between
the two. The establishment of standard cost for direct materials involves the determination of, a] standard quantity
of standard raw materials and b] standard price of raw material consumed. The standard quantity of materials is
determined with the help of production department and while fixing the same; normal or inevitable losses are
taken into consideration. The cost accounting department in co-operation with the purchase department
determines standard price of material consumed. Recent prices, past prices and the likely trend of prices in the
future are taken into consideration while fixing the standard prices. Similarly stock on hand, purchase orders
already placed and likely fluctuations in the price should also be taken into consideration while fixing the material
price standards.

Direct Labour:
Labour is also an important element of cost and the standard labour cost indicates the labour cost that should be
incurred. Two factors need to be taken into consideration while fixing the standard labour cost. The first one is
the standard time and the second one is the standard rate. For setting the standard time, it is necessary to conduct
time and motion study with the help of Work Study Engineer. Firstly motion study is conducted to identify
unnecessary motions and then to eliminate them. After elimination of unnecessary motions, standard time is
allotted to the motions that are required to be performed for producing the product. While determining the
standard time, allowance is made for normal idle time to cover mental and physical fatigue. The standard wage rate
is fixed after considering the level of rates in the market, the degree of skill required for performing the job, the
availability of manpower and the wage structure in the concerned industry. Concept of ‘Standard Hour’ is
extremely important in setting the standards for labour. It is a hypothetical hour, which represents the amount of
work, which should be performed in one hour under standard conditions.

Factory Overhead Standards:

Setting of standard for overhead costs, there is a need to determine, a]standard capacity and b] standard overhead
cost for that capacity. The standard overhead cost can be computed using normal capacity. Normal capacity is not
the total installed capacity but it is the practical capacity, which is based on the resources available and efficient
utilization of the same. After this the standard overheads are fixed. In case of variable overheads, since they
remain constant per unit of the production, it is necessary to calculate only standard variable overhead rate per
unit or per hour. In case of fixed overheads, budgeted fixed overheads and budgeted production are to be taken
into consideration. A standard rate of fixed overhead per unit is then computed by dividing the budgeted fixed
overheads by the budgeted production.

Direct Expenses:
If at all there are some items of standard expenses, rate per unit of the same may be determined on the basis of
budgeted output and budgeted direct expenses.

The advantages of standard costing

Though there are several advantages of standard costing, the following are more important:
1. Carefully planned standards aids the budgeting process.
2. Standard costs provide a yardstick against which actual costs can be measured.
3. The setting of standards involves determining the best materials and methods which may lead to cost
economies.
4. A target of efficiency is set for employees to reach and cost consciousness is stimulated.
5. Variances can be calculated which enable the principle of ‘management by exception’ to be operated. 6. Only
the variances which exceed acceptable tolerance limits need to be investigated by management with a view to
control action.
6. Standard costs simplify the process of bookkeeping in cost accounting, because they are easier to use than
LIFO, FIFO and weighted average costs.
7. Standard times simplify the process of production scheduling.
8. Standard performance levels might provide an incentive for individuals to achieve targets for themselves at
work.

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VARIANCE ANALYSIS
After setting the standards and standard costs for various elements of cost, the next important step is to compute
variances for each element of cost. Variance is the difference between the standard cost and the actual cost. In
other words it is the difference between what the cost should have been and what the actual cost is. Element wise
computation of variances is given in the following paragraphs.

A] Material Variances: In the material variances, the main objective is to find out the difference between the
standard cost of material used for actual production and actual cost of material used. Thus the main variance in
this category is the cost variance, which is thereafter broken down into other variances. These variances are given
below.

I] Material Cost Variance: As mentioned above, this variance shows the difference between the standard cost of
material consumed for actual production and the actual cost. The following formula is used for computation of
this variance.

_ Material Cost Variance:

Standard Cost of Material Consumed for Actual Production – Actual Cost If the actual cost of material consumed
is less than the standard cost of material consumed, the variance is ‘favourable’, otherwise it is adverse.

_ Material Price Variance: One of the reasons for difference between the standard material cost and actual
material cost is the difference between the standard price and actual price. Material Price Variance measures the
difference between the standard price and actual price with reference to the actual quantity consumed. The
computation is as shown below:

_ Material Price Variance: Actual Quantity [Standard Price – Actual Price]

_ Material Quantity [Usage] Variance: This variance measures the difference between the standard quantity of
material consumed for actual production and the actual quantity consumed and the same is multiplied by standard
price. The computation is as shown below.

_ Material Quantity [Usage] Variance: Standard Price [Standard Quantity – Actual Quantity] The total of Price
Variance and Quantity Variance is equal to Cost Variance Material Cost Variance = Material Price Variance +
Material Quantity Variance

_ Material Mix Variance: In case of several products, two or more types of raw materials are mixed to produce
the final product. In such cases, standard proportion of mixture is decided in advance. For example, in
manufacturing one unit of product ‘P’, material A and B may have to be mixed in a standard proportion of 3:2.
This is called as a standard mix. However, when the actual production begins, the actual proportion of mix may
have to be changed due to several reasons like non-availability of a particular material etc. In such cases material
mix variance arises. The mix variance is computed in the following manner.
• Material Mix Variance = Standard Cost of Standard Mix – Standard Cost of Actual Mix

_ Material Yield Variance: In any manufacturing process, some unavoidable loss always takes place. Thus if the
input is 100, output may be 95, 5 units being normal or unavoidable loss. The normal loss is always anticipated
and taken into consideration while determining the standard quantity. Yield variance arises when the actual loss is
more or less than the normal loss. The computation of yield variance is as given below.
• Material Yield Variance = SYR [Actual Yield – Standard Yield]
SYR = Standard Yield Rate, i.e. standard cost per unit of standard output.
Reconciliation: Quantity Variance = Mix Variance + Yield Variance.

B] Labour Variances: Like the material variances, labour variances arise due to the difference between the
standard labour cost for actual production and the actual labour cost. The following variances are computed in
case of direct labour.

I] Labour Cost Variance: This variance is the main variance in case of labour and arises due to the difference
between the standard labour cost for actual production and the actual labour cost. The following formula is used
for computation of this variance.

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Labour Cost Variance = Standard Labour Cost for Actual Production – Actual Labour Cost This variance will be
favourable is the actual labour cost is less than the standard labour cost and adverse if the actual labour cost is
more than the standard labour cost.

II] Labour Rate Variance: One of the reasons for labour cost variance is the difference between the standard
rate of wages and actual wages rate. The labour rate variance indicates the difference between the standard labour
rate and the actual labour rate paid. The formula for computation is as under.

Labour Rate Variance: Actual Hours Paid [Standard Rate – Actual Rate]
This variance will be favourable if the actual rate paid is less than the standard rate. The labour rate variance is that
portion of direct labour cost variance, which is due to the difference between the labour rates.

III] Labour Efficiency Variance: It is of paramount importance that efficiency of labour is measured. For doing
this, the actual time taken by the workers should be compared with the standard time allowed for the job. The
standard time allowed for a particular job is decided with the help of time and motion study. The efficiency
variance is computed with the help of the following formula.
Labour Efficiency Variance = Standard Rate [Standard Hours for Actual Output – Actual Hours worked]
This variance will be favourable is the actual time taken is less than the standard time.

IV] Labour Mix Variance or Gang Composition Variance: This variance is similar to the material mix variance
and is computed in the same manner. In doing a particular job, there may be a particular combination of labour
force, which may consist of skilled, semiskilled and unskilled workers. However due to some practical difficulties,
this composition may have to be changed. How much is the loss caused due to this change or how much is the
gain due to this change is indicated by this variance. The computation is done with the help of the following
formula.
Labour Mix Variance = Standard Cost of Standard Mix – Standard Cost of Actual Mix.

V] Labour Yield Variance: This variance indicates the difference between the actual output and the standard
output based on actual hours. In other words, a comparison is made between the actual production achieved and
the production that should have been achieved in actual number of working hours. The variance will be
favourable is the actual output achieved is more than the standard output. The computation is done in the
following manner.
Labour Yield Variance = Average Standard Wage Rate Per Unit [Actual Output – Standard Output]

VI] Idle Time Variance: This variance indicates the loss caused due to abnormal idle time. While fixing the
standard time, normal idle time is taken into consideration. However if the actual idle time is more than the
standard/normal idle time, it is called as abnormal idle time. This variance will be always adverse and will be
computed as shown below.
Idle Time Variance = Abnormal Idle Time X Standard Rate.

DIFFERENCE BETWEEN STANDARD COSTING AND BUDGETARY CONTROL

Standard Costing Budgetary Control

Standard costing is a technique used to set Budgetary control involves the establishment of
predetermined costs for various elements of budgets (financial plans) for various functions or
production, such as materials, labour, and overheads, activities within an organization and comparing actual
to establish benchmarks for comparison with actual performance against these budgets to monitor and
costs. control financial activities.
Focuses on setting predetermined costs for individual Focuses on setting financial targets for overall
cost elements involved in the production process performance, including revenues, expenses, and profits,
across different functions or departments within the
organization.
Typically short-term in nature, focusing on costs Can be short-term or long-term, depending on the
incurred during the production process budget period set by the organization, but often covers
a fiscal year.
Primarily aimed at cost control and performance Aimed at planning, coordinating, and controlling
evaluation by comparing actual costs with standard overall financial activities by setting targets, allocating
costs to identify variances and take corrective actions resources, and evaluating performance against
budgeted figures.

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Primarily used in manufacturing industries where Applicable to various types of organizations across
production costs are a significant component of different sectors, including manufacturing, service, and
overall expenses non-profit organizations.
Less flexible compared to budgetary control as it More flexible as it allows for adjustments to budgets
focuses on predetermined costs based on historical based on changing circumstances, such as economic
data or industry standards. conditions or business priorities
Focuses on controlling costs through variance analysis Focuses on controlling overall financial performance
and corrective actions to ensure that actual costs align by monitoring actual performance against budgeted
with predetermined standards. targets and taking corrective actions to address any
deviations.
Evaluates performance based on cost variances Evaluates performance based on variances between
between actual and standard costs, focusing on actual and budgeted figures across different financial
efficiency and cost-effectiveness in production categories, providing insights into overall financial
health and performance.

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