Financial Performance Management
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. “ Budgeting” – A tool for Planning
Session Plan
1. Planning Process
2. Elements
3. Purpose
4. Types
5. Sales, Production & Purchases
6. Flexible Budgeting
7. Cash Budget
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BUDGETING AND PROFIT
PLANNING
Planning Process
Budget-Definition, Meaning
and Purpose
Preparation/Types of Budgets
Planning Process
Budgeting is a tool of planning. Planning involves specification of the basic
objectives that the organisation will pursue and the fundamental policies that
will guide it. In operational terms,
it involves four steps:
(1) Objectives
Objectives are broad and long-range desired state or position in future.
(2) Goals
Goals are quantitative targets to be achieved in specified period.
(3) Strategies
Strategies represent specific course of action to achieve goals.
(4) Plans
The final step is the preparation of budgets/profit plans. It converts goals and strategies
into annual operating plans.
Budget
A budget is defined as a comprehensive and coordinated plan,
expressed in financial terms, for the operations and resources
of an enterprise for some specified period in the future.
The essential elements of a budget are:
(1) Plan
(2) Financial terms
(3) Operations and resources
(4) Specific future period
(5) Comprehensive coverage
(6) Coordination
1. Plan
The first ingredient of a budget is its plan. It includes two aspects which
have a bearing on the operations of an enterprise. One set of factors, which
determine a firm’s future operations are wholly external and beyond its
control. The second set of factors affecting future activities are within the
firm’s control and discretion, that is, they are internal.
2. Operations and Resources
A budget is a mechanism to plan for the firm’s operations and resources.
The operations are reflected in revenues and expenses.
The plan also covers the resources of the firm. The planning of resources
means the planning of the various assets and the sources of capital to
finance these assets. The assets could be fixed assets as well as current
assets.
3. Financial Terms
Budgets are prepared in financial terms, that is, in terms of monetary value
such as the rupee, dollar, and so on. The reason is that the monetary unit is
a common denominator.
4. Specified Future Period
A budget relates to a specified period of time, usually one year.
5. Comprehensiveness
A budget is comprehensive in that all the activities and operations of
an organisation are included in it. It covers the organisation as a
whole and not only some segments. The modus operandi is that
budgets are prepared for each segment/facet/activity/division of an
organisation.
6. Coordination
Budgets are prepared for the different components/ segments/
divisions/ facets/activities of an organisation so as to take care of
the situations and problems of each component. The budgets for
each of the components are prepared in harmony with each another.
This is called coordination.
Budget Purpose
The main objectives of budgeting are:
1. Explicit statement of expectations
2. Communication
3. Coordination,
[Link] as a framework for judging
performance
1. Explicit Statement of Expectations
One purpose of budgeting is to state expectations in formal terms so that
most of the underlying assumptions may be identified. A firm has the
basic objective of optimising long-run profit. Its long-range goals
also include survival, consumer satisfaction, employee
welfare, personal power and prestige, and so on.
However, a budget does not lay down a statement of expectations in rigid
terms. A budget should be modified when necessary in the light of
the changes in the factors/assumptions on which the
original estimates were based.
2. Communication
Another purpose of budgeting is to communicate or inform others of the
goals and methods selected by top management. Since budgeting
deals with fundamental policies and objectives, it is
prepared by top management.
3. Coordination
Yet another purpose of budgeting is coordination. The term ‘coordination’
refers to the operation of all departments of an organisation in
such a way that there is no bottleneck or imbalance.
In view of the above, coordination is a major function of budgeting.
Budgets should be drafted in such a way that the operations
of the various departments are related to each other for
the achievement of the overall goal.
4. Expectations as a Framework for Judging Performance
Finally, a budget establishes expectations as a framework for judging
employee performance.
TYPES OF BUDGETS
The overall budget is known as the master budget. A master
budget normally consists of three
types of budgets:
(i) Operating Budgets
(ii) Financial Budgets
(iii) Special Decision Budgets
Operating Budget
Operating budgets relate to physical activities/
operations such as sales, production,
and so on.
Operating budget has the following components
Sales budget,
Production budget,
Purchase budget,
Direct labour budget,
Manufacturing expenses budget, and
Administrative and selling expenses budget, and so on.
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Approaches to budgeting
There are a number of different budgetary systems:
• Top down vs bottom up budgeting
• Incremental budgeting
• Zero-based budgeting (ZBB)
• Rolling budgets
• Activity-based budgeting
• Feed-forward control.
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• Budgeting and participation
• There are basically two ways in which a budget can be set: from the top down (imposed budget)
from the bottom up (participatory budget).
• Imposed style: An imposed/top-down budget is 'a budget allowance which is set without permitting the
ultimate budget holder to have the opportunity to participate in the budgeting process'
•
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Advantages of imposed style
There are a number of reasons why it might be preferable for organisations to choose the top-
down approach to budgeting, as opposed to the bottom-up style. The following are advantages of
the imposed style, but also some of these are reasons why the bottom-up style can be less
useful in comparison.
• (1) Involving managers in the setting of budgets is more time consuming than if senior
managers simply imposed the budgets.
• (2) Managers may not have the skills or motivation to participate usefully in the budgeting
process.
• (3) Senior managers have the better overall view of the company and its resources and
may be better-placed to create a budget which utilises those scarce resources to best
effect.
• (4) Senior managers also are aware of the longer term strategic objectives of the
organisation and can prepare a budget which is in line with that strategy.
• (5) Budget holders may build budgetary slack or bias into the budget in order to make the
budget easy to achieve and themselves look good.
• (6) By having the budgets imposed by senior managers, i.e. someone outside the
department, a more objective, fresher perspective may be gained.
• (7) If the participation is only pseudo-participation and the budgets are frequently drastically
changed by senior management, then this will cause dissatisfaction and the effect will be to
demotivate staff.
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Special Decision Budgets
The third category of budgets are special decision budgets.
They relate to inventory levels, break-even analysis, and so
on.
Fixed and Flexible Budgets
Fixed Budgets
Budgets prepared at a single level of activity, with no prospect of modification
in the light of changed circumstances, are referred to as fixed budgets.
Flexible Budgets
The alternative to fixed budgets are flexible/variable/sliding budgets
Flexible Budgets
The term ‘flexible’ is an apt description of the essential
features of these budgets. A flexible budget estimates costs
at several levels of activity.
Its merit is that instead of one estimate, it contains several
estimates/plans in different assumed circumstances. It
is a useful tool in real world situations, that is, unpredictable
environment.
A flexible budget, in a sense, is a series of fixed budgets and
any increase/decrease in the level/volume of activity must be
reflected in it.
The conceptual framework of flexible budgeting relates
to: (i) Measure of volume and (ii) Cost behaviour with
change in volume
Each expense in each department/segment is to be
categorised into fixed, variable and mixed components.
A budget may first be prepared at the expected level of
activity, say, 100 per cent capacity. Additional
columns may then be added for costs below and above,
90 per cent and 110 per cent capacity and so on.
Table 1 Hypothetical Ltd—Flexible Budget (Maintenance Department)
Volume (labour-hours) 4,000 4,500 5,000 5,500 6,000
Variable costs:
Labour Rs 6,000 Rs 6,750 Rs 7,500 Rs 8,250 Rs 9,000
Material 2,400 2,700 3,000 3,300 3,600
Others 800 900 1,000 1,100 1,200
Mixed costs:
Labour 2,300 2,400 2,500 2,600 2,700
Maintenance 1,400 1,450 1,500 1,550 1,600
Other supplies 2,500 2,750 3,000 3,250 3,500
Discretionary fixed costs:
Training 1,500 2,000 2,000 2,000 2,500
Experimental methods 3,500 4,000 4,000 4,000 4,500
Committed fixed costs:
Depreciation 5,000 5,000 5,000 5,000 5,000
Rent, lease cost 3,500 3,500 3,500 3,500 3,500
Total 28,900 31,450 33,000 34,550 37,100
Hypothetical Ltd—Flexible Budget (Manufacturing Department)
Volume (machine-hours) 50 60 70 80 90
Variable costs:
Power Rs 500 Rs 600 Rs 700 Rs 800 Rs 900
Helpers 250 300 350 400 450
Discretionary fixed costs:
Training 800 900 900 900 1,000
Tools 200 200 200 300 300
Committed fixed costs:
Depreciation 1,200 1,200 1,200 1,200 1,200
Rent 1,000 1,000 1,000 1,000 1,000
Total 3,950 4,200 4,350 4,600 4,850
Modified Flexible Budgets
Flexible budgets, as a tool of planning and control, are superior
to fixed budgets.
The major weaknesses of fixed budgets are their inability to:
Show the potential variability of various estimates used in the preparation of the budget,
and
Indicate the range within which costs may be expected to vary. They are, therefore, not
useful in an uncertain and unpredictable environment.
Flexible budgets present estimates at different levels of activity, and are more useful.
Limitations
Flexible budgets suffer from one limitation in that they do not explicitly consider the
relative probability of a particular volume/cost being achieved. This limitation can be
overcome by using a modified
flexible budget which will include columns for different levels
of estimates: most likely, optimistic and pessimistic.
Hypothetical Ltd—Modified Flexible Budget (Manufacturing Department)
Pessimistic Most likely Optimistic
Volume (labour-hours) 4,250 5,000 5,850
Variable costs:
Labour Rs 6,375 Rs 7,500 Rs 8,775
Materials 2,650 3,000 3,510
Others 850 1,000 1,170
Mixed costs:
Labour 2,350 2,500 3,425
Maintenance 1,425 1,500 1,585
Other supplies 2,625 3,000 2,670
Discretionary fixed costs:
Training 1,750 2,000 2,250
Experimental methods 3,750 4,000 4,250
Committed fixed costs:
Depreciation 5,000 5,000 5,000
Rent, etc. 3,500 3,500 3,500
Total 30,275 33,000 36,135
Y Ltd. is working on 80% capacity and its Flexible Budget is as follows:
Output 60,000 units, sales value Rs. 12,00,000, material cost Rs. 30,000, wages R
2,10,000, variable expenses Rs. 1,20,000, Semi-variable expenses Rs. 70,000 and
fixed costs Rs. 2,00,000.
A proposal for additional sale of 7,500 units is available, if it is accepted and
supplied at Rs. 14.00 each. The semi-variable overheads increases by Rs. 2,500 fo
the additional production. Advise the management.
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