UNIT II

BUDGET
The chartered institute of management accountants London defines a budget as “a financial and/or
quantitative statement “prepared and approved prior to a defined period of time, of the policy to be pursued
during the period for the purpose of attaining a given objective. The detailed and structured plan has two
axes: physical and financial. The translation of the policies and activities planned for a definite period of time
in to physical terms results in Programmes and into financial terms results into budgets. The act of setting
programmes is called programming and that of budgets is called budgeting. The essentials of a budget are:
 It is prepared in advance
 It is based on a future plan of action
 It relates to a future period is based on objectives to be attained
 It is a statement expressed in monetary and /or physical units prepared for the implementation of policy
formulated by the management

BUDGETARY CONTROL
The Chartered Institute of Management Accountants London defines budgetary control as the establishment
of budgets relating to the responsibilities of executives to the requirements of a policy and the continuous
comparison of actual with budgeted results either to secure by individual or to provide a as basis for its
revision.
Steps involved in budgetary control
1. Establishment of budgets: targets or budgets are fixed for each function relating to the responsibilities of
individual executives. The functional budgets are then co coordinated with each other so that an overall
budget for the firm may be prepared.
2. Measurements of actual performance
3. Comparison of actual performance with budgeted performance to detect deviation or variances:
Actual data are compared with fixed budgets or adjusted budgets. The comparison with fixed budgets may
not serve any useful purpose. The other alternative is flexible budgetary control.
4. Analyzing the causes of variances and reporting

OBJECTIVES OF BUDGETARY CONTROL

1. To combine the ideas of all levels of management in the preparation of the budget.
2. To coordinate all the activities of the business.
3. To centralize control.
4. To decentralize responsibility to each manager involved
5. To act as a guide for management decision making when unforeseeable conditions affect the
business.
6. To plan and control income and expenditure so that maximize profitability is achieved.
7. To direct capital expenditure in the most profitable direction.
8. To ensure that sufficient working capacity is available for the efficient operation of the business.
9. To provide a yardstick against which actual results can be compared.
10. To show management where action is needed to remedy a situation.

ADVANTAGES OF BUDGETARY CONTROL

1. It brings efficiency and economy in the working of the business enterprises.
2. It establishes divisional and departmental responsibility.
3. It coordinates various divisions of the business-like production, marketing, financial, personnel and
administrative divisions.
4 It guards against undue optimism leading to over expansion.
5. It acts as a safety signal for the management.
6. Seasonal variations in production can be reduced by developing new fill in products.
7. Budgetory control helps in developing effective communication system, by serving as an excellent vehicle
for the exchange of ideas and coordination of plans among various levels of management.
8. It helps management in most profitable combination of different factors of production.
9. Managements which have developed a well-ordered budget plan receive greater favour from credit
agencies
10. It is the only means of predetermining the necessity of financing and helps to avoid the possibility of both
under capitalization and over capitalization.
11. Management by exception: Budgeting permits the management to focus attention on significant matters
through budgetary reports. Thus, it facilitates management by exception and there by saves the time and
energy.
12. Planning: Budgeting keeps management to plan for the future.
13. Coordination: - budgeting helps to coordinate, integrate and balance the efforts of various departments in
the lights of the overall objectives of the enterprise.
14. Control: Budgeted performance is the most relevant standard for comparison than past performance,
since past performance is based on historical factors which are constantly changing

LIMITATIONS OF BUDGETARY CONTROL

1. Budgets if are based on approximations and personal estimation, may prove wrong. Therefore, the quality
of budgets is associated with the quality and experience of the budgeted person.
2. In the dynamic world, these happen to be rapid change in the business conditions. With the result, business
executives face a lot of difficulties in the execution of budgets
3. The installation of budgeting system is a costly affair.
4. Opposition against the spirit of budgeting: The opposition is due to human nature – the tendency to resist
change.
5. Budget targets are sometimes considered as pressure tactics and may lower the morale of the employees
6. Time factor: Accuracy in budgeting comes through experience. Management must not expect too much
during the development period.
7. Not a substitute for management: Budget is only a management tool. It cannot substitute management.
8. Co-operation required: The success of the budgetary control depends on the cooperation and teamwork.

BUDGETING AND FORECASTING

Sometimes the budgeting and forecasting are used interchangeably. Forecasting may be defined as the
prediction of future factors as a basis for formulating or reassessing business strategy and to assist in
planning.
According to the National Association of Accountant (USA), “Forecasting is the process of predicting or
estimating a future happening”.
Forecasting is a preliminary step for budgeting. The budgeting starts where the forecasting ends. Forecast is
mere an estimate of what is likely to happen, but a budget is a programme to be followed. Forecasts have
wider scope and can be made even for those areas where no budgeting is required.

INSTALLATION OF BUDGETARY CONTROL SYSTEM

1. Determination of the Objectives: Introduction of a system of budgetary control requires a clear
perspective of the objectives that are sought to be achieved. The objective is to achieve the desired /greater
profits. Having determined the objectives of budgetary control the following further problems will have to be
sorted out.
a) laying down of a plan for the implementation of the firm’s objectives
b) coordination of the activities of the different departments
c) Controlling each function so that best possible results can be achieved.
2. Organization for Budgeting: it includes setting up of a definite plan of organization. The responsibility
of each executive must be clearly defined.
3. Budget Manual: The budget manual is a written document or document which specifies the objectives of
the budgeting organization and procedures. This is defined by Institute of Costs and Management
Accountants (I.C.M.A) as a document which set out the responsibilities of the persons engaged in the routine
of, and the forms and records required for budgetary control.
Following are the matters involved in a budget manual
 Description of the system and its objectives.
 Procedure to be adopted in operating the system.
 Definition of duties and responsibilities.
 Reports and statements required for each budget period.
 The accounts code in use.
 Deadline by which data are too be submitted
4. Responsibility for Budgeting
a) Budget Controller: The chief executive is responsible for the budget programme but it will be better if
the large part of the supervisory responsibility is delegated top an official designated as budget controller or
budget director. The budget controller should have knowledge of the technical side of the business and
should report direct to the president.
b) Budget Committee: In small companies the budget officer or the accountant may coordinate all the work
connected with the budgets. But in the case of large companies’ budget committee is established. The budget
controller will be assisted in his work by the budget committee. The budget committee consists of heads of
various departments such as production, sales, finance etc.
The main functions of the committee are:
 To provide historical information to help managers in forecasting.
 To approve budgets.
 To advice in the preparation of budgets.
 To ensure that the budgets are submitted in due time
 To prepare budget summaries.
 To identify the responsibility for deviation if any
 To coordinate the budget programme
 To prepare the master budget after financial budgets have been approved
 To define general policies of management in relation to the budget
 To review budgets
5. Fixation of Budget Period: Budget period means the period for which a budget is prepared and
employed. The budget period will depend upon a) nature of the business b) the costing techniques to be
applied. For example, in case of mass production or continuous industries it is necessary to compare
continuously the actuals with the budgets, so the budget period should be short time.
6. Budget Procedures
a) Determination of Key Factor: This is the factor whose influence must first be assessed in order to ensure
that functional budgets are reasonably capable of fulfillment. The key factor known variously as the
“limiting” or “governing” or “principal budget” factor is of vital importance. It may not be same for each
budget period, as the circumstances change. It determines priorities in functional budgets (sales, production,
purchases, cash etc)
Among the main key factors that affect budgeting are as follows:
 Materials: Availability, Restrictions imposed by licenses, quotas etc.
 Labour: General Shortage, Shortage in certain key processes
 Plant: Insufficient capacity due to lack of capital
 Lack of space, Lack of markets, Bottlenecks in certain key processes
 Sales: Low market demand, Shortage in experienced salesman, Insufficient advertisement due to lack of
money
 Management: Lack of capital, restricting policy, inefficient executive
 Insufficient research into product design and methods
b) Making of forecasts: It is the estimate about the probabilities for a given period of time. Forecasts are
made regarding sales, production cost and financial requirements of the business.
c) Consideration of alternative combination of forecasts: Alternative combinations of forecasts are
considered with a view to obtain the most efficient overall plan so as to maximize profits.
d) Preparation of budgets: on finalization of the forecasts the budgets will be prepared. All the budgets will
be combined and coordinated into one master budget.
e) Choice between fixed and flexible budgets: A budget may be fixed or flexible. A fixed budget is based
on a fixed volume of activity. A flexible budget is prepared for changing levels of activity.

CLASSIFICATION OF BUDGETS
Different authorities have given different classification of budgets. Budgets are classified
A. According to time period
B. According to function
C. According to flexibility

ACCORDING TO TIME PERIOD

a. Long term budget: Budget designed for long period (5-10years) it is termed as a long-term budget.
b. Short term budget: Budgets designed for a period less than 5 years are known as short term budgets.
c. Current budgets: Budgets which are prepared for a very short span are called current budgets.
d. Rolling budgets: These budgets are also known as progressive budgets. In a rolling budget the budget
period will never end.

ACCORDING TO FUNCTION
a. Sales budget: Total sales in terms of quantity, value periods and areas are forecasted in this budget. Sales
budget is based on the sales forecast for the given period. The following factors are taken while preparing a
sales budget:
 Past sales figures and trends
 Salesman’s estimates
 Plant capacity
 General trade prospects
 Orders on hand
 Proposed expansion of discontinuance of products
 Seasonal fluctuations
 Potential markets
 Availability of material and supply
 Financial aspects
b. Production budget: It forecasts quantity of production in terms of itemsd, periods etc. Production budget
attempts to estimate the number of units of each product that the company is planning to produce.
c. Cost of production budget: separate budgets are prepared for different elements of cost such as direct
materials; direct Labour, factory overheads, selling and distribution overheads etc. All these budgets are
known as cost of production budgets.
d. Purchase budget: The quantity and value of purchase required for production are forecasted by purchase
budgets.
e. Research budgets
f. Capital expenditure budgets: The amount of cost of capital required for the procurement of capital
assets during the period is estimated in this budget.
g. Cash budget: This budget is a forecast of the cash position by time period for a specific duration of time.
h. Master budgets: This is known as the total budget. It is the summary of all individual functional
budgets.

ACCORDING TO FLEXIBILITY
a. Fixed budget: A budget prepared on the basis of a standard or fixed level of activity is known as a fixed
budget. It does not change in levels of activity.
The Institute of Costs and Works Accountants, London defined fixed budget as “a budget which is designed
to remain unchanged irrespective of the level of activity actually attained”. Fixed budget is a plan that
expresses only one level of estimated activity or volume
b. Flexible budget: flexible budget is simply a series of fixed budgets that apply to various level of
production.
According to I.C.W.A, London, a flexible budget is “a budget which, by recognizing difference between
fixed, semifixed and variable costs, is designed to change in relation to the level of activity obtained.
Flexible budgeting is desirable in the following cases:
 Where on account of typical nature of the business the sales are unpredictable e.g., in luxury or semi
luxury trades.
 Where the venture is a new one and it is almost impossible to foresee the public demand, e.g., novelties in
the fashion
 Where the business is subject to the vagaries of nature such as soft drinks
 Where the progress depends on adequate supply of labour and the business is in area which is already
suffering from shortage of labour.

PERFORMANCE BUDGETING
The origin of performance budgeting can be found in government fiscal budgeting. Performance budgeting
involves evaluation of the performance of the organization the context of both specific as well as overall
objectives of the organization. Performance budgeting requires preparation of performance reports. Such
reports compare budget and actual data and show any existing variances.
Thus, performance budgeting is a system of budgeting which states operations in terms of functions and
activities.
Steps involved in performance budgeting
1. Formulation of departmental objectives
2. Establishing a meaningful functional programme and activity classification
3. Bringing the system of accounting and financial management in accord with this classification
4. Evolving suitable norms, yardsticks, work units of performance and unit costs
5. Performance appraisal
Objectives of performance budgeting
1. To bring coordination between various physical and financial aspects of the programme
2. To make budget formulation process simple
3. To improve the efficiency and quality of performance audit
4. To make management more accountable for its actions
5. To serve as controlling tool for financial operations

ZERO BASE BUDGETING (ZBB)

Definition: Peter A Phyre who introduced Zero Base Budgeting (ZBB) in Texas Instruments, defines “An
operating and budgeting process which requires each manager to justify his entire budget request in detail
from scratch (hence zero base) and shift the burden of proof to each manager to justify why should spend any
money at all.”
ZBB therefore starts with a basic premise that the budget for the next period is zero.

STEPS INVOLVED IN ZBB

1. Defining the decision units: A decision unit is a tangible activity or group of activities for which a single
manager has the responsibility for its successful performance.
2. Defining objectives of each decision units
3. Identifying activities in the form of decision packages (DP): for any given activity there may be
several alternatives DP’s each describing different levels of efforts and cost benefit relationship.
4. Ranking of alternative DP’s: ranking of DP’s is done in order of decreasing benefit to the organization,
using cost benefit analysis techniques.
5. Forwarding the ranking DP’s: Decision packages so ranked are forwarded to the next higher
organizational unit, for review, merger with other comparable DP’s and for reranking
6. Finalization of budgets: finally, the budgets are prepared for each decision unit (DU) and are approved
by the top management.

IMPORTANCE/USES OF ZBB
 ZBB fosters a culture of efficiency and cost effectiveness and for that matter, inculcates cost
consciousness among managers.
 ZBB allows for quick budget adjustments during the period when revenues fluctuate widely.
 ZBBimproved budgeting process by focusing on objectives, priorities and needs.
 ZBB will provide an objective base to prune or zero-out programme that have out-lived their utility and
expand high-impact programmes.
 Responsibility accounting system can become more effective under ZBB.
 Allocation of resources is made according to needs and the benefits derived.
 ZBB ensures participation from all concerned and facilitates coordination in planning and control.
 Long range goals and plans can be linked with the annual budgets through the ZBB.

LIMITATIONS OF ZBB
 Problems in implementation: ZBB requires personal involvement from top management and considerable
problems are faced while formulating decision packages.
 Rank of decision packages: is another problem in the pursuance of ZBB.
 Involvement of high cost- limits the advantages of ZBB.
 Lack of feedback-to the managers about reason for their DP’s being attempted or rejected.

STANDARD COSTING AND VARIANCE ANALYSIS

Standard costing is a specialized technique of costing under which standard costs are predetermined, actual
costs are compared with such predetermined costs, if there is any variation take corrective action to control it.
It serves as an effective too in the hands of the management for planning, controlling and coordination of
various activities of the business.
According to chartered institute of management accountants, London standard costing is “the preparation and
use of standard costs, their comparison with the actual costs and the analysis of variances to their causes and
points of incidence.” The methods of standard costing are prepared to show (a.) the standard costs (b) the
actual cost (c) the difference between these costs which is termed as variance.
DIFFERENCE BETWEEN BUDGETARY CONTROL AND STANDARD COSTING
Budgetary control Standard costing
Budgetary control is concerned with the Standard costing is related with the control
operation of the business as a whole and of expenses and it is more intensive.
hence it is more extensive.
Budget is a projection of financial accounts. Standard cost is a projection of cost
accounts.
It does not necessarily involve It requires standardization of products.
standardization of products.
Budgetary control can be adopted in part It is not possible to operate in parts.
also.
Budget can be operated without standards. Standard costing cannot exist without
budgets.

STANDARD COSTING, ESTIMATED COSTING AND HISTORICAL COSTING

Under Historical costing the costs are the actual costs and, therefore, control does not exist.
Estimated costing refers to the system of costing under which costs are estimated in advance. This means
the costs which are likely to be incurred during the given period of time.
Standard costing is a specialized technique of costing under which standard costs are predetermined, actual
costs are compared with such predetermined costs, if there is any variation take corrective action to control it.

DIFFERENCE BETWEEN ESTIMATED COSTS AND STANDARD COSTS

Estimated cost Standard cost
Estimated cost can be used in any business Standard costs can be applied in a business
which is running under historical cost under standard costing system.
system.
Compilation of estimated costs may be Calculations on scientific basis are made for
made at any time for any specific purpose. arriving at standard costs.
The use of estimated costs is statistical data Standard costs are used as a regular system of
only. accounts from which variances are found out.
The primary emphasis under estimation is The main aspect is cost control. Standard costs
on the ascertainment of costs and such costs are the yardsticks to measure the performance.
depend on expected actuals or past
performances.
Estimated costs can be ascertained for a part Standard costs are to be fixed in respect of
of the business and for a particular business. every aspect of business.

ADVANTAGES OF STANDARD COSTING

1. Formulation of production and price policies: Standard costing acts as a valuable guide to management
in the formulation of price and production policies. It assists the management in the field of inventory
pricing, product pricing, and profit planning and reporting
2. Comparison and analysis of data: Standard costing provides a stable and sound basis for comparison of
actual costs with standard costs according to different elements. It indicates places where remedial action is
necessary and how far improvement is possible in the long run.
3. Cost consciousness: Standard costing also provides incentives to workers and middle and top executive
for efficient work.
4. Better capacity to anticipate: A tighter, more accurate and effective budget can be formulated and it
helps to find out the deviations of actuals with the standards.
5. Delegation of authority and fixation of responsibility: Delegation of authority and fixation of
responsibility can be done by management to control the affairs in different departments.
6. Management by exception (MBO): The principle ‘management by exception” can be made applicable in
the business. This helps the management in concentrating in attention on cases which are off-standard i.e.,
below or above the standard.
7. Better economy, efficiency and productivity: Men, machine and materials are more effectively utilised
and thus economies can be affected in business together with increased productivity.
8. Supports budgetary control: If the standard costs are effectively determined, they help in their
effectiveness of the budgetary control by providing best basis for estimating future cost performance.
9. Supports responsibility accounting: Responsibility accounting is a system in which various cost centres
are formed and responsibility for cost control is assigned to the concerned cost centre.

LIMITATIONS OF STANDARD COSTING

The limitations of standard costing are as follows.
 Standard fixation is a lengthy procedure and involves plenty of time, money and energy.
 Fixation of standard is not possible for every type of work for operations.
 If standards are based merely on judgments rather than facts, they will be subjective and affected with
human error.
 Standard costing requires continuous revision of standards in the light of changed circumstances.
 Too tight or unattainable standards cause demotivation in employees and causes inefficiency.

CONTROL RATIOS
Under a budgetary control system, actual performance is compared to budgeted performance to enable the
identification of variances. Deviations or variances may be favorable or unfavorable, and they may be
expressed in terms of absolute figures or in terms of ratios. When deviations or variances are expressed in
terms of ratios, these ratios are referred to as control ratios.
Types of Control Ratios
1) Capacity Ratio: The capacity ratio is also known as the actual usage of budgeted capacity ratio. It shows
the relationship between the actual number of working hours and the budgeted number of working hours.
This ratio indicates the extent to which available facilities have actually been utilized during the budget
period.
Formula: Capacity ratio = (Actual hours / Budgeted hours) x 100
2) Activity Ratio: The activity ratio is the number of standard hours equivalent to the work produced
expressed as a percentage of the budgeted standard hours.
This ratio measures the level of activity at which a business is operating.
Formula: Activity ratio = (Actual production in standard hours / Budgeted production in standard hours) x
100
3) Efficiency Ratio: The efficiency ratio is the number of standard hours equivalent to the work produced
expressed as a percentage of the actual hours spent in production. This ratio measures the efficiency of a
firm's operations.
Formula: Efficiency ratio = (Actual production in standard hours / Actual hours worked) x 100