CHAPTER FOUR

4 Budgets and Budgetary Control

Learning Objectives:
To familiarize you with:
 The basic aspects of financial planning and the role of budgeting.

 The various types of budgets & the preparation of a Master budget.

 Some new ideas and developments in the area of budgeting.

Introduction
For you, reviewing the past information alone is not enough since your job
involves not only predicting but also shaping the future of your enterprise.
This requires proper planning about the activities of the business. Finance
being the life blood of business, financial planning is of utmost significance
to a businessman. A budget is an important tool for financial planning and
control.

Financial Planning
Financial planning is concerned with rising of funds and their effective
utilization with a view to maximize the wealth of the company. It includes
the determination of:
 The amount of funds needed for implementing various budget plans.

 The pattern of financing, i.e., the forms and proportions of various

corporate securities, such as shares, debentures, bonds, bank loans to
be issued or raised.

 The timing of the sales (floatation) of securities.

In spite of a good financial plan, the desired results may not be achieved if
there is no effective control to ensure its implementation. The budgets
represent a set of yardsticks/ benchmarks or guidelines for use in controlling
internal operations of an organization. The management, through budgets,
can evaluate the performance of every level of the organization. The
discrepancy between plan performance and actual performance is
highlighted through budgets. The organization may have to change the
course of its operations in a particular area or revise its plans keeping in view
the changing conditions.

What is a budget?

A budget is a plan expressed in quantitative, usually monetary terms,

covering a specified period of time, usually one year. In other words, a
budget is a systematic plan for the utilization of manpower and
material resources. In a business organization a budget represents an
estimate of future costs and revenues. Budgets may be divided into two
basic classes: Capital budgets, and Operating budgets.

Capital budgets are directed towards proposed expenditures for new

projects and often require special financing.
The operating budgets are directed towards achieving short term
operating goals of the organization, for instance, production or profit goals in
a business firm.
Operating budgets may be sub-divided into various departmental or financial
budgets.

The main characteristics of a budget are:

a. It is prepared in advance and is derived from the long term strategy of
the organization.

b. It relates to future period for which objectives or goals have already

been laid down.

c. It is expressed in quantitative form, physical or monetary units, or

both.

A budget helps us in the following ways:

1. It brings about efficiency and improvement in the working of the
organization.

2. It is a way of communicating the plans to various units of the

organization. By establishing the divisional, departmental, sectional
budgets, exact responsibilities are designed. It thus minimizes the
possibilities of back-passing, if the budget figures are not met.

3. It is a way of motivating managers to achieve the goals set for the

units.

4. It serves as a benchmark for controlling ongoing operations.

 5. It helps in developing a team spirit where participation in budgeting
is encountered.

6. It helps in reducing wastages and losses by revealing them in time

for corrective action.

7. It serves as a basis for evaluating the performance of managers.

8. It serves as a means of educating managers.

Budgetary Control
No system of planning can be successful without having an effective and
efficient system of control. The exercise of control in the organization with
the help of budgets is known as “budgetary control”.
The process of budgetary control includes:
i. Preparation of various budgets

ii. Continuous comparison of actual performance with budgetary

performance.

iii. Revision of budgets in the light of changed circumstances.

A system of budgetary control should not become rigid. There should be
enough scope for flexibility to provide individual initiatives and derive.
Budgetary control is an important device for making the organization more
efficient on all fronts. It is an important tool for controlling costs and
achieving the overall objectives.

Objectives of Budgetary Control

Budgetary control is essential for policy planning and control. It also acts as
an instrument of coordination. The main objectives of budgetary control are
as follows:

1. To ensure planning for future by setting up various budgets. The

requirements and expected performance of the enterprise are
anticipated.

2. To coordinate the activities of different departments.

3. To coordinate various cost centers and departments with efficiency

and economy.

4. Elimination of waste and increase in profitability.

 5. To anticipate capital expenditure for future.

6. To centralize the control system.

7. Fixation of responsibility of various individuals in the organization.

Characteristics of Good Budgeting

1. A good budget system should involve persons at different levels while
preparing the budget. The subordinates should not feel any imposition
on them.

2. There should be a proper fixation of authority and responsibility. The

delegation of authority should be done in a proper way.

3. The targets of the budgets should be realistic, if the targets are difficult
to be achieved then they will not enthuse the persons concerned.

4. A good system of accounting is also essential to make the budgeting

successful.

5. The budgeting system should have a whole-hearted support of the top

management.

6. The employees should be imparted budgeting education. There should

be meetings and discussions and the targets should be explained to
the employees concerned.

7. A proper reporting system should be introduced; the actual results

should be promptly reported so that performance appraisal is
undertaken.

Installing a Budgetary Control System

Having understood the meaning and significance of budgetary control in an
organization, it will be useful to you to know how a budgetary control system
can be installed in the organization. This requires, first of all, finding answers
to the following questions in the context of an organization:
1. What is likely to happen?

2. What can be made to happen?

3. What are the objectives to be achieved?

 4. What are the constraints and to what extent their effects can be
minimized?

Having found answers to the above questions, the following steps may be
taken for installing an effective system of budgetary control in an
organization.
I. Organization for Budgeting
The setting of a definite plan of organization is the first step towards
installing budgetary control system in an organization. A budget manual
should be prepared giving details of the powers, duties, responsibilities and
areas of operation of each executive in the organization.
Organization Chart for budgetary control

Chief executive/ General manger

Budget Officer

Budget Committee

Accounts Manager
Production Manager Marking Manager Finance Manager HR Manager R & D Manager
Production budget Sales budget Receipts budget
Cost budget
.plant Utilization Advertisements cost budget .Payments Budget Labor budget D&D Budget

II. Responsibility for budgeting

The responsibility for preparation and implementation of the budgets may be

fixed as under:
a. Budget Officer/ Controller: Although the chief executive is
finally responsible form the budget program, it is better if a large
part of the supervisory responsibility is delegated to an official
designated as a Budget officer or Budget controller. Such a
 person should have knowledge of the technical details of the
business and should report directly to the Chief executive or the
General manager of the organization.

b. Budget Committee: The Budget Officer is assisted in his

work by the budget Committee. The committee may consist of
Heads of Various departments, Viz., production, sales, finance,
human resource, etc. with the Budget Officer its chairman. It is
generally the responsibility of the Budget Officer to submit,
discuss, and finally approve the budget figures. Each head of the
department should have his own sub-committee with executives
working under him as its members.

c. Fixation of the Budget Period: Budget period means the

period for which a budget is prepared and employed. The budget
period depends upon the nature of the business and the control
techniques.

d. Budget Procedures: Having established the budget

organization and fixed the budget period, the actual work or
budgetary control can be taken upon the following patterns:

i. Key factor: It is also termed as Budget Limiting factor. The extent of

the influence of this factor must first be assessed in order to ensure that the
budget targets are met. It would be desirable to prepare first the budget
relating to this particular factor, and then prepare the other budgets. The key
factor should be correctly identified.

ii. Making a forecast: A forecast is an estimate of the future financial

conditions or operating results. Any estimate is based upon consideration of
probabilities. An estimate differs from a budget in that the latter embodies
an operating plan of an organization. A budget envisages a commitment to
certain objectives or targets which the management seeks to attain on the
basis of the forecasts prepared. A forecast may be prepared in financial or
physical terms for sales, production, costs, or other resources acquired for
business. Instead of just one forecast a number of alternative forecasts may
be considered with a view to attaining the most realistic overall plan.

iii. Preparing budgets: After the forecasts have been

finished the preparation of budgets follows. The budget activity
 starts with the preparation of the sales budget. Then production
budget is prepared on the basis of the sales budget and the
production capability available. Financial budgets (like Cash or
Working Capital) will be prepared on the basis of sales forecasts and
production budget. All these budgets are combined and coordinated
into a Master Budget. The budgets may be revised in the course
of the financial period if it becomes necessary to do so in view of
the unexpected developments which have already taken place or
are likely to take place.

Limitations of Budgetary Control

Despite many good points of budgetary control there are some limitations of
this system. Some of the limitations are discussed below:
1. Uncertain future. The budgets are prepared for the future period.
Despite best estimates made for the future, the prediction may not
always come true. The future uncertainties reduce the utility of
budgetary control system.
2. Budgetary Revisions Required. Budgets are prepared on the
assumptions that certain conditions will prevail. Because of future
uncertainties, assumed conditions may not prevail necessitating the
revision of budgetary targets.
3. Discourages Efficient Persons. Under budgetary control system the
targets are given to every person in the organization. The common
tendency of people is to achieve the targets only. There may be some
efficient persons who can exceed the targets but they will not feel
contented by reaching the targets. So budgeting may serve as
constraints on managerial initiatives.
4. Problem of Coordination. The success of budgetary control depends
upon the coordination among different departments. The performance
of one department affects the results of other departments. To
overcome the problem of coordination a Budgetary Officer is needed.
Every concern cannot afford to appoint a Budgetary Officer. The lack of
coordination among different departments results in poor
performance.
5. Conflict among Different Departments. Budgetary control may
lead to conflicts among functional departments. Every departmental
head worries for his department goals without thinking of business
 goal. Every department tries to get maximum allocations of funds and
this raises a conflict among different departments.
6. Depends upon Support of Top Management. Budgetary control
system depends upon the support of top management. The
management should be enthusiastic for the success of this system and
should give full support for it. If at any time there is a lack of support
from top management then this system will collapse.

Classification and Types of Budgets

The budgets are usually classified according to their nature. The following
are the types of budgets which are commonly used:

A. According to time

1. Long term budgets (5 to 10 years)

2. Short term budgets (1 to 2 years)

3. Current budgets (monthly or weekly)

B. On the basis of function

1. Operating budgets

i. Sales budget

ii. Production budget

iii. Production cost budgets

iv. Plant utilization budget

v. Selling & Administrative budgets

vi. Program budgets

vii. Responsibility budgets

2. Financial budgets
 i. Cash budget

ii. Working capital budget

iii. Capital expenditure budget

iv. Budgeted income Statement

v. Budgeted balance Sheet

3. Master budget

C. On the basis of flexibility

i. Fixed budget (given level of activity)

ii. Flexible budget (consists of series of budgets for different levels

of activity)

A. Classification according to time

1. Long term budgets: - The budgets are prepared to depict long
term planning of the business. The period of long term budgets varies
between five to ten years. The long term planning is done by the top
level management, it is not generally known to lower levels of
management. Long time budgets are prepared for some sections of the
concern such as capital expenditure, research and development, long
term finances; etc.
2. Short term budgets: - These budgets are generally for one or two
years and are in the form of monetary terms.
3. Current budgets: - The period of current budgets is generally of
months and weeks. These budgets relate to the current activities of
the business. According to I.C.W.A London, “current budget is a budget
which is established for use over a short period of time and is related
to current conditions”.
B. Classification on the basis of functions
1. Operating budgets: - These budgets relate to the different
activates or operations of a firm. The number of such budgets depends
upon the size and nature of business. The commonly used operating
budgets are:-
a. Sales budget
b. production budget
c. production cost budget
d. purchase budge, etc.
2. Financial budget: - Financial budgets are concerned with cash
receipts and disbursements, working capital, capital expenditure,
financial position and results of business operations. The commonly
used financial budgets are
a. cash budget
b. working capital budget
c. capital expenditure budget
d. income statement budget
e. statement of retained earnings budget
f. budgeted balance sheet or position statement budget
3. Master budget: - various functional budgets are integrated into
Master budget. This budget is prepared by the ultimate integration of
separate functional budgets. According to l.C.W.A London, “The Master
budget is the summary budget incorporating its functional budgets”.
Master budget is prepared by the budget of officer and it remains with
the top level management. This budget is used to co-ordinate the
activities of various functional departments and also to help as control
device.
 C. Classification on the basis of flexibility
A budget may be fixed or flexible. A fixed budget is based on a fixed
volume of activity. It may lose its effectiveness in planning and
controlling if the actual capacity utilization is different from what was
planned for any particular unit of time, e.g., a month or a quarter.
The flexible budget is more useful for changing levels of activity as it
considers fixed and variable costs separately. If flexible budgeting
approach is adapted, the Budget Officer can analyze the variance
between actual costs and budgeted costs depending upon the actual
levels of activity attained during a period of time.

Components of Master budget

The terms used to describe assorted budget schedules vary from
organization to organization, however, most Master budgets have
common elements. The usual Master budget for a non-manufacturing
company has the following components.
A. Operating budget
1. Sales budget (and other cost driver budgets as necessary)
2. Purchase budget
3. Cost of goods sold budget
4. Operating expenses budget
5. Budgeted income statement
B. Financial budget
1. Capital budget
2. Cash budget
C. Budgeted balance sheet
The two major parts of a Master budget are the operating budget and
the financial budget. The operating budget focuses on the income
statement and its supporting schedules, though sometimes called the
profit plan. An operating budget may show a budgeted loss, or even by
used to budget expenses in an organization or agency with no sales
revenues. In contrast, the financial budget focuses on the effects that
the operating budget and other plans (such as capital budgets and
repayments of debt) will have on cash.
Basic Steps in Preparation of Master Budget for
Merchandising Enterprise:-
The principal steps in preparing the Master budget are
Operating budget
1. using the data, given, prepare the following defiled schedules for
each of the months of the planning horizon.
a. Sales budget
b. Cash collection form customers
c. Purchase budget
d. Disbursements for purchases
f. Disbursements for operating expenses
2. using these schedules, prepare a budgeted income statement
financial budget
3. Using the data given and the supporting schedules, prepare the
following forecasted financial statements.
A. cash budget including details of borrowings, repayments, and
interest for each month of the planning horizon
B. Budgeted balance sheet as of the end period
You will need schedules 1a, 1c, and 1e to prepare the budgeted
income statement and schedules 1b, 1d and 1f to prepare the cash
budget.
Organizations with effective budget systems have specific guidelines
for the steps and timing of budget preparation. Although the details
differ, the guidelines invariably include the preceding steps.

Step 1. Preparation of operation budget

You should now be ready to trace the budgeting process.
Step 1a. Sales budget
The sales budget is the starting point for budgeting because inventory
levels, purchases and operating expenses are geared to the rate of
sales activities.
Step 1b. Cash collections
It is easiest to prepare schedule b, cash collections, at the same time
as preparing the sales budget. Cash collections include the current
month’s cash sales plus the previous month’s credit sales. We will use
total collections in preparing the cash budget.
Step 1c. Purchases budget
After sales are budgeted, prepare the purchase budget (schedule c).
The total merchandise needed will be the sum of the desired ending
inventory plus the amount needed to fulfill budgeted sales demand.
The total need will be partially met by the beginning inventory; the
remainder must come from planned purchases.
The purchases are computed as follows:-
Budgeted purchases = desired ending inventory and cost of goods sold
less beginning inventory
Step 1d. Disbursements for purchases
Scheduled, disbursements for purchase, is based on the purchase
budget. Disbursements include if 50% of the current month’s
purchases and if 50% of the previous month’s purchases. No will use
total disbursements in preparing the cash budget

Step 1.e operating expense budget

The budgeting of operating expenses depends on various factors.
Month-to-month fluctuations in sales volume and other cost drive
activity directly influence many operating expenses. Example of
expenses driven by sales volume include sales commissions and many
delivery activities [such as rent, insurance, depreciation, and salaries]
with appropriate relevant rages and are regarded as fixed.
Trace the total operating expenses in the final column of schedule,
which summarizes these expenses, to the budgeted income statement.
Step1 f operating expenses disbursements
Disbursements for operating expenses are based on the operating
expense budget. Disbursements include 50% of last month’s and this
month’s wages and commissions, and miscellaneous and rent
expenses. We will use the total of these disbursements in preparing
the cash budget.
Step 2: preparation of budgeted income statement
Step1a through if provide enough information to construct a budgeted
income statement from operations. The income statement will be
complete after addition of the interest expense, which is computed
after the cash budget, has been prepared. Budgeted income from
operations is often a benchmark for judging management
performance.
Step3: Preparation of financial budget
The second major part of the Master budget is the financial budget,
which consists of the capital budget, cash budget, and ending balance
sheet.
Step 3a- Cash Budget

The cash budget is a statement of planned cash receipts and

disbursements. The cash budget is heavily affected by the level of
operations summarized in the budgeted income statement.
The total cash available before financing equals the beginning cash
balance plus cash receipts. Cash receipts depends on collections from
customers’ accounts receivable and cash sales and n their operating
income sources.

Cash disbursement for

1. Purchases depend on the credit terms expended by suppliers and
the bill paying habits of the buyer
2. Payroll depends on wage, salary and commission terms and on
payroll dates.
3. Some costs and expenses depend on contractual terms for
installment payments, mortgage payments, rents, leases and
miscellaneous items.
4. other disbursements include outlays for fixed assets, long term
investments, dividends and the like
Management determines the minimum cash balance desired
depending on the nature of the business and credit arrangements.
Financing requirements depend on how the total cash available
compares with the total cash needed. Needs include the
disbursements plus the desired ending cash balance. If the total cash
available is less than the cash needed, borrowing is necessary to cover
the planned deficiency. If there is an excess, loans may be repaid. The
pertinent outlays for interest expenses are usually contained in this
section of the cash budget.
Cash budgets help management to avoid having unnecessary idle
cash, on the one hand, and unnecessary cash deficiencies, on the
other. A well-managed financing program keeps cash balances from
becoming too large or too small.
Step 3b Budgeted Balance Sheet
The final step in preparing the Master budget is to construct the
budgeted balance sheet that projects each balance sheet item in
accordance with the business plan as expressed in the previous
schedules.
When the complete Master budget is formulated, management can
consider all the major financial statements as a basis for changing the
course of events:

Illustration
To illustrate the budgeting process, we will use as an example the ABC
company as follows:-
Given data
1. The budgeted period: - July-Sep. 202x (for 3 months)
2. The actual balance sheet, June 30 th, 202x is shown below
ABC Company
 Balance sheet
June 30th, 202x
ASSETS LIABILITY & CAPITAL

Cash 20,000 Account payable

16,000
A/R 12,000 Wages payable 3,000
Inventory 16,000 Commission payable 600
Prepaid insur. 10,000 Owners equity 54,400
Equipment 30,000
Accn. Deprecation (14,000)
____
Total 74,000
74,000
2. All sales are made 60% on account and 40% on cash. The credit
sales are entirely collected following the month of sales
3. Purchases are made 60% on account and 40% on cash, The credit
purchases are paid in following month the amount of purchase
4. Payments for wages and commission are made 70% in the month
and 30% in the following month
5. Money can be borrowed at 9% interest, borrowing is made at the
begun and repayments are end of months on FIFO based in
multiples of Birr 2000.00.
6. Cost of goods sold is estimated at 65% of sales and ending
inventory of Birr 40,000.00 is desired at the end of any month.
7. Minimum cash balance of birr 20,000.00 is required at the end of
any month.
8. The organization has a plan to purchase a new equipment in the
first half of August for birr 10,000 that will be used expenditure to
acquired fixed asset
9. Cost equipment and insurance expire at a rate of 20% on book
value per month
10. Salesmen commission are estimated to be 10% of sales
11. Forecast for wages and sales are as follows:

July August September

Sales 20,000 100,000 18,000
Wages 6,000 4000 4000
Required:-
Prepare a Master budget for three months ending Sep. 202x.

Solution
ABC Company
Master Budget
For 3 Months Ending Sep30, 202X
1A. Sales budget July Aug. Sep.
Remark

Cash sales, 40% 8000 40,000 7,200

Plus credit sales, 60% 12,000 60,000 10,800
Total sales, 100% 20,000 100,000
18,000 138,000
1B. Collection from sales
Cash sales 40% 8000 40000 7200
Plus collection of A/R, 60% 12000 12000
60000
 Total 20000 52000
67200
1C. Purchases budget
C.G.S (65% of sales) 13000 65000 11700
89700
Plus desired ending inventory 40000 40000
40000
Available for sales 53000 105000 51700
Less beginning inventory 16000 40000 40000
Purchased 37000 65000 11700

1D. disbursements for purchase July Aug Sep. Remark

Cash purchase, 40% 14800 26000 4680

Plus payment of A/P, 60% 16000 22200 39000

Total 30800 48200 43680
1.E operating expense budget
Wages 6000 4000 4000
Sales commission (10% of sales) 2000 10000 1800
Insurance (20%) 2000 1600 1280
Depreciation (20%) 3200 4560 3648
Total 13200 20160 10728
44088

1.F Disbursements and operating

Operating expenses
For this month
Wages (70%) 4200 2800 2800
 Commission (70%) 1400 7000 1260
For last month
Wages (30%) 3000 1800 1200
Commission (30%) 600 600 3000
Total 9200 12200 8260
2. BUDGETED INCOME STATEMENT
ABC COMPANY
FOR CASTLED INCOME STATEMENT
3 MONTHS ENDING SEP 30, 202X
Sales data source of data
Sales 138,000 1A
Less cost of goods sold 89,700 1C
Gross margin 48,300
Less Operating expenses 44,088 1E
Income from operation 4,212

3A. Cash budget ABC Company cash budget for 3 months

ending Sep 30, 202X July
Aug. Sep. Remark

Beginning cash balance 20000 20000

21600
Add. Cash collection 20000 52000 67200
Total cash available
before financing(W) 40000 72000 88800
Less cash disbursements
Purchase 30800 48200 43680
Expense 9200 12200 8260
Equipment __--____ 10000 _---__
Total cash disbursements (X) 40000 70400
51940
Add minimum cash
balance desired (Y) 20000 20000 20000
Total cash needed 60000 90400 71940
Excess (deficiency) of total cash
Available over total cash needed
Before financing (W-X-Y) (20000) (18400) 16860
Financing
Borrowing (at beginning
of month) 20000 20000 -----_
Repayment of debt (at end
of month) -------- (16000)
Interest (at 9% per year) ---- ---- (360.00)
Total cash increase (decrease)
From financing (Z) 20000 20000 (16360)
Ending cash balance ((W-X) +Z) 20000 21600 20500

Additional
1. interest on the principal paid September 202X
Interest = Principal x Rate x Time
 16,000 x 9/100 x 3/12 = 360.00
2. loans outstanding September 202X
1st Loan = 20,000 – 16,000 = 4,000
2nd Loan 20,000
Total 24,000
3. Interest accrued on loans outstanding
4000 x 9/100 x 3/12 = 90.00
20,000 x 9/100 x 2/12 = 300.00
Total 390.00
4. Total interest expense (paid and un paid)
360+390 = 750.00
Forecasted capital statement
Beginning capital June 201X ---- ---------------------------54,400
Operating income statement ------4212.00
Less:- Interest (360+390) 750.00
Net increase in capital 3462.00
Ending capital, September 202X 57,862.00

3. B Budgeted balance sheet

ABC Company
Budgeted balance sheet
September 30, 202X
Current Assets Current liabilities
Cash 20,500 Account payable
7020
Account receivable 10,800 Wage payable 1200
Inventory 40000 Commission payable 540
Insurance 5120 Loans Payable 24000
Equipment 40000 Interest payable
390
(30,000+10,000) Owners’ Equity
57862
Acc. Dep. (25,408) (54,400+3462)
(14,000+11,408) _________ _____
Total Assets 91,012 Total Lib. & Capital
91,012