Unit 3.

Budget and budgetary control

 Introduction:
A budget is an accounting plan. It is a formal plan of action expressed in monetary terms. It could be
seen as a statement of expected income and expenses under certain anticipated operating conditions.
It is a quantified plan for future activities – quantitative blue print for action.
Every organization achieves its purposes by coordinating different activities. For the execution of goals
efficient planning of these activities is very important and that is why the management has a crucial
role to play in drawing out the plans for its business. Various activities within a company should be
synchronized by the preparation of plans of actions for future periods. These comprehensive plans are
usually referred to as budgets. Budgeting is a management device used for short‐term planning and
control. It is not just accounting exercise.
 Definition of budget and budgetary control:
 According to CIMA (Chartered Institute of Management Accountants) UK, a budget is “A plan
quantified in monetary terms prepared and approved prior to a defined period of time, usually
showing planned income to be generated and, expenditure to be incurred during the period and the
capital to be employed to attain a given objective.”
 Keller & Ferrara, “a budget is a plan of action to achieve stated objectives based on predetermined
series of related assumptions.”
 [Link] states, “A budget is a written plan covering projected activities of a firm for a definite time
period.”
One can elicit the explicit characteristics of budget after observing the above definitions. They are…
• · It is mainly a forecasting and controlling device.
• · It is prepared in advance before the actual operation of the company or project.
• · It is in connection with definite future period.
• · Before implementation, it is to be approved by the management.
• · It also shows capital to be employed during the period.
Budgetary Control is a method of managing costs through preparation of budgets. Budgeting is thus
only a part of the budgetary control. According to CIMA, “Budgetary control is the establishment of
budgets relating to the responsibilities of executives of a policy and the continuous comparison of the
actual with the budgeted results, either to secure by individual action, the objective of the policy or to
provide a basis for its revision.”
 Objectives:
 Planning: Planning has been defined as the design of a desired future position for an entity and it rests
on the belief that the future position can be attained by uninterrupted management action. Detailed
plans relating to production, sales, raw‐material requirements, labour needs, capital additions, etc. are
drawn out. By planning many problems estimated long before they arise and solution can be thought

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 Unit 3. Budget and budgetary control

of through careful study. In short, budgeting forces the management to think ahead, to foresee and
prepare for the anticipated conditions. Planning is a constant process since it requires constant revision
with changing conditions.
 Co‐ordination: Budgeting plays a significant role in establishing and maintaining coordination.
Budgeting assists managers in coordinating their efforts so that problems of the business are solved in
harmony with the objectives of its divisions. Efficient planning and business contribute a lot in
achieving the targets. Lack of co‐ordination in an organization is observed when a department head is
permitted to enlarge the department on the specific needs of that department only, although such
development may negatively affect other departments and alter their performances. Thus, co‐
ordination is required at all vertical as well as horizontal levels.
 Measurement of Success: Budgets present a useful means of informing managers how well they are
performing in meeting targets they have previously helped to set. In many companies, there is a
practice of rewarding employees on the basis of their accomplished low budget targets or promotion
of a manager is linked to his budget success record. Success is determined by comparing the past
performance with previous period's performance.
 Motivation: Budget is always considered a useful tool for encouraging managers to complete things in
line with the business objectives. If individuals have intensely participated in the preparation of
budgets, it acts as a strong motivating force to achieve the goals.
 Communication: A budget serves as a means of communicating information within a firm.
 The standard budget copies are distributed to all management people provide not only sufficient
understanding and knowledge of the programmes and guidelines to be followed but also give
knowledge about the restrictions to be adhered to.
 Control: Control is essential to make sure that plans and objectives laid down in the budget are being
achieved. Control, when applied to budgeting, as a systematized effort is to keep the management
informed of whether planned performance is being achieved or not.

 Essential requirements:
1) Support of top management: If the budget structure is to be made successful, the consideration by
every member of the management not only is fully supported but also the impulsion and direction
should also come from the top management. No control system can be effective unless the
organization is convinced that the management considers the system to be important.
2) Team Work: This is an essential requirement, if the budgets are ready from “the bottom up” in a
grass root manner. The top management must understand and give enthusiastic support to the
system. In fact, it requires education and participation at all levels. The benefits of budgeting need to
be sold to all.

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 Unit 3. Budget and budgetary control

3) Realistic Objectives: The budget figures should be realistic and represent logically attainable goals.
The responsible executives should agree that the budget goals are reasonable and attainable.
4) Excellent Reporting System: Reports comparing budget and actual results should be promptly
prepared and special attention focused on significant exceptions i.e. figures that are significantly
different from expected. An effective budgeting system also requires the presence of a proper feed‐
back system.
5) Structure of Budget team: This team receives the forecasts and targets of each department as well
as periodic reports and confirms the final acceptable targets in form of Master Budget. The team also
approves the departmental budgets.
6) Well defined Business Policies: All budgets reveal that the business policies formulated by the
higher level management. In other words, budgets should always be after taking into account the
policies set for particular department or function. But for this purpose, policies should be precise and
clearly defined as well as free from any ambiguity.
7) Integration with Standard Costing System: Where standard costing system is also used, it should
be completely integrated with the budget programme, in respect of both budget preparation and
variance analysis.
8) Inspirational Approach: All the employees or staff other than executives should be strongly and
properly inspired towards budgeting system. Human beings by nature do not like any pressure and
they dislike or even rebel against anything forced upon them.
 Advantages and disadvantages:
Advantages
1. This system provides basic policies for initiatives.
2. It enables the management to perform business in the most professional manner because budgets
are prepared to get the optimum use of resources and the objectives framed.
3. It ensures team work and thus encourages the spirit of support and mutual understanding among
the staff.
4. It increases production efficiency, eliminates waste and controls the costs.
5. It shows to the management where action is needed to remedy a position.
6. Budgeting also aids in obtaining bank credit.
7. It reviews the present situation and pinpoints the changes which are necessary.
8. With its help, tasks such as like planning, coordination and control happen effectively and efficiently.
9. It involves an advance planning which is looked upon with support by many credit agencies as a
marker of sound management.

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 Unit 3. Budget and budgetary control

Disadvantages:
1. It tends to bring about rigidity in operation, which is harmful. As budget estimates are quantitative
expression of all relevant data, there is a tendency to attach some sort of rigidity or finality to them.
2. It being expensive is beyond the capacity of small undertakings. The mechanism of budgeting system
is a detailed process involving too much time and costs.
3. Budgeting cannot take the position of management but it is only an instrument of management.
‘The budget should be considered not as a master, but as a servant.’ It is totally misconception to think
that the introduction of budgeting alone is enough to ensure success and to security of future profits.
4. It sometimes leads to produce conflicts among the managers as each of them tries to take credit to
achieve the budget targets.
5. Simple preparation of budget will not ensure its proper implementation. If it is not implemented
properly, it may lower morale.
6. The installation and function of a budgetary control system is a costly affair as it requires employing
the specialized staff and involves other expenditure which small companies may find difficult to incur.

 Types of budgets:

Functional Classification:
 Sales Budget:
The sales budget is an estimate of total sales which may be articulated in financial or quantitative
terms. It is normally forms the fundamental basis on which all other budgets are constructed. In
practice, quantitative budget is prepared first then it is translated into economic terms. While
preparing the Sales Budget, the Quantitative Budget is generally the starting point in the operation of
budgetary control because sales become, more often than not, the principal budget factor. The factor
to be consider in forecasting sales are as follows:
 Study of past sales to determine trends in the market.

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 Estimates made by salesman various markets of company products.

 Changes of business policy and method.
 Government policy, controls, rules and Guidelines etc.
 Potential market and availability of material and supply.
 Production Budget:
The production budget is prepared on the basis of estimated production for budget period. Usually,
the production budget is based on the sales budget. At the time of preparing the budget, the
production manager will consider the physical facilities like plant, power, factory space, materials and
labour, available for the period. Production budget envisages the production program for achieving
the sales target. The budget may be expressed in terms of quantities or money or both. Production
may be computed as follows: Units to be produced = Desired closing stock of finished goods +
Budgeted sales – Beginning stock of finished goods.
 Production Cost Budget:
This budget shows the estimated cost of production. The production budget demonstrates the
capacity of production. These capacities of production are expressed in terms of cost in production
cost budget. The cost of production is shown in detail in respect of material cost, labour cost and
factory overhead. Thus production cost budget is based upon Production Budget, Material Cost
Budget, Labour Cost Budget and Factory overhead.
 Raw‐Material Budget:
Direct Materials budget is prepared with an intention to determine standard material cost per unit and
consequently it involves quantities to be used and the rate per unit. This budget shows the estimated
quantity of all the raw materials and components needed for production demanded by the production
budget.
Raw material serves the following purposes:
 It supports the purchasing department in scheduling the purchases.
 Requirement of raw‐materials is decided on the basis of production budget.
 It provides data for raw material control.
 Helps in deciding terms and conditions of purchase like credit purchase, cash purchase, payment
period etc.
 It should be noted that raw material budget generally deals with only the direct materials
whereas indirect materials and supplies are included in the overhead cost budget.
 Purchase Budget:
Strategic planning of purchases offers one of the most important areas of reduction cost in many
concerns. This will consist of direct and indirect material and services. The purchasing budget may be
expressed in terms of quantity or money.

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 Unit 3. Budget and budgetary control

The main purposes of this budget are:

 It designates cash requirement in respect of purchase to be made during budget period; and
 It is facilitates the purchasing department to plan its operations in time in respect of purchases
so that long term forward contract may be organized.
 Labour Budget:
Human resources are highly expensive item in the operation of an enterprise. Hence, like other factors
of production, the management should find out in advance personnel requirements for various jobs in
the enterprise.
This budget may be classified into labour requirement budget and labour recruitment budget. The
labour necessities in the various job categories such as unskilled, semi‐skilled and supervisory are
determined with the help of all the head of the departments. The labour employment is made keeping
in view the requirement of the job and its qualifications, the degree of skill and experience required
and the rate of pay.
 Production Overhead Budget:
The manufacturing overhead budget includes direct material, direct labour and indirect expenses. The
production overhead budget represents the estimate of all the production overhead i.e. fixed, variable,
semi‐variable to be incurred during the budget period. The reality that overheads include many
different types of expenses creates considerable problems in:
1) Fixed overheads i.e., that which is to remain stable irrespective of vary in the volume of output,
2) Apportion of manufacturing overheads to products manufactured, semi variable cost i.e., those
which are partly variable and partly fixed.
3) Control of production overheads.
4) Variable overheads i.e., that which is likely to vary with the output.
The production overhead budget engages the preparation of overheads budget for each division of
the factory as it is desirable to have estimates of manufacturing overheads prepared by those
overheads to have the responsibility for incurring them. Service departments cost are projected and
allocated to the production departments in the proportion of the services received by each
department.
 Selling And Distribution Cost Budget:
The Selling and Distribution Cost budget is estimating of the cost of selling, advertising, delivery of
goods to customers etc. throughout the budget period. This budget is closely associated to sales
budget in the logic that sales forecasts significantly influence the forecasts of these expenses.
Nevertheless, all other linked information should also be taken into consideration in the preparation
of selling and distribution budget. The sales manager is responsible for selling and distribution cost
budget. Naturally, he prepares this budget with the help of managers of sub‐divisions of the sales

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department. The preparation of this budget would be based on the analysis of the market condition
by the management, advertising policies, research programs and many other factors. Some companies
prepare a separate advertising budget, particularly when spending on advertisements are quite high.
 Administration Cost Budget:
This budget includes the administrative costs for non‐manufacturing business activities like director’s
fees, managing directors’ salaries, office lightings, heating and air condition etc.
Most of these expenses are fixed so they should not be too difficult to forecast. There are semi‐variable
expenses which get affected by the expected rise or fall in cost which should be taken into account.
Generally, this budget is prepared in the form of fixed budget.
 Capital‐ Expenditure Budget:
This budget stands for the expenditure on all fixed assets for the duration of the budget period. This
budget is normally prepared for a longer period than the other functional budgets. It includes such
items as new buildings, land, machinery and intangible items like patents, etc. This budget is designed
under the observation of the accountant which is supported by the plant engineer and other functional
managers. At the time of preparation of the budget some important information should be observed:
 Overfilling on the production facilities of certain departments as revealed by the plant
utilization budget.
 Long‐term business policy with regard to technical developments.
 Potential demand for certain products.
 Cash Budget:
The cash budget is a sketch of the business estimated cash inflows and outflows over a specific period
of time. Cash budget is one of the most important and one of the last to be prepared.
It is a detailed projection of cash receipts from all sources and cash payments for all purposes and the
resultants cash balance during the budget. It is a mechanism for controlling and coordinating the fiscal
side of business to ensure solvency and provides the basis for forecasting and financing required to
cover up any deficiency in cash. Cash budget thus plays a vital role in the financing management of a
business undertaken. Cash budget assists the management in determining the future liquidity
requirements of the firm, forecasting for business of those needs, exercising control over cash. So,
cash budget thus plays a vital role in the financial management of a business enterprise.
Function of Cash Budget:
 It makes sure that enough cash is available when it is required.
 It designates cash excesses and shortages so that steps may be taken in time to invest any
excess cash or to borrow funds to meet any shortages.
 It shows whether capital expenditure could be financed internally.
 It provides funds for standard growth.

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 Unit 3. Budget and budgetary control

 It provides a sound basis to manage cash position.

Advantages of Cash Budget:
1. Usage of Cash: Management can plan out the use of cash in accord with the changes of receipt and
payment. Payments can be planned when sufficient cash is available and continue the business activity
with the minimum amount of working capital.
2. Allocation for Capital Investment: It is dual benefits such as capital expenditure projects can be
financed internally and can get an idea for cash availability of capital investment.
3. Provision of Excess Funds: It reveals the availability of excess cash. In this regard management can
decide to invest excess funds for short term or long term according to the requirements in the
business.
4. Pay‐out Policy: This budgetary system may help the management for future pay‐out policy in the
form of dividend. In case the cash budget liquid position is not favourable, the management may
reduce the rate of dividend or maintain dividend amount or skip dividend for the year.
5. Provision for acquiring Funds: It gives the top level management ideas for acquiring funds for
particular time duration and sources to be explored.
6. Profitable Use of Cash: Business person can take decision for the best use of liquidity to make more
profitable transaction. It can be used at the time of bulk purchase payments and one get the benefit
of discount.
Limitation of Cash Budget:
1. Complex Assumption: Business is full of uncertainties, so it is very difficult to have near perfect
estimates of cash receipts and payments, especially for a longer duration. It can be predicted for short
duration such as of three to four months.
2. Inflexibility: If the finance manager fails to show flexibility in implementing the cash budget, it will
incur adverse effects. If the manager follows strictly adheres to the estimates of cash inflow it may
negatively result in losing customers. Likewise, loyalty in payments may lead to deterioration of liquid
position.
3. Costly: Application of this technique necessitates collecting of statistical information from various
sources and expert personnel in operation research would be the costliest deal. It becomes expensive
which may not be affordable to small business houses.

 Flexibility Budget:
 Fixed Budget:
A fixed budget is prepared for one level of output and one set of condition. This is a budget in which
targets are tightly fixed. It is known as a static budget. It is firm and prepared with the assumption that
there will be no change in the budgeted level of motion. Thus, it does not provide room for any

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modification in expenditure due to the change in the projected conditions and activity. Fixed budgets
are prepared well in advance.
This budget is not useful because:
• The conditions go on the changing and cannot be expected to be firm.
• The management will not be in a position to assess, the performance of different heads on the basis
of budgets prepared by them because to the budgeted level of activity.
• It is hardly of any use as a mechanism of budgetary control because it does not make any difference
between fixed, semi‐variable and variable costs
• It does not provide any space for alteration in the budgeted figures as a result of change in cost due to
change in the level of activity.
 Flexible Budget:
• This is a dynamic budget. In comparison with a fixed budget, a flexible budget is one “which is designed
to change in relation to the level of activity attained.” An equally accurate use of the flexible budgets
is for the purposes of control.
• Flexible budgeting has been developed with the objective of changing the budget figures so that they
may correspond with the actual output achieved. It is more sensible and practical, because changes
expected at different levels of activity are given due consideration. Thus a budget might be prepared
for various levels of activity in accord with capacity utilization.
Flexible budget may prove more useful in the following conditions:
 Where the level of activity varies from period to period.
 Where the business is new and as such it is difficult to forecast the demand.
 Where the organization is suffering from the shortage of any factor of production. For example,
material, labour, etc. as the level of activity depends upon the availability of such a factor.
 Where the nature of business is such that sales go on changing.
 Where the changes in fashion or trend affects the production and sales.
 Where the organization introduces the new products or changes the patterns and designs of its
products frequently.
 Where a large part of output is intended for the export.
Uses of Flexible Budget:
In flexible budgets numbers are adjustable to any given set of operating conditions. It is, therefore,
more sensible than a fixed budget which is true only in one set of operating environment.
Flexible budgets are also useful from the view point of control. Actual performance of an executive
should be compared with what he should have achieved in the actual circumstances and not with what
he should have achieved under quite different circumstances. At last, flexible budgets are more

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realistic, practical and useful. Fixed budgets, on the other hand, have a limited application and are
suited only for items like fixed costs.
 Zero Base Budgeting:
The ‘Zero‐Base’ refers to a ‘nil‐budget’ as the starting point. It starts with a presumption that the
budget for the next period is ‘zero’ until the demand for a function, process, or project is not justified
for single penny.
The assumption is that without such justification, no expenditure will be allowed. In effect, each
manager or functional head is required to carry out cost‐benefit analysis of each of the activities, etc.
under his control and for which he is responsible.

 Time Based Budgets:

 Long-term Budget
This budget is related to the planning operations of an organization for a period of 5 to 10 years. The
long-term budget may be adversely affected due to unpredictable factors. Therefore, from a control
point of view, the long-term budget should be supplemented by short-term budgets.
Example: Research and Development Budget, Capital Expenditure Budget, etc.
 Short-term Budget
This budget is drawn usually for one year. Sometimes a budget may be prepared for a shorter period
(like monthly budget, quarterly budget, etc.). Short-term budgets are prepared in detail and these
budgets help to exercise control over day-to-day operations.
Example: Material Consumption Budget, Labor Utilization Budget, Cash Budget, etc.
 Current Budget
A budget that is established for use over a short period and is related to the current conditions is called
the Current Budget. This budget is adjusted to the current conditions prevailing in the business.
 Rolling Budget
A rolling budget is a continuous budget that is updated regularly when the earlier budget expires, or
we can say it is an extension of the current budget. A rolling budget is also known as a budget rollover.

SH481U Accounts and Finance for Entrepreneurs