Module VI - Budget & Budgetary Control

Its meaning, uses & limitation, budgeting & profit, different types of
budgets.

Introduction
Budgeting has come to be accepted as an efficient method of short-term planning and
control. It is employed, no doubt, in large business houses, but even the small businesses are
using it at least in some informal manner. Through the budgets, a business wants to know
clearly as to what it proposes to do during an accounting period or a part thereof. The
technique of budgeting is an important application of Management Accounting. Probably, the
greatest aid to good management that has ever been devised is the use of budgets and budgetary
control. It is a versatile tool and has helped managers cope with many problems including
inflation.

DEFINITION OF BUDGET
The Chartered Institute of Management Accountants, England, defines a 'budget' as under:
“A financial and/or quantitative statement, prepared and approved prior to define period of time,
of the policy to be persuade during that period for the purpose of attaining a given objective."
According to Brown and Howard “A budget is a predetermined statement of managerial policy
during the given period which provides a standard for comparison with the results actually
achieved."

Essentials of a Budget
An analysis of the above said definitions reveal the following essentials of a budget:
(1) It is prepared for a definite future period.
(2) It is a statement prepared prior to a defined period of time.
(3) The Budget is monetary or quantitative statement of policy.
(4) The Budget is a predetermined statement and its purpose is to attain a given objective.
A budget, therefore, be taken as a document which is closely related to both the managerial as
well as accounting functions of an organization.

Forecast Vs. Budget

Forecast is mainly concerned with an assessment of probable future events. Budget is a
planned result that an enterprise aims to attain. Forecasting precedes preparation of a budget
as it is an important part of the budgeting process. It is said that the budgetary process is more a
test of forecasting skill than anything else. A budget is both a mechanism for profit planning
and technique of operating cost control. In order to establish a budget it is essential to forecast
various important variables like sales, selling prices, availability of materials, prices of materials,
wage rates etc.
Difference between Forecast and Budget
Both budgets and forecasts refer to the anticipated actions and events. But still there are
wide differences between budgets and forecasts as given below:

BUDGETARY CONTROL
Budgetary Control is the process of establishment of budgets relating to various activities
and comparing the budgeted figures with the actual performance for arriving at deviations,
if any. Accordingly, there cannot be budgetary control without budgets. Budgetary Control is a
system which uses budgets as a means of planning and controlling.
According to I.C.M.A. England Budgetary control is defined by Terminology as the
establishment of budgets relating to the responsibilities of executives to the requirements of a
policy and the continuous comparison of actual with the budgeted results, either to secure by
individual actions the objectives of that policy or to provide a basis for its revision.
Brown and Howard defines budgetary control is "a system of controlling costs which includes
the preparation of budgets, co-ordinating the department and establishing responsibilities,
comparing actual performance with the budgeted and acting upon results to achieve
maximum profitability."
The above definitions reveal the following essentials of budgetary control:
(1) Establishment of objectives for each function and section of the organization.
(2) Comparison of actual performance with budget.
(3) Ascertainment of the causes for such deviations of actual from the budgeted performance.
(4) Taking suitable corrective action from different available alternatives to achieve the desired
objectives.
Objectives of Budgetary Control
Budgetary Control is planned to assist the management for policy formulation, planning,
controlling and co-ordinating the general objectives of budgetary control and can be stated in the
following ways:
(1) Planning: A budget is a plan of action. Budgeting ensures a detailed plan of action for a
business over a period of time.
(2) Co-ordination: Budgetary control co-ordinates the various activities of the entity or
organization and secure co-operation of all concerned towards the common goal.
(3) Control: Control is necessary to ensure that plans and objectives are being achieved.
Control follows planning and co-ordination. No control performance is possible without
predetermined standards. Thus, budgetary control makes control possible by continuous
measures against predetermined targets. If there is any variation between the budgeted
performance and the actual performance, the same is subject to analysis and corrective action.

Advantages of Budgetary Control

The advantages of budgetary control may be summarized as follows:
(1) It facilitates reduction of cost.
(2) Budgetary control guides the management in planning and formulation of policies.
(3) Budgetary control facilitates effective co-ordination of activities of the various departments
and functions by setting their limits and goals.
(4) It ensures maximization of profits through cost control and optimum utilization of
resources.
(5) It evaluates for the continuous review of performance of different budget centers.
(6) It helps to the management in efficient and economic production control.
(7) It facilitates corrective actions, whenever there are inefficiencies and weaknesses
comparing actual performance with budget.
(8) It guides management in research and development.
(9) It ensures economy in working.
(10) It helps to adopt the principles of standard costing.

Limitations of Budgetary Control

Budgetary Control is an effective tool for management control. However, it has certain
important limitations which are identified below:
(1) The budget plan is based on estimates and forecasting. Forecasting cannot be considered to
be an exact science. If the budget plans are made on the basis of inaccurate forecasts then the
budget program may not be accurate and ineffective.
(2) For reasons of uncertainty about future, and changing circumstances which may develop
later on, budget may prove short or excess of actual requirements.
(3) Effective implementation of budgetary control depends upon willingness, co-operation and
understanding among people reasonable for execution. Lack of co-operation leads to
inefficient performance.
(4) The system is not a substitute for management. It is merely like a management tool.
(5) Budgeting may be cumbersome and time consuming process.

Types of Budgets
As budgets serve different purposes, different types of budgets have been developed. The
following are the different classification of budgets developed on the basis of time, functions,
and flexibility or capacity.
(A) Classification on the basis of Time:
1. Long-Term Budgets
2. Short-Term Budgets
3. Current Budgets
(B) Classification according to Functions:
1. Functional or Subsidiary Budgets
2. Master Budgets
(C) Classification on the basis of Capacity:
1. Fixed Budgets
2. Flexible Budgets
The following chart can explain this more:
(A) Classification on the Basis of Time
1. Long-Term Budgets: Long-term budgets are prepared for a longer period varies between
five to ten years. It is usually developed by the top level management. These budgets
summaries’ the general plan of operations and its expected consequences. Long-Term
Budgets are prepared for important activities like composition of its capital expenditure, new
product development and research, long-term finance etc.
2. Short-Term Budgets: These budgets are usually prepared for a period of one year.
Sometimes they may be prepared for shorter period as for quarterly or half yearly. The scope
of budgeting activity may vary considerably among different organization.
3. Current Budgets: Current budgets are prepared for the current operations of the business.
The planning period of a budget generally in months or weeks. As per ICMA London,
"Current budget is a budget which is established for use over a short period of time and related
to current conditions."
(B) Classification on the Basis of Function
1. Functional Budget: The functional budget is one which relates to any of the functions of an
organization. The number of functional budgets depends upon the size and nature of
business. The following are the commonly used:
(1) Sales Budget
(2) Purchase Budget
(3) Production Budget
(4) Selling and Distribution Cost Budget
(5) Labour Cost Budget
(6) Cash Budget
(7) Capital Expenditure Budget
2. Master Budget: The Master Budget is a summary budget. This budget encompasses all the
functional activities into one harmonious unit. The ICMA England defines a Master Budget as
“the summary budget incorporating its functional budgets, which is finally approved,
adopted and employed.”
(C) Classification on the Basis of Capacity
1. Fixed Budget: A fixed budget is designed to remain unchanged irrespective of the level of
activity actually attained.
A budget is drawn for a particular level of activity is called fixed budget. According to ICWA
London "Fixed budget is a budget which is designed to remain unchanged irrespective of the
level of activity actually attained." Fixed budget is usually prepared before the beginning of
the financial year. This type of budget is not going to highlight the cost variances due to the
difference in the levels of activity. Fixed Budgets are suitable under static conditions.
2. Flexible Budget: A flexible budget is a budget which is designed to change in accordance
with the various level of activity actually attained.
Flexible Budget is also called Variable or Sliding Scale budget, "takes both the fixed and
manufacturing costs into account. Flexible budget is the opposite of static budget showing the
expected cost at a single level of activity. According to ICMA, England defined Flexible
Budget is a budget which is designed to change in accordance with the level of activity
actually attained."
According to the principles that guide the preparation of the flexible budget a series of fixed
budgets are drawn for different levels of activity. A flexible budget often shows the budgeted
expenses against each item of cost corresponding to the different levels of activity. This
budget has come into use for solving the problems caused by the application of the fixed
budget.

SOME IMPORTANT BUDGETS

Sales Budget
Sales Budget is one of the important functional budgets. Sales estimate is the commencement
of budgeting may be made in quantitative terms. Sales budget is primarily concerned with
forecasting of what products will be sold in what quantities and at what prices during the
budget period. Sales budget is prepared by the sales executives taking into account number of
relevant and influencing factors such as : (1) Analysis of past sales (Product wise; Territory wise,
Quote wise), (2) Key Factors, (3) Market Conditions, (4) Production Capacity, (5) Government
Restrictions (6) Competitor's Strength and Weakness, (7) Advertisement, Publicity and Sales
Promotion, (8) Pricing Policy, (9) Consumer Behaviour, (10) Nature of Business, (11 ) Types of
Product, (12) Company Objectives, (13) Salesmen's Report (14) Marketing Research's Reports
(15) Product Life Cycle.
Production Budget
Production budget is usually prepared on the basis of sales budget. But it also takes into
account the stock levels desired to be maintained. The estimated output of business firm
during a budget period will be forecast in production budget. The production budget
determines the level of activity of the produce business and facilities planning of production so
as to maximum efficiency. The production budget is prepared by the chief executives of the
production department. While preparing the production budget, the factors like estimated
sales, availability of raw materials, plant capacity, availability of labour, budgeted stock
requirements etc. are carefully considered.
Cost of Production Budget
After Preparation of production budget, this budget is prepared. Production Cost Budgets
show the cost of the production determined in the production budget. Cost of Production
Budget is grouped in to Material Cost Budget, Labour Cost Budget and Overhead Cost
Budget. Because it breaks up the cost of each product into three main elements: material, labour
and overheads. Overheads may be further subdivided in to fixed, variable and semi-fixed
overheads. Therefore separate budgets required for each item.
Material Purchase Budget
The different levels of material stock are based on planned out. Once the production budget is
prepared, it is necessary to consider the requirement of materials to carry out the production
activities. Material Purchase Budget is concerned with purchase and requirement of direct
materials to be made during the budget period. While preparing the materials purchase budget,
the following factors to be considered carefully:
(1) Estimated sales and production. (2) Requirement of materials during budget period. (3)
Expected changes in the prices of raw materials. (4) Different stock levels, EOQ etc. (5)
Availability of raw materials, i.e., seasonal or otherwise. (6) Availability of financial resources.
(7) Price trend in the market. (8) Company's stock policy etc.
Cash Budget
This budget represents the anticipated receipts and payment of cash during the budget period.
The cash budget also called as Functional Budget. Cash budget is the most important of the
entire functional budget because; cash is required for the purpose to meeting its current cash
obligations. If at any time, a concern fails to meet its obligations, it will be technically insolvent.
Therefore, this budget is prepared on the basis of detailed cash receipts and cash payments.
The estimated Cash Receipts include: (1) Cash Sales (2) Credit Sales (3) Collection from
Sundry Debtors (4) Bills Receivable (5) Interest Received (6) Income from Sale of Investment
(7) Commission Received (8) Dividend Received (9) Income from Non-Trading Operations etc.
The estimated Cash Payments include the following: (1) Cash Purchase (2) Payment to
Creditors (3) Payment of Wages (4) Payments relate to Production Expenses (5) Payments relate
to Office and Administrative Expenses (6) Payments relate to Selling and Distribution Expenses
(7) Any other payments relate to Revenue and Capital Expenditure (8) Income Tax Payable,
Dividend Payable etc.
Master Budget
When the functional budgets have been completed, the budget committee will prepare a Master
Budget for the target of the concern. Accordingly a budget which is prepared incorporating
the summaries of all functional budgets. It comprises of budgeted profit and loss account,
budgeted balance sheet, budgeted production, sales and costs. The ICMA England defines a
Master Budget as "the summary budget incorporating its functional budgets, which is finally
approved, adopted and employed." The Master Budget represents the activities of a business
during a profit plan. This budget is also helpful in coordinating activities of various functional
departments.
Zero Based Budgeting (ZBB)
Zero Based Budgeting is a new technique of budgeting. It is designed to meet the needs of the
management in order to ensure the operational efficiency and effective utilization of the
allocated resources of a concern. This technique was originally developed by Peter A. Phyhrr,
Manager of Taxas Instrument during 1969. This concept is widely used in USA for controlling
their state expenditure when Mr. Jimmy Carter was the president of the USA. At present the
technique has for its global recognition for many countries have implemented in real terms.
According to Peter A. Phyhrr ZBB is defined as an "Operative Planning and Budgeting
Process" which requires each Manager to justify his entire budget in detail from Scratch
(hence zero base) and shifts the burden of proof to each Manager to justify why we should
spend any money at all." In zero-base budgeting, a manager at all levels has to justify the
importance of activity and to allocate the resources on priority bass.