BUDGETING PROCESS

• A budget is a quantified plan of action for a forthcoming accounting period.

• A budget can be set from the top down (imposed budget) or from the bottom up
(participatory budget).
Top down’ and ‘bottom up’ are two different approaches to budget preparation.

• (A) with top-down budgeting, budget targets are set at senior management level for the
organization as a whole and for each major department or activity within the
organization. The departmental budget targets are then given to the departmental
managers, who are required to prepare a budget that conforms to the targets that have
been imposed on them from above.
• Similarly, when budgets have been set at departmental level, targets are then given to
managers lower down the organization hierarchy; these managers are then require to
prepare budgets that meet the targets for their area of operations that have been
imposed on them.
 management level for the
organization as a whole and for
each major department or activity
within the organization. The
departmental budget targets are then
given to the departmental managers,
who are required to prepare a
budget that conforms to the targets
Top down’ and that two
‘bottom up’ are have different
been imposed on them
approaches
from above.
to budget•preparation
Similarly, when budgets have been
set at departmental level, targets are
then given to managers lower down
the organization hierarchy; these
managers are then require to
prepare budgets that meet the
targets for their area of operations
that have been imposed on them.
(B) with bottom-up budgeting, the budgeting process starts at a
relatively low level of management. Managers are required to
draft a budget for their area of operations. These are submitted to
their superior, who combines the lower-level budgets into a
combined budget for the department as a whole. Departmental
budgets are then submitted to senior management, where they are
combined into a coordinated budget for the organization as a
whole.

Top-down budgeting takes much less time and planning effort than
bottom-up budgeting and senior management can use top-down
budgets to impose their views. Bottom-up budgeting is much more
time consuming, and draft budgets may have to be revised many
times until they are properly coordinated.
 achievement of
the
organization's
Objectives of a
· Motivate budgetary
objectives planning and control system
employees to · Compel
improve their planning
performance
·
· Establish a
Communicate
system of
ideas and
control
plans
· Provide a
framework for · Coordinate
responsibility activities
accounting
TYPES OF BUDGET
 Incremental budgeting
• With the ‘traditional’ approach to budgeting, known as incremental budgeting,
the budget for the next financial year is based on the actual results for the
current financial year. At its simplest level, a budget based on an incremental
costing approach is the actual (or budgeted) performance for the current year,
adjusted for expected growth and inflation. Incremental budgeting encourages
slack and wasteful spending to creep into budgets.
• Incremental budgeting is a method of budgeting in which next year’s budget is
prepared by using the
• current’s year’s actual results as a starting point, and making adjustments for
expected inflation, sales
• growth or decline and other known changes.
Advantages and disadvantages of incremental budgets
 Fixed and flexible budgets
• A fixed budget is a financial plan that does not change throughout the budget
period, regardless of any changes from the plan in the actual volume of activity.
• A flexible budget recognizes cost behavior and changes as the actual volume of
activity changes. A fixed budget is normally used for planning purposes and is
prepared in advance of the beginning of the financial period. A flexible budget
is used for control purposes and is normally prepared retrospectively, when the
actual level of activity in a period is known.
 Fixed budgets
• A fixed budget is a budget which remains unchanged throughout the budget period, regardless of
differences between the actual and the original planned volume of output or sales.
• The master budget, which is prepared and approved before the beginning of the budget period, is
normally a fixed budget. The term 'fixed' means the following.
(a) The budget is prepared on the basis of an estimated volume of production and an estimated
volume of sales, but no plans are made for the event that actual volumes of production and
sales may differ from budgeted volumes.
(b) When actual volumes of production and sales during a control period (month or four weeks or
quarter) are achieved, the budget is not adjusted or revised (in retrospect) to the new levels of
activity.
• The major purpose of a fixed budget is for planning. It is prepared at the planning stage, when it
is used to define the objectives and targets of the organization for the budget period (financial
year).
 Flexible budgets
• A flexible budget is a budget which, by recognizing different cost behavior patterns, is
changed as the volume of output and sales changes. It recognizes cost behavior patterns, such
as changes in sales revenue and variable costs as sales volumes change, and step changes in
fixed costs as activity levels rise or fall by more than a certain amount.
• Flexible budgets may be used in one of two ways.
(a) At the planning stage. An organization may prepare flexible budgets at the planning stage
for different levels of activity. For example, suppose that a company expects to sell 10,000
units of output during the next year. if the company thinks that output and sales might be as
low as 8,000 units or as high as 12,000 units, it may prepare contingency flexible budgets,
at volumes of, say 8,000, 9,000, 11,000 and 12,000 units and then assess the possible
outcomes.
(b) Retrospectively. At the end of each month (control period) or year, the results that should
have been achieved given the actual circumstances (the flexible budget) can be compared
with the actual results. As we shall see, flexible budgets are an essential factor in budgetary
control.
 Zero based budgeting

• Zero based budgeting involves preparing a budget for each cost center or activity from
a zero base. Every item of expenditure has then to be justified in its entirety in order to
be included in the next year's budget.
• The principle behind zero based budgeting (ZBB) is that the budget for each cost
center should be made from 'scratch' or zero. Every item of expenditure must be
justified in its entirety in order to be included in the next year's budget.
• The aim of zero based budgeting is to remove unnecessary and wasteful spending from
the budget. It can be particularly useful in budgeting for administrative expenses and
administrative departments, where there may be a tendency to tolerate unnecessary
spending.
The advantages of zero based budgeting are as follows.
• It is possible to identify and remove inefficient or obsolete operations.
• It forces employees to avoid wasteful expenditure.
• It can increase motivation of staff by promoting a culture of efficiency.
• It responds to changes in the business environment.
• ZBB documentation provides an in-depth appraisal of an organization's operations.
• It challenges the status quo.
In summary, ZBB should result in a more efficient allocation of resources.
• The major disadvantage of zero based budgeting is the enormous extra volume of
paperwork created and the extra time required to prepare the budget. The assumptions
about costs and benefits in each package must be continually updated and new packages
developed as soon as new activities emerge. The following problems might also occur.
 Activity based budgeting
• At its simplest, activity based budgeting (ABB) is merely the use of activity based
costing methods as a basis for preparing budgets.
• Activity based budgeting involves defining the activities that underlie the financial
figures in each function and using the level of activity to decide how much resource
should be allocated, how well it is being managed and to explain variances from budget.
• Activity based budgeting differs from traditional budgeting in the way that budgets are
prepared for overhead costs. Overhead costs are budgeted on the basis of activities,
rather than on a departmental basis.
 Rolling budgets
• Rolling budgets (also called continuous budgets) are budgets which are continuously
updated throughout a financial year, by adding a further period (say a month or a
quarter) and removing the corresponding period that has just ended.
• There is a risk that in a period of rapid and continual change, budgets cease to be
useful as a plan and guide for management. To deal with this risk, budgets may be
reviewed and amended regularly.
• If management need to revise their plans regularly, to keep them relevant and realistic,
they may decide to introduce a system of rolling budgets.
• Instead of preparing a periodic budget annually for the full budget period, new budgets
are prepared every one, two, three or four months (so that there are three, four, six, or
even twelve budgets each year). Each of these budgets would cover for the next twelve
months so that the current budget is extended by an extra period as the current period
ends: hence the name rolling budgets.
 Quantitative analysis
in budgeting
• Analyzing fixed and variable costs: high-low method
• The high-low method is a quantitative technique for analysing total costs into their
fixed cost and variable cost elements.
• Step 1: Review records of costs in previous periods.

 Select the period with the highest activity level

 Select the period with the lowest activity level

Step 2: If inflation makes it difficult to compare costs, adjust by indexing up or down.

• Step 3 Determine the following.
• Total costs at high activity level
• Total costs at low activity level
• Total units at high activity level
• Total units at low activity level
• Step 4: The difference between total costs at the high and the low activity levels must
consist entirely of variable costs, since fixed costs are the same at both activity levels. So
calculate the following.
•𝑇𝑜𝑡𝑎𝑙
= Variable
𝑐𝑜𝑠𝑡 𝑎𝑡cost
ℎ𝑖𝑔ℎper unit (v)𝑙𝑒𝑣𝑒𝑙 −𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑎𝑡 𝑙𝑜𝑤 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑙𝑒𝑣𝑒𝑙
𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑡𝑦
=𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
𝑇𝑜𝑡𝑎𝑙 𝑢𝑛𝑖𝑡𝑠 𝑎𝑡 ℎ𝑖𝑔ℎ 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑙𝑒𝑣𝑒𝑙 −𝑡𝑜𝑡𝑎𝑙 𝑢𝑛𝑖𝑡𝑠 𝑎𝑡 𝑙𝑜𝑤 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑙𝑒𝑣𝑒𝑙
•Step 5: The fixed costs can be determined as follows. (Total cost at high activity level )
– (total units at high activity level × variable cost per unit)
example
SOLUTION
 APPLICATION OF Flexible budgets
• Comparison of a fixed budget with the actual results for a different level of activity is
of little use for control purposes. Flexible budgets should be used to show what cost
and revenues should have been for the actual level of activity.
• A flexible budget is a budget which, by recognizing different cost behavior patterns,
changes as volume of activity (output and sales) changes.
• Preparing a flexible budget
• Step 1; the first step in the preparation of a flexible budget is the determination
of cost behavior patterns, which means deciding whether costs are fixed,
variable or semi-variable.
• Step 2; The second step in the preparation of a flexible budget is to calculate the
budget cost allowance (budget expenditure/flexed budget) for each cost item.
• Budget cost allowance = budgeted fixed cost + (number of units x variable cost
per unit)
• Semi-variable costs therefore; need splitting into their fixed and variable
components so that the budget cost allowance can be calculated.
• One method for splitting semi-variable costs is the high/low method.
 Flexible budgets and performance management
• Budgetary control involves drawing up budgets for the areas of responsibility
for individual managers (for example production managers, purchasing
managers and so on) and regularly comparing actual results against expected
results.
• The differences between actual results and expected results are reported as
variances and these are used to provide a guideline for control action by
individual managers. Note that individual managers are held responsible for
investigating differences between budgeted and actual results, and are then
expected to take corrective action or amend the plan in the light of actual
events.
• The wrong approach to budgetary control is to compare actual results against a
fixed budget.
The wrong approach to budgetary control is to compare actual results against a fixed
budget. Suppose that a company manufactures a single product, Z. Budgeted results
and actual results for June 20X2 are
shown below.
• Communicating details of
budget policy and guidelines
to those people responsible
for the preparation of
budgets;
• Determining the factor that
restricts output;
STAGES IN THE BUDGETING PROCESS

• Preparation of the sales

budget;
• Initial preparation of various
budgets;
• Negotiation of budgets with
superiors;
• Coordination and review of
budgets;
• Final acceptance of budgets;
• Ongoing review of budgets.

as follows:
important
stages are
The
 Components of Master Budgets
• Operating Budget – building blocks leading to the creation of the
Budgeted Income Statement
• Financial Budget – building blocks based on the Operating Budget that
lead to the creation of the Budgeted Balance Sheet and the Budgeted
Statement of Cash Flows
 Basic Operating Budget Steps
1. Prepare the Revenues Budget
2. Prepare the Production Budget (in Units)
3. Prepare the Direct Materials Usage Budget and Direct Materials
Purchases Budget
4. Prepare the Direct Manufacturing Labor Budget
 Basic Operating Budget Steps
5. Prepare the Manufacturing Overhead Costs Budget
6. Prepare the Ending Inventories Budget
7. Prepare the Cost of Goods Sold Budget
8. Prepare the Operating Expense (Period Cost) Budget
9. Prepare the Budgeted Income Statement
 Basic Financial Budget Steps
Based on the Operating Budgets:
1. Prepare the Capital Expenditures Budget
2. Prepare the Cash Budget
3. Prepare the Budgeted Balance Sheet
4. Prepare the Budgeted Statement of Cash Flows
 Sample
Master
Budget,
Illustrated
 CASH BUDGETS
• The Objective Of The Cash Budget Is To Ensure That Sufficient Cash Is Available At All
Times To Meet The Level Of Operations That Are Outlined In The Various Budgets.
• Cash budgets can help a firm to avoid cash balances that are surplus to its requirements by
enabling management to take steps in advance to invest the surplus cash in short-term
investments. Alternatively, cash deficiencies can be identified in advance, and steps can be
taken to ensure that bank loans will be available to meet any temporary cash deficiencies.
• The overall aim should be to manage the cash of the firm to attain maximum cash availability
and maximum interest income on any idle funds.
Example
 Other Budgeting Issues
• Financial-planning software may be employed to conduct
sensitivity (“what-if”) analysis to assist in the budgetary
process
• Kaizen Budgeting – incorporating continuous improvement
factors in the budgeting process
• Activity-Based Budgeting – incorporating Activity-Based
Costing in the budgetary process
 Budgeting and the Organization:
Responsibility Accounting
• Responsibility Center – a part, segment, or subunit of a organization
whose manager is accountable for a specified set of activities
• Responsibility Accounting – a system that measures the plans, budgets,
actions and actual results of each Responsibility Center
 Types of Responsibility Centers
1. Cost – accountable for costs only
2. Revenue – accountable for revenues only
3. Profit – accountable for revenues & costs
4. Investment – accountable for investments, revenues, and costs
 Budgets and Feedback
• Budgets offer feedback in the form of variances: actual results deviate
from budgeted targets
• Variances provide managers with
• Early warning of problems
• A basis for performance evaluation
• A basis for strategy evaluation
 Controllability
• Controllability is the degree of influence that a manager has over costs,
revenues, or related items for which he is being held responsible
• Responsibility Accounting focuses on information sharing, not in laying
blame on a particular manager
 Budgeting and Human Behavior
• The budgeting process may be abused both by superiors and subordinates,
leading to negative outcomes
• Superiors may dominate the budget process or hold subordinates
accountable for events they have no control over
• Subordinates may build “budgetary slack” into their budgets
 Budgetary Slack
• The practice of underestimating budgeted revenues, or overestimating
budgeted expenses, in an effort to make the resulting budgeted goals
(profits) more easily attainable
 CRITICISMS OF BUDGETING
• The Major Criticism Is That The Annual Budgeting Process Is Incapable Of Meeting The
Demands Of The Competitive Environment In Today’s Information Age.
• These following criticisms relating to the annual budgeting process:
1. Encouraging Rigid Planning And Incremental Thinking;
2. Being Time-consuming;
3. Ignoring Key Drivers Of Shareholder Value By Focusing Too Much Attention On Short-term Financial
Numbers;
4. Being A Yearly Rigid Ritual That Impedes Firms From Being Flexible And Adaptive In The Increasingly
Unpredictable Environment Facing Contemporary Organizations
1. Tying The Company To A 12-month Commitment, Which Is Risky Since It Is Based On
Uncertain Forecasts;
2. Meeting Only The Lowest Targets And Not Attempting To Beat The Targets;
3. Spending What Is In The Budget Even If This Is Not Necessary In Order To Guard
Against Next Year’s Budget Being Reduced;
4. Achieving The Budget Even If This Results In Undesirable Actions
5. Being Disconnected From Strategy.
THANK YOU