Course Name: Cost and Management

Accounting
Module 5: Budget & Budgetary Control

Budget
In “A Dictionary for Accountants”, Kohler defines budget as:

1. Any financial plan serving as an estimate of and a control over future operations.

2. Hence, any estimate of future costs.

3. Any systematic plan for the utilisation of manpower, material or other resources.

The Chartered Institute of Management Accountants, London, (terminology) defines a

budget as

“A plan expressed in money. It is prepared and approved prior to the budget period and may show
income, expenditure and the capital to be employed. May be drawn up showing incremental effects
on former budgeted or actual figures, or be compiled by zero-based budgeting.”

A budget is a precise statement of the financial and quantitative implications of the course of action
that management has decided to follow in the immediate next period of time (usually a year).

Thus, the essential features of a budget are as follows:

(i) It is a statement expressed in monetary and/or physical units prepared for the implementation
of policy formulated by the management.
(ii) It is laid down prior to the budget period during which it is followed.

(iii) It is prepared for the definite future period.

(iv) The policy to be followed to attain the given objective must be laid before the budget is
prepared.

Budgetary Control:

Budgetary control is a system of management and accounting control. It means the control of
operations with the aid of budgets. It is one of the important tools of control.

The Institute of Cost and Management Accounts, England, 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 action the objectives of that policy or to provide a basis for its revision.

Steps involved in the budgetary control:

Budgetary control involves the following steps.
1. Preparation of budgets for each function and section of the organization.
2. Recording of actual performance.
3. Continuous comparison of actual performance with the budgets and the ascertainment of
deviations.
4. Prompt investigations into differences.
5. Prompt remedial action when required.
6. Revision of budgets in the light of changed circumstances.
Objectives of Budgetary control the important objectives of
budgetary control can be summarized as follows.
(i) To plan the policy of a business for the coming period for achievement of the firm is objectives
and its translation into monetary and quantitative terms.
(ii) To determine the responsibility of each department and executive so that they are made
accountable for definite and precise results.
(iii) To coordinate the activities of a business so that each is a part of an integral total.
(iv) To provide for continuous comparison of actual and budgeted performance in terms of results
achieved and costs incurred so that cause for any inefficiency is immediately detected and
removed.
(v) To control and direct each function so that best possible results may be obtained.

ADVANTAGES OF BUDGETARY CONTROL

(1) Budgetary control aims at maximization of profits through effective planning and control of
income and expenditure - directing capital and resources to the best and most profitable channel.
(2) There is a planned approach to expenditure and financing of the business so that economy is
affected in the utilization of funds to the optimum benefit of the concern.
(3) It provides a clear definition of the objective and policies of the concern and a tool for objecting
these policies to periodic examination.
(4) The task of managerial co-ordination is facilitated through budgetary control.
(5) Since each level of management is aware of the task and is fully conscious as to the best way
by which it is to be performed, maximum effective utilisation of men, materials and resources can
be attained.
(6) Reports are furnished under the principles of management or control by exception. Only
deviations from budgets which point out the weak spots and inefficiencies are properly looked
into.
(7) It cultivates in the management the habit of thinking ahead - making careful study of the
problems in advance before taking decisions.
(8) A budgetary control system assists delegation of authority and is a powerful tool of
responsibility accounting.

LIMITATIONS OF BUDGETARY CONTROL

(1) Budgetary control starts with the formulation of budgets which are mere estimates. Therefore,
the adequacy or otherwise of budgetary control system, to a very large extent, depends upon the
adequacy or accuracy with which estimates are made.
(2) Budgets are meant to deal with business conditions which are constantly changing. Therefore,
budgets estimates lose much of their usefulness under changing conditions because of their
rigidity. It is necessary that budgetary control system should be kept adequately flexible.
(3) The system of budgetary control is based on quantitative data and represent only an impersonal
appraisal to the conduct of business activity unless it is supported by proper management of
personal administration.
(4) It has often been found that in practice the organisation of budgetary control system become
top heavy and, therefore, costly specially from the point of view of small concern.
(5) Budgets and budgetary control have given rise to a very unhealthy tendency to be regarded as
the solvent of all business problems. This has resulted in a very luke-warm human effort to deal
with such problems and ultimately results in failure of budgetary control system.

Classification of Budgets
The budgets are classified according to their nature. The following are the types of budgets which
are commonly used.
A. Classification According to Time
B. Classification According to Function:
C. Classification According to Flexibility:
A. Classification According to Time:
i) Short period Budget: These budgets are usually for a period of one year.
ii) Long period Budget: These budgets are for a longer period say 5 to 10 years.
iii) Current Budget: These budgets are for a very short period, say, a month or a quarter
and are related to current conditions.

B. Classification According to Function:

A functional budget is a budget which relates to any of the functions of an organization. The
following are the commonly used functional budgets.
1. Sales Budget:
A sales budget is an estimate of expected sales during the budget period. It may be stated
in terms of money or quantity or both. It contains information relating to sales, month-wise,
product wise and area wise. Sales budgets should be carefully prepared as the preparation
of other budgets is dependent on it.
1. Past sales figures
2. Salesmen’s estimates
3. Plant capacity
4. Availability of raw materials
5. Seasonal fluctuations
6. Availability of finance
7. Competition
8. Orders on hand
9. Other factors like political conditions, government policies etc.
2. Production Budget:
The preparation of production budget is dependent on the sales budget. Production budget is an
estimate of quantity of goods that must be produced during the budget period. It may be stated in
terms of money or quantity (weights, units etc.) or both. Production may be calculated as follows:
Units to produced = Budgeted Sales + Desired closing stock – Opening stock
3. Materials Budget:
Materials may be direct or indirect. The materials budget deals with only the direct materials.
Indirect materials are included in the factory overhead budget.
Materials budget can be classified into two categories – Materials Requirement Budget and
Materials Purchase Budget. Materials Requirement Budget is an estimate of total quantities of
material required for production during the budget period. The Material purchase Budget is an
estimate of quantities of raw materials to be purchased for production during the budget period.

4. Direct Labour Budget:

This indicates detailed requirements of direct labour and its cost to achieve the production target.
This budget is classified into two categories namely, labour requirement and labour recruitment
budget. The labour requirement budget gives information regarding the different classes of labour
required for each department, their rates of pay and the hours to be spent. The labour recruitment
budget states the additional direct workers to be recruited.

5. Factory Overhead Budget:

Factory overheads include indirect material, indirect labour and indirect expenses. Factor overhead
budget indicates the factory overheads to be incurred in the budget period. The expenses included
in the budget are classified into fixed, variable and semi-variable expenses. Fixed expenses are
estimated on the basis of past records. Variable expenses are estimated on the basis of budgeted
output.
6. Administrative Expenses Budget:
The budget is an estimate of administrative expenses to be incurred in the budget period. E.g. rent,
salaries, insurance etc.
7. Selling and Distribution Overhead Budget:
The budget gives an estimate of selling and distribution expenses to be incurred in the budget
period. For example, Salesmen’s salary, commission, advertisement, transportation costs etc. It is
prepared by the sales executive. It is closely linked with sales budget.
8. Capital Expenditure Budget:
This budget shows the estimated expenditure on fixed assets during the budget period. Separate
budgets may be prepared for each item of assets, if necessary. For example, building budget, plant
and machinery budget etc. This budget is prepared for a longer period say 5 years or 10 years.
9. Cash Budget:
This budget gives an estimate of receipts and payments of cash during the budget period. It is
prepared by the chief accountant. It shows the cash available and needed from time to meet the
capital requirements of the organization. This budget is prepared in two parts – one showing an
estimate of receipts and the other showing an estimate of payments. Cash budget can be prepared
by any of the following methods:
(a) Receipts and Payments method
(b) The Adjusted Profit and Loss Account method (c) The Balance Sheet method.
10. Master Budget:
Finally, master budget is prepared incorporating all functional budgets. It is defined as, “the
summary budget incorporating the functional budgets which is finally approved, adopted and
employed”, The budget may take the form of budgeted profit and loss account and balance sheet.
It contains sales, production cost, cash position, debtor, fixed assets, bills payable etc. It also shows
the gross and net profits and the important accounting ratios. It has to be approved by the board of
directors before it is put into operation.

C. Classification According to Flexibility:

1. Fixed Budget:
Fixed budget is also called static budget. It may be defined as, “a budget designed to remain
unchanged irrespective of the level of activity actually attained”. This budget is most suited for
fixed expenses, which have no relation to the volume of output. It is ineffective for cost control
purposes. It is useless for comparison with actual performance when the level of activity changes.
2. Flexible Budget:
Flexible budget is also called variable budget. It may be defined as, “A budget designed to change
in accordance with the level of activity actually attained”. It shows estimated costs and profit at
different levels of output. It facilitates comparison of actual performance with the budget at any
level of output. To prepare flexible budget, all costs should be classified into fixed, variable and
semi-variable. It is more elastic, useful and practical. It is used for the purpose of control.
Illustration
ZERO BASE BUDGETING

The concept of zero-base budgeting was developed in U.S.A. Under zero-base budgeting, each
programme and each of its constituent part is challenged for its very inclusion in each years budget.
Programme objectives are also re-examined with a view to start things afresh. It requires review
analysis and evaluation of each programme in order to justify its inclusion or exclusion from final
budget. Following steps are usually involved:
(i) Describing and analysing all current or proposed programmes usually called
“decision packages”. This consists of identification, analysis and formulation
assists an evaluation in terms of purposes, consequence, performance measures,
alternatives and cause and benefits. Decision units are the lowest level programmes
or organisational entity for which budgets are prepared.
(ii) Ranking of decision packages alongwith documents in support of these packages.
(iii) The sources are allocated in accordance with the ranking. Zero-base budgeting is
based on the premise that every rupee of expenditure requires justification. The
traditional budgeting approach includes expenditures of previous year which are
automatically incorporated in new budget proposals and only increments are
subjected to debate.
Zero base budgeting assumes that a responsibility centre manager has had no previous
expenditure. Important features of zero-base budgeting are:
(i) Concentration of efforts is not simply on “how much” a unit will spend but “why”
it needs to spend.
(ii) Choices are made on the basis of what each unit can offer for a specific cost.
(iii) Individual unit’s objects are linked to corporate targets.
(iv) Quick budget adjustments can be made if, during the operating year costs are
required to maintain expenditure level.
(v) Alternative ways are considered.
(vi) Participation of all levels in decision-making.
Difference between Traditional Budgeting and Zero-Base Budgeting
(i) Traditional budgeting is accounting-oriented. Main stress happens to be on
previous level of expenditure. Zero base budgeting makes a decision-oriented
approach.
(ii) In traditional budgeting, first reference is made to past level of spending and then
demand is made for inflation and new programmes. In zero base budgeting a
decision unit is broken into understandable decision packages which are ranked
according to importance to enable top management to focus attention only on
decision packages which enjoy priority to others.
(iii) In traditional budgeting, some managers deliberately inflate their budget request so
that after the cuts they still get what they want. In zero base budgeting, a rational
analysis of budget proposal is attempted.
(iv) Traditional budgeting is not as clear and responsive as zero base budgeting.
(v) In traditional budgeting, it is for top management to decide why a particular amount
should be spent on a particular decision unit. In zero base budgeting this
responsibility is shifted from top management to the manager of decision unit.
Cash Budget

A cash budget is an estimation of the cash flows of a business over a specific period of
time. This could be for a weekly, monthly, quarterly, or annual budget. This budget is used to
assess whether the entity has sufficient cash to continue operating over the given time frame.
The cash budget provides a company insight into its cash needs (and any surplus) and helps to
determine an efficient allocation of cash. How a

Cash Budget Works

Companies use sales and production forecasts to create a cash budget, along with assumptions
about necessary spending and accounts receivable collections. A cash budget is necessary to
assess whether a company will have enough cash to continue operations. If a company does not
have enough liquidity to operate, it must raise more capital by issuing stock or taking on more
debt.

A cash roll forward computes the cash inflows and outflows for a month, and it uses the ending
balance as the beginning balance for the following month. This process allows the company to
forecast cash needs throughout the year, and changes to the roll forward to adjust the cash
balances for all future months.

Short-Term Cash Budget vs. Long-Term Cash Budget

Cash budgets are usually viewed in either the short-term or the long-term. Short-term cash
budgets focus on the cash requirements needed for the next week or months whereas long-term
cash budget focuses on cash needs for the next year to several years.

Short-term cash budgets will look at items such as utility bills, rent, payroll, payments to
suppliers, other operating expenses, and investments. Long-term cash budgets focus on
quarterly and annual tax payments, capital expenditure projects, and long-term investments.
Long-term cash budgets usually require more strategic planning and detailed analysis as they
require cash to be tied up for a longer period of time.

It's also prudent to budget cash requirements for any emergencies or unexpected needs for cash
that may arise, particularly if the business is new and all aspects of operations are not fully
realized.
Flexible budget

A flexible budget is a budget that adjusts to a company's activity or volume levels. Unlike a static
budget, which doesn't change from the amounts established when the company creates the budget,
a flexible budget continuously changes with a business' cost variations. This type of budgeting
often includes variable rates per unit rather than a fixed amount, which allows you to anticipate
potential increases or decreases in monetary needs. It's usually based on changes in a company's
actual revenue and uses percentages of revenue rather than static numbers.

For instance, when using a flexible budget, you may allocate 25% of a company's revenue to salary
instead of allocating $100,000 to salary in a given year. This allocation accounts for any changes
in the company's revenue and staff that may occur throughout the year.