BUDGETING AND BUDGETARY CONTROL

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

It is prepared for a specific time period. It is normally expressed in financial terms and
prepared for one year.
Budgetary control applies to a system of management and accounting control by
which all operations and output are forecast as far as ahead as possible and the actual
results, when known, are compared with the budget estimates.
Advantages of Budgetary control
1. Effective planning- Budgetary control aims at maximization of profit through
effective planning and control of income and expenditure, directing capital
resources to the best and most profitable channel.
2. Motivation to management- It motivates to make an early and timely study of
its problems.
3. Productive competition- Budgetary control provides incentive to perform with
more efficiency to lead for higher output and thus encourages for productive
competition.
4. Stability in business operation- Since budgets are properly phased and targets
are set for each control period.
5. Tool for periodical evaluation- It provides a tool through which managerial
policy and goals are periodically evaluated, tested and established as
guidelines for the entire organization.
6. Co-operation and team spirit- In the task of preparation of budget there is a
participation of management personnel placed at all levels of organization.

Aims of budgeting
1. Planning- look to the future
2. Control- actual results are compared against the budget and action is taken as
appropriate
3. Communication- forms the basis of reporting by junior and senior managers
4. Co-ordination- allows the business to co-ordinate all diverse actions towards a
common corporate goal
5. Evaluation- evaluate the financial results and actions of managers within the
business
6. Motivation- rewards should be given for operating within or under budgeted
levels of expenditure
7. Authorization and delegation.
Performance hierarchy
1. Strategic planning is long term, looks at the whole organization and defines
resource requirements.
2. Tactical planning is medium term, looks at the department/divisional level and
specifies how to use resources
3. Operational planning is very short term, very detailed and is mainly concerned
with control. Most budgeting activities fall within operational planning to
include advertising spend, sales forecasts, inventory policies etc.
Budgets and Performance Management
The budget is the target against which the performance of the budget centre or the
manager is measured.
The advantages of this approach are that:
1. Clear target known throughout organization
2. Managers are involved in setting the targets make it them more realistic

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 3. Budget target can be linked to individual rewards, which may provide
motivation to improve performance.
The Disadvantage of the approach
1. Managers may work towards specific short-term budget and not long-term
organizational goals
2. Managers may distort results to try to exceed targets and gain rewards.
Behavioural aspects of budgeting
Budgets and Behaviour
Individuals react to the demands of budgeting and budgetary control in different ways
and their behavior can damage the budgeting process.
1. Dysfunctional behavior- individual managers seek to achieve their own
objectives at the expense of the objectives of the organizations.
2. Budget slack (or bias) a deliberate over-estimate of expenditure and / or under-
estimation of revenues in the budgeting process i.e. to make life easy, targets
are exceeded and bonuses won.
Management Styles
He described three management styles that can be applied to budgets and performance
management.
1. Budget-constrained style
The performance evaluation is the managers’ success in meeting budget targets in
the short term, with no consideration for other aspects of performance that are not
targeted in the budget
2. Profit- conscious style
The performance of a manager is measured in terms of his ability to increase the
overall effectives of his area of responsibility, in relation to meeting the longer-
term objectives of the organizations.
3. Non- accounting style
Performance evaluation is not based on budgetary information, and accounting
information plays a relatively unimportant role. Other, non- accounting
performance indicators, such as quality, are as important as the budget targets.
Participation in setting targets
All managers need be involved in setting targets, senior management without
consultation junior may mean impose the budgets to them.
Advantages of participation
1. Increased motivation
2. Better understanding of an individual managers’ aspiration
3. Improve co-ordination within units
4. Specific resource needs are included
5. Based on information from employees
Disadvantages of participation
1. Time consuming
2. May result in a wide range of targets which are seen as unfair
3. Managers may understate targets to make them easier to achieve (i.e.
incorporate budgetary slack)
4. Negotiation may become a political process
5. Unachievable and may cause dissatisfaction
Corporate Objective includes:
Profitability Customer satisfaction
Market share Quality
Growth Industrial relations

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 Cash flow Added value
Return on capital employed Earning per share
Risk
Objectives of budgetary systems
1. Ensure the achievement of the organizations’ objectives
2. Compel planning
3. Co-ordinate activities –maximum integration
4. Communicate ideas and plans
5. Provide a framework for responsibility accounting
6. Establish a system of control
7. Motivate employees to improve their performance
Conflicting objectives
The implications of resolution will often be specific to the organization and will
depend on:
1. The specific purpose for which the budget is to be used
2. The management style and culture of the organization
3. The knowledge and experience of the managers preparing budgets
Resolution
1. Preparation of cash based targets
2. Give managers share options so they focus on shareholder wealth
3. Negotiation and compromise
4. Give priority
5. Ensuring each manager gets a satisfactory result, thought not as much as they
want
6. Use more non-financial indicates that focus on key long term issues such as
quality, productivity etc
7. Link bonuses to longer time periods later than short time
8. Greater scrutiny of budgets
9. Better training of managers
Approaches to budgeting
1. Top down and bottom up budgeting
2. Rolling budgets
3. Incremental budgets
4. Activity-based budgeting
5. Feed-forward control
6. Zero-based budgeting (ZBB)
Top down and bottom up budgeting
Allows staff to participate in target setting
Top down budget
A budget that is without allowing the ultimate budget holder to have the opportunity
to participate in the budgeting process, also called “authoritative” or non-
participative”
Bottom up budget
Budget holders have the opportunity to participate in setting their own budget. A
bottom up budget is also called participative budget. Junior managers would be
reviewed and challenged by senior management.
Advantages of participative budgets
1. Increased motivation
2. Contain better information
3. Increases managers understanding and commitment

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 4. Better communication
5. Senior managers can concentrate on strategy
Disadvantages of participative budgets
1. Senior managers may lack control
2. Bad decisions from inexperienced managers
3. Budgets may lack corporate objectives as managers lack a strategic
perspective
4. Figure may be subject to bias as junior managers may set easily achievable
targets (budget slack)
5. Budget preparation is slower and disputes can arise
Rolling budgets
Rolling budgets (continuous budgets) are budgets which are continuously updated by
adding a further period (say a month or quarter) and deducting the earliest period.
Advantages of rolling budgets
1. Process is more accurate
2. Reduce the element of uncertainty
3. They force managers to reassess the budget regularly, and to produce budgets
which are up date in the light of current events and expectations.
4. This budget is realistic giving a better motivation to managers.
5. Planning and control will be based on recent plan which is likely to be more
realistic.
6. There is always a budget which extends for several months ahead.
Disadvantages of rolling budgets
1. Involve more time, effort and money in budget preparations.
2. An increase in budgeting work may lead to less control of actual results.
3. There is a danger that the budget may become the last budget “plus or minus a
bit”
Illustration
A company uses rolling budgeting and has a sales budget as follows:
Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
Ksh Ksh Ksh Ksh Ksh
Sales 125,750 132,038 138,640 145,572 542,000

Actual sales for Quarter 1 were Ksh123,450. The adverse variance is fully explained
by competition being more intense than expected and growth being lower than
anticipated. The budget committee has proposed that the revised assumption for sales
growth should be 3% per quarter.
Required:
Update the budget as appropriate.
Solution
The revised budget should incorporate 3% growth starting from the actual sales figure
of quarter 1 and should include a figure for quarter 1 of the following year.
Working
3% of 123,450 + 123,450 =127,154
3% of 127,154 +127,154 = 130,969
3% of 130,969 + 130,969 =134,898
3% of 134,898 +134,898 = 138,945
531,966

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 Quarter 2 Quarter 3 Quarter 4 Quarter 1 Total
Ksh Ksh Ksh Ksh Ksh
Sales 127,154 130,969 134,898 138,945 531,966

Incremental Budgets
The traditional approach to budgeting in the public sector has been incremental and
this has resulted in existing patterns of public expenditure being locked in.
An incremental budget starts with the previous periods’ budget or actual results and
adds (or subtracts) an incremental amount to cover inflation and other known
changes.
It is suitable for stable businesses, where costs are not expected to change
significantly.
Advantages of incremental budget
1. Quickest and easiest method
2. Assuming that the historic figures are acceptable only the incremental needs to
be justified.
Disadvantages of incremental budget
1. Uneconomic activities may be continued
2. Managers may spend unnecessarily to use up their budgeted expenditure
allowances.
3. Builds in previous problems and inefficiencies.
Illustration
X Ltd produce two products A and C in the last year 2007 it produced 640 units of A
and 350 units of C incurring costs of Ksh 672,000. Analysis of the costs is that 75%
is variable. 60% of these variable costs vary in line with the number of A produced
and the reminder with the number of C
The budget for the year 2008 is now being prepared using an incremental budgeting
approach. The following additional information is available for 2008
ü All costs will be 4% higher than the average paid in 2007
ü Efficiency levels will remain unchanged
ü Expected output of A is 750 units and of C are 340 units.
Required:
What is the budgeted total variable cost of product C (to the nearest Ksh100) for the
full year 2008?
Solution
2007 costs
Total variable costs = 75% x 672,000 =Ksh 504,000
Proportion relating to product C = 40% x 504,000 = Ksh 201,600
Cost per unit of product C = 201,600/350 =Ksh 576
2008 budget costs
Inflated cost per unit of C = 1.04 x Ksh 576 = 599.04
Total variable cost for product C = 340 x 599.04 = Ksh 203,673.6
Activity Based Budgeting (ABB)
The approach is based on an activity frame work and utilizing cost driver data in the
budget-setting
ABB produces more accurate budgets and enable greater control of overhead
expenditure.
Advantages of ABB
1. It draws attention to the cost of overhead activities.

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 2. It provides information for the control of activity costs
3. It provides a useful basis for monitoring controlling overhead costs
4. It provides useful control information by emphasizing that activity cost might
be controllable if the activity volume can be controlled.
5. Provides useful information for a total quality management (TQM)
Disadvantages of ABB
1. Amount of time and effort needed to identify the key activities and their cost
drivers.
2. ABB might not be appropriate for the organization and its activities and cost
structures.
3. ABB needs the clear individual responsibilities for activities.
4. Overhead costs are not controllable.

Illustration
A company has prepared an activity-based budget for its stores department. The
budgeted costs are:

Cost driver Budgeted cost

Receiving goods Number of deliveries Ksh 80 per delivery
Issuing goods from store Number of stores Ksh 40 per requisition
requisitions
Ordering Number of orders Ksh 25 per order
Counting stock Number of stock counts Ksh1,000 per count
Keeping records Ksh 24,000 each year
Supervision Ksh 30,000 each year
Actual results for April were:
Activity Quality Actual costs
Ksh
Receiving goods 45 orders delivered 3,450
Issuing goods 100 requisitions 4,400
Ordering 36 orders 960
Counting 2 stock counts 1,750
Record keeping 1,900
Supervision 2,700
15,160
Prepare a variance report for the month.
Solution
Report of variance analysis:
Activity Expected Actual Variances
Cost Ksh Cost Ksh Ksh
Receiving goods 45 orders delivered 3,600 3,450 150(F)
Issuing goods 100 requisitions 4,000 4,400 400(A)
Ordering 36 orders 900 960 60(A)
Counting 2 stock counts 2,000 1,750 250(F)

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Record keeping 2,000 1,900 100(F)
Supervision 2,500 2,700 200(A)
15,000 15,160 160(A)
Feed forward control
Is defined as the forecasting of differences between actual and planned outcomes and
implementation of actions before the event, to avoid such differences
Feed-forward looks ahead and compares:
ü The target or objectives for the period
ü The actual results forecast.
Advantages
1. It informs managers of what is likely to happen unless control action is taken
2. It encourages managers to deal with problems before they occur
3. Reforecast on a monthly or continuous basis can store time.
Disadvantage
1. It may be time consuming as control reports must be produced regularly
2. It may require a sophisticated forecasting system, which might be expensive
Zero-Based Budgeting (ZBB)
Is that the budget for each cost centre should be made from “scratch” or zero
ZBB involves preparing a budget for each cost centre from a zero base. Every item of
expenditure has then to be justified.
Without approval the budget allowance is zero.
It is especially useful for:
1. It ensure optimum use of financial resources
2. Inefficient or obsolete operations can be identified and discontinued.
3. It increases the participation of all level of management in budget preparation
4. It allows budget adjustment during the year.
5. It links budget with corporate objectives
6. It provides the management with significant data base and can be helpful to
operational audit.
7. Resources should be allocated efficiently and economically
8. Leads to increased staff involvement at all levels.
9. Attention is focused on outputs in relation to value for money
10. Knowledge and understanding of the cost behavior patterns of the organization
will be enhanced.
Disadvantages
1. It requires more-time (time consuming)
2. It expects a high degree of managerial skills
3. Its application is limited
4. It may emphasize short-term benefits
5. Managers, staff and unions may feel threatened.
6. The rankings of packages may be subjective where the benefits are of a
qualitative nature
7. Difficult to compare
8. The budgeting process may become too rigid and the company may not be
able to react to unforeseen opportunities or threats
9. Incremental costs and benefits of alternative courses of action are difficult to
quantity accurately.
Budget preparation
Master preparation
The master budget is a summary budget which incorporates all functional budgets

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Is the budget into which all subsidiary budgets are consolidated? It includes:
1) Budgeted income statement
2) Budgeted balance sheet
3) Budgeted cash flow statement (cash budget)
Functional budgets
Functional budgets are prepared and consolidated to produce the master budget. The
normal assumption is that demand is the principal budget factor
Functional budget is useful for variance analysis
Production budget
Budgeted production = Forecast sales + Closing inventory – Opening inventory
Or
Budgeted production = Forecast sales + Increase in inventory
Material usage Budget
Material usage = Usage per unit x units produced
Materials purchase Budget
Materials purchase budget = Forecast materials usage + Increase in inventory
Or Materials purchase budgeted = Forecast materials usage + Closing inventory-
Opening inventory

Illustration
A company plans to sell 400 units in the forthcoming year. Inventories of 100 units
of finished goods and 300kg of raw materials are held at the current year end. They
are both expected to fall by 25% during next year due to more efficient stockholding
procedures. A loss of 10% is expected on all raw materials received from suppliers.
One unit of output requires 5 kg of raw material.
What are the budgeted production units, raw material usage and raw material
purchases?
Solution
Budgeted production = 400 + 75 - 100 = 375
Raw material usage = 375 x 5 = 1875kg
Raw material purchases = 1875 + 225 – 300 =1800 kg
(Excluding losses) = 1800 = 2000kg
0.9
Working note:
100 x 25% = 25 100 - 25 = 75
300 x 25% = 75 300 - 75 = 225
100% -10% = 90% Or 0.9
Flexible Budgeting
Is prepared at a single level of activity, prepared with the cost behavior of all cost
elements known and classifieds either fixed or variable
Prepared at a number of activity levels and can be “flexed” or changed to actual level
of activity for budgetary control purposes.
Illustration
The expenses budgeted for production of 10,000 units in a factory is furnished below:
Per unit
Ksh
Materials 70
Labour 25
Variable overheads 20
Fixed overheads (100,000) 10

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Variable expenses (Direct) 5
Selling expenses (10% fixed) 13
Administration expenses (50,000) 5
Distribution expenses (20% fixed) 7
155
Prepare a budget for the production of (a) 8,000 units and (b) 6,000 units, for the year
ended 31st Dec. 2010. Assume that administration expenses are rigid for all level of
production.

Solution
Flexible Budget (for the period ended 31st Dec.2010
Level of operation
8,000 units 6,000 units
Ksh Ksh
A: Variable Costs:
Materials 560,000 420,000
Labour 200,000 150,000
Variable expenses 40,000 30,000
Variable overheads 160,000 120,000
Total of A 960,000 720,000
B: Semi-Variable Costs:
Selling expenses 106,600 83,200
Distribution expenses 58,800 47,600
Total of A & B 1,125,400 850,800
C: Fixed Costs:
Fixed overheads 100,000 100,000
Administrative expense 50,000 50,000
Total A+B+C 1,275,400 1,000,800
Working note:
Selling expenses
Total selling expenses 10,000 units (130,000 – 13,000) = 117,000
117,000/10,000 = 11.70
11.70 x 8,000 = 93,600 + 13,000 = 106,600 at 8,000 units
11.70 x 6,000 = 70,200 + 13,000 = 83,200 at 6,000 units
Distribution expenses
Total distribution 10,000 units (70,000 – 14, 000) = 56,000
56,000/10,000 = 5.60
5.60 x 8,000 = 44,800 + 14,000 = 58,800 at 8,000 units
5.60 x 6,000 = 33,600 + 14,000 = 47,600 at 6,000 units
Selecting a suitable budgetary system
There are many approaches to budgeting and organization will wish to select a system
which is most appropriate.
Factors, which will determine suitability include:
1. Type of organization
2. Type of industry
3. Type of product or product range
4. Culture of the organization
Information for budgeting
Main sources of information for budgeting purpose are:

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 1. Previous year’s actual results
2. Managers knowledge
3. Research and development of new product and study techniques.
4. Statistical techniques such as linear regression may help to forecast sales.
5. External sources of information i.e. suppliers price list, estimates of inflation
and exchange rate movements.
Uncertainty surroundings budgeting
Since budgets are predictions and plans for the future, non-controllable events will
make the outcome of particular actions uncertain.
Factors contributing to uncertainty:
1. Sales may be lower owing to recession
2. Customers may be lost owing to lack of goods of lower productivity
3. Inflation
4. Government fiscal policy
5. Natural disasters.
6. Changes in suppler costs and terms of supply
Spreadsheets in budgeting
A spreadsheet is a computer package which stores data in a matrix format where the
intersection of each row and column is referred to as a cell.
Advantages of spreadsheets
1. Handles very complex problems
2. Formulae and look up tables can be used so that if any figure is amended, all
the figures will be immediately recalculated.
3. The results can be printed out or distributed to other users electronically,
quickly and easily.
4. Most programmes can also represent the results graphically e.g. balances can
be shown in a bar chart.
Disadvantages of spreadsheets
1. Take time to build up and develop.
2. Data can be accidentally changed (or deleted)
3. Errors can be produce invalid output
4. The manipulation of the data using such a mathematical approach may lead to
loss of the original concepts.
5. Access to unauthorized users (security)

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