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CHAPTER 25: COST MANAGEMENT - BUDGETARY CONTROL

Introduction

Budget, budgeting, budgetary control and standard costing are essential tools frequently used by business executives for the purpose of planning, execution and control of business activities. In the case of budgetary control, the exercise starts with the setting up of budgets or targets, measuring achievements, comparing actual achievements with budget and ends with the taking remedial actions, in case the actual figures differ with the budgetary ones.

Meaning of Budget and Budgeting

Budget — CIMA defines a budget as, “A budget is a financial and/or quantitative statement, prepared prior to a defined period of time, of the policy to be pursued during that period for the purpose of attaining a given objective.”

Features of Budget

A Budget must be expressed either in quantitative form i.e., the number of units of different products or it may be expressed in rupees of each product or it may be quantitative and financial form i.e., the number of units and rupees of each product etc.
It must be prepared before the time for which it is required, for example, if budget is required for the year 2013-14, it must be prepared in the year 2012-13.
Budget must be prepared for a definite period.
Budget must be prepared in accordance with the policies of the business enterprise.
Budgets are prepared normally for attaining organisational objectives, because policies are formulated to achieve the objectives and those are translated into quantitative and financial form.

Preparation of Budget

The preparation of budget requires many important activities as enumerated below:

Definition of Objective — A budget is a plan for the achievement of certain organisational objectives. It is therefore desirable that these objectives are defined precisely.

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Location of the Key or Budget Factor — Key budget factor sets a limit to the total activity. For e.g., Non availability of power does not allow production to increase in spite of demand. For proper budgeting, it must be identified and its influence on production on sales estimated properly while preparing the budget.
Appointment of Budget Controller — Formulation of a budget usually requires service of a whole-time senior executive. He must be assisted in this work by a Budget Committee, consisting of all the heads of departments along with the Managing Director as the Chairman. The Budget Controller/Officer is responsible for coordinating and development of budget programmes and preparing the manual of instruction, known as Budget manual.
Preparation and circulation of Budget Manual — The budget manual is a booklet specifying the objectives of an organisation in relation to its strategy.
Fixation of Budget Period — The period covered by budget is known as budget period. In practice the budget committee determines the length of the budget period suitable for the business.
Determination of Standard activity or Output — For preparing budget for the future, past statistics, though important, cannot be completely relied upon. Therefore, though results of the past should be studied, but these should only be applied when there is a likelihood of similar conditions repeating in future.

BUDGETARY CONTROL

Budgetary control is defined as “the establishment of budgets relating 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 objective of that policy or to provide a basis for its revision.”

Steps for Budgetary Control

Establishment of Budgets

Budgetary control primarily aims at preparation of various budgets such as sales Budget, production budget, overhead expenses budget, cash budget etc.
Responsibilities of executives

The budgetary control system is designed to fix responsibilities on executives through preparation of budgets.
Policy making

The established policies of the organisation are designed as budgets so as to fix responsibility on executives.

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Comparison of actuals with budgets

After establishing the budgets, the actuals are compared with them and any deviations, if any are called variances.
Achieving the desired result

The desired result of the budgetary control system is comparison of actuals with the budgeted results and the causes of variances, if any, are analysed.
Reporting to Top Management

After the causes of Variances are analysed, the variances and their causes are reported to top management so that the remedial action can be taken.

PAGE 46 — CLASSIFICATION OF BUDGET

The page contains a diagram titled:

CLASSIFICATION OF BUDGET

The diagram organizes “Budget” under five main bases:

                                  BUDGET
                                     |
        ----------------------------------------------------------------
        |                 |                 |             |            |
    Period/Time     Nature of          Functions     Master Budget  Capacity
                    expenditure
                    and receipts
        |                 |                 |                            |
   -------------       ---------       -------------------------      -----------
   |      |      |       |      |       |      |      |      |        |         |
 Long   Short Current  Capital Revenue Sales Production Materials   Fixed    Flexible
 Term   Term  Budget   Budget  Budget   Budget  Budget   Budget     Budget     Budget
 Budget Budget
                                                |
                                           Purchase Budget
                                                |
                                            Cash Budget
                                                |
                                       Direct Labour Budget
                                                |
                                  Selling & Distribution Cost Budget
                                                |
                                  Administration Cost Budget
                                                |
                                    Capital Expenditure Budget
                                                |
                                             R&D Budget

More explicitly, the visible classification is:

Period/Time

Long Term Budget
Short Term Budget
Current Budget

Nature of expenditure and receipts

Capital Budget
Revenue Budget

Functions

Sales Budget
Production Budget
Materials Budget
Purchase Budget
Cash Budget
Direct Labour Budget
Selling & Distribution Cost Budget
Administration Cost Budget
Capital Expenditure Budget
R&D Budget

Master Budget

Master Budget

Capacity

Fixed Budget
Flexible Budget

PAGE 47 — CLASSIFICATION OF BUDGETS

Budgets are broadly classified based on:

Time
Nature of expenditure and receipts
Functions
Master Budget
Capacity

ON THE BASIS OF TIME

a) Long term budget: Budget prepared covering a period of more than a year. Of course, it may be for 3 years, 5 years, 10 years and even 20 years etc.,

b) Short term budget: These budgets are generally for one or two years and are in the form of monetary term.

c) Current budget: The period of current budget is generally of months and weeks. These budgets relate to the current activities of the business.

ON THE BASIS OF NATURE OF EXPENDITURE AND RECEIPTS

a) Capital Budget: It is a budget prepared for capital receipts and expenditure such as obtaining loans, issue of shares, purchase of assets, etc.

b) Revenue Budget: A Budget covering revenue receipts and expenses for a certain period is called Revenue Budget. Examples: Sales, other incomes, purchases, administrative expenses etc.

ON THE BASIS OF FUNCTIONS

Functional Budget: If budgets are prepared of a business concern for a certain period taking each and every function separately such budgets are called functional budgets. Example: Production, Sales, purchases, cost of production, cash, materials etc.

Types of Functional Budgets

Sales Budget: The sales budget is a forecast of total sales, expressed in terms of money or quantity or both. The first step in the preparation of the sales budget is to forecast as accurately as possible, the sales anticipated during the budget period. Sales forecasts are usually prepared by the sales manager assisted by the market research personnel.
Production Budget: The production budget is a forecast of the production for the budget period. Production budget is prepared in two parts, viz. production volume budget for the physical units of the products to be manufactured and the cost of

PAGE 48 — TYPES OF FUNCTIONAL BUDGETS

production or manufacturing budget detailing the budgeted cost under material, labour, and factory overhead in respect of the products.

Materials Budget: The material budget includes quantities of direct materials; the quantities of each raw material needed for each finished product in the budget period is specified. The input data for this budget is obtained by applying standard material usage rates by each type of material to the volume of output budgeted.
Purchase Budget: The purchase budget establishes the quantity and value of the various items of materials to be purchased for delivery at specified points of time during the budget period taking into account the production schedule of the concern and the inventory requirements. It takes into account the requirements for the entire budget plan as per the sales, materials, maintenance, research and development, and capital budgets. Purchases may be required to be made in respect of direct and indirect materials, finished goods for resale, components and parts, and purchased services. Before incorporation in the purchase budget, these purchase requirements should be suitably ascertained. Purchase budget also includes material procurement budget.
Cash Budget: Cash Budget is estimated receipts and expenses for a definite period, which usually are cash sales, collection from debtors and other receipts and expenses and payment to suppliers, payment of wages, payment of other expenses etc.
Direct Labour Budget or Personnel Budget: This budget is based on: (a) Production Budget, (b) Sales Budget, (c) Capital expenses Budget, (d) Research and Development cost Budget, (e) possibility of new wage agreements. The main purposes of this budget are to: (1) help in the efficient labour management, (2) show the planned outlay on direct and indirect wages.
Selling and Distribution Cost Budget: This budget is based on: (a) Sales budget, (b) Selling and Distribution cost budget for the current period, (c) Actual selling and distribution costs for the current period, (d) Expected changes in the rate of commission on sales, method of distribution, advertisement policy, etc.
Administration Cost Budget: This budget shows the total estimated cost of administration, i.e. cost of formulating the policy, directing the organisation and controlling the operations. Most of the expenses relating to administration are of ‘fixed’ nature within defined limits. This budget is easy to prepare. Formally each budget centre or department prepares its own budget which gets incorporated in this budget afterwards.
Capital Expenditure Budget: It is the planned outlay on fixed assets viz. Land, Building, Plant &Machinery etc. during the budget period. This budget is generally prepared for a long period, say5 or 10 years. For control purposes, it is broken down into short periods. Preparation of this budget is the responsibility of Head of Accounts,

PAGE 49 — CAPITAL EXPENDITURE, R&D, MASTER BUDGET AND CAPACITY

who will be assisted by the plant manager and other functional heads, based on a number of information, e.g.

a. Plant utilisation budget

b. Long term business policy

c. Potential demand for certain products

d. On the basis of information, a company may decide for extension factory capacity, purchase of new and better factory equipments which will entail heavy capital expenditure.

Research and Development Budget (R & D Budget): It is a planned outlay on R & D activities of a company. The budget covers materials, equipments and supplies, salaries, expenses, and other costs relating to design, development, and technical research projects.

MASTER BUDGET:

Once all the functional budgets are created, then the master budget is prepared. It is an integrated budget that reflects the estimated profit and loss and financial position using Budgeted Profit & Loss Account and Budgeted Balance Sheet of the concern. Master budget, also known as summary budget or finalized profit plan, combines all the budgets for a period into one harmonious unit and thus, it shows the overall budget plan. Before the budget plan is put into operation, the master budget is considered by the top management and revised if the position of profit disclosed therein is not found to be satisfactory. After suitable revision is made, the master budget is finally approved and put into action.

ON THE BASIS OF CAPACITY

Fixed or Rigid budget: A fixed budget is a budget designed to remain unchanged irrespective of the level of activity actually attained.
Flexible Budget: A flexible budget is defined as a budget which, by recognising the difference between fixed, semi-variable and variable costs is designed to change in relation to the level of activity attained.

ZERO-BASED BUDGETING (ZBB)

It is an approach to making a budget from scratch. It is prepared by not considering the figures of last year and by assuming zero base.

Zero-Based Budgeting (ZBB) is a method of budgeting which requires each cost element to be specifically justified, though the activities to which the budget relates are being undertaken for the first time, without approval, the budget allowance is ‘zero’. It is an activity based

PAGE 50 — ZERO-BASED BUDGETING AND PERFORMANCE BUDGETING

budgeting system in which budget is prepared for each activity and the justification in the form of cost-benefits for the activity is necessary to be given. The activities are evaluated and prioritised by the management based on the factors viz. availability of funds, regulatory requirement, parity with organisational objectives etc.

ZBB involves various stages:

(a) Identification of decision packages and their description in detail,

(b) Evaluation of decision packages,

(d) Allocation of resources after approval of the budget committee and the top management.

Zero-based budgeting is better than traditional budgeting due to following reasons:

It gives an opportunity for the management to allocate resources to various activities after a detailed cost benefit analysis.
It helps the management to identify wasteful expenditure and eliminate them.
It also facilitates the management in linking the functional budgets with corporate objectives.
It facilitates introduction of a system of Management by Objectives (MBO).

PERFORMANCE BUDGETING

It involves evaluation of the performance of an organisation in the context of both specific as well as overall objectives of the organisation. The responsibility of various levels of management is predetermined in terms of output or result keeping in view authority vested with them. The main concepts of such a system are enumerated below:

It is based on a classification of managerial level for the purpose of establishing a budget for each level. The individual in charge of that level should be made responsible and held accountable for its performance over a given period of time.
The starting point of the performance budgeting system rests with the organisation chart in which the spheres of jurisdiction have been determined. Authority leads to the responsibility for certain costs and expenses which are forecast or present in the budget with the knowledge of the manager concerned.
The costs in each individual’s or department’s budget should be limited to the cost controllable by him.
The person concerned should have the authority to bear the responsibility.

VISUAL / DIAGRAM CHECK

The source contains an image-based classification diagram on page 46, which has been converted above into a structured text hierarchy. Its main branches are:

Budget →

Period/Time → Long Term Budget, Short Term Budget, Current Budget
Nature of expenditure and receipts → Capital Budget, Revenue Budget
Functions → Sales Budget, Production Budget, Materials Budget, Purchase Budget, Cash Budget, Direct Labour Budget, Selling & Distribution Cost Budget, Administration Cost Budget, Capital Expenditure Budget, R&D Budget
Master Budget → Master Budget
Capacity → Fixed Budget, Flexible Budget

No other separate tables/diagrams are visibly embedded in the supplied 8-page document; the remaining pages are text-based content.

L-25-COST MANAGEMENT - BUDGETARY CONTROL